Are You Ready for Waves of Property Defaults?
The pandemic hit the hotel and office leasing businesses hard in 2020. Subsequently, lenders and investors have been closely monitoring their commercial real estate portfolios to reassess asset quality and underlying assumptions.
In 2020, CMBS and CRE CLO market participants saw major hotel chains, such as Hilton and Marriott, downgraded to their lender’s internal watchlist due to the deteriorating capacity to service outstanding debt amid the negative business outlook due to COVID-19 disruptions.
Large global office leasing businesses also announced profit losses during the fiscal year of 2020. “In offices across major U.S. cities, we saw continued declines in net effective rents,” noted Karen Brennan, the CFO of JLL (Jones Lang Lasalle), a Chicago-headquartered real estate services and investment group, speaking at the firm’s latest earnings call on February 9. The group saw 43% lower global office leasing volumes, year-over-year, as of December 31, 2020.
CRE Loan Quality Drops
As of February 2021, 8.23% of CRE loans were deemed criticized, indicating an elevated level of credit risk.
Notes: Criticized = percentage of loan outstanding balances risk rated Special Mention, Substandard, Doubtful, or Loss.
Source: RMA/AFS Risk Analysis Service
Hard Hits: Hotels and Offices
For banks and non-bank lenders, CRE industry headwinds raised significant concerns about what may be lurking within their credit portfolios. Data provided by the Risk Management Association (RMA) and Automated Financial Systems (AFS) has indicated an upcoming wave of loan defaults from the lodging real estate sector.
According to monthly bank loan data released by RMA’s Risk Analysis Service and AFS during a webcast on March 25, Credit Trends in Commercial Lending, the lodging sector showed the weakest credit quality within the CRE portfolio.
Specifically, about 45% of the lodging sector’s outstanding balance fell into the categories of nonaccruing or criticized, the RAS database shows. The database totals more than 700,000 individual loans, representing about $1 trillion in committed exposures from contributing banks in the US.
Hard Hits: Hotel Loans
As of February 2021, 45% of CRE loans in the lodging sector were deemed nonaccruing or criticized.
Notes: Criticized = percentage of loan outstanding balances risk rated Special Mention, Substandard, Doubtful, or Loss
Classified = percentage of loan outstanding balances risk rated Substandard, Doubtful, or Loss
Top property types based on the concentration of loan outstanding balances
Excludes Paycheck Protection Program (PPP) loans.
Source: RMA/AFS Risk Analysis Service
Rising vacancy rates seen across the office sector may reflect a reduction in demand resulting from 2020’s widespread transition to a remote working environment. Office space vacancies in New York City, Chicago, and Washington D.C. ranged from 11% to 18% at the end of 2020, up from 7% to 14% at the end of 2019, as per data provided by CBRE, a Dallas-headquartered commercial real estate services and investment group.
Rents for core locations have started to fall since Q4 2020. Moreover, the rate of decline is expected to accelerate over the next 6 to 12 months, according to CBRE’s Q4 2020 Office Data. For example, the commercial rental decline accelerated in downtown Chicago, where prime property rent decreased 9.5% year-over-year as of December 31, 2020.
Increased vacancy rates and declines in rental rates deal a one-two punch to CRE lessors reliant on monthly rental income as a source of repayment for lenders.
Wells Fargo, Bank of America, and U.S. Bancorp recently reported an increase in non-performing loan amounts as well as higher loan loss estimates in the commercial banking business segment, partly due to exposures in the CRE sector.
Wells Fargo’s Q4 results showed that its nonaccrual loans increased $706 million, or 9%, predominantly because of increases in the commercial real estate, residential mortgage, and lease financing portfolios.
Bank of America estimates higher credit losses in the near term, as per the latest earnings result. The bank is considering about $38.7 billion in commercial loans to be impaired as of Q4 2020. According to the quarterly disclosures, the bank saw an increase of $3.0 billion, or 8%, in the ‘commercial reservable criticized utilized exposure’, driven by commercial real estate, primarily hotels.
Bank of America's estimated amount for overall credit loan and lease losses was sized at $18.8 billion, representing 2.04% of total outstanding loans and leases. This was an increase from $9.4 billion, or 0.97% of the corresponding total amount from December 31, 2019.
U.S. Bancorp also reported an uptick in nonperforming loans during 2020 driven by increases in total commercial real estate nonperforming loans. Its Q4 2020 results show nonperforming assets were sized at $1.2 billion as of December 31, 2020, compared with $829 million from the previous year.
Note that banks’ adoption of the Current Expected Credit Loss (CECL) standard also impacts the comparison of year-over-year loan loss reserves, due to the transition from an allowance based on incurred losses in 2019 to an allowance based on expected losses beginning in 2020.
Evolving standards have also encouraged banks to advance their risk rating practices to mitigate concentration risk. For example, Bank of America decreased its provision expense for commercial loans in Q4, partially by reducing exposures to industries that were heavily impacted by COVID-19.
With that, credit officers are keen to use both qualitative and quantitative approaches to make risk rating changes and manage them across credit portfolios.
According to Seth Waller, CCO at TIAA Bank and RMA Credit Risk Council Chair, it is essential to consistently apply a given risk rating methodology to similar credit portfolio types and adjust downstream for idiosyncratic exposures. Additionally, he noted the need for more holistic lending and risk rating approaches.
“How do we think about this [loan] from a PD and LGD perspective and what types of factors would make us look at this particular loan as better or worse from the PD and the LGD perspective? Now that we moved to more of a quantitative approach that is in the hands of underwriters putting that transaction together, they are better equipped to understand the drivers that are important there,” noted Waller in an interview with RMA in November 2020.
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As Product Marketing Specialist, Adalla is responsible for driving both the strategic and tactical aspects of RMA’s product sales. Prior to RMA, Adalla worked as a reporter for global media services and publication groups such as PEI Media and the Financial Times Group. She started her career at Campbell Lutyens, a global private capital advisory group. As an avid learner and a curious adventurer, Adalla speaks Korean, English, and Spanish, and has traveled to 19 countries. She graduated from Incheon National University with a Bachelor of International Trade in Northeast Asia Economic Studies.