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What COVID-19’s impact on commercial real estate means for financial institutions

May 12, 2020

The COVID-19 pandemic has had serious implications for most businesses, including commercial real estate.

Many retailers are closed and restaurants, if open, are delivery or pick-up only or serving at lower capacities based on state mandates. The hospitality industry is reeling. Student housing occupancy for fall has taken a dive. There is concern in multi-family units over rent collections and rent growth.

Data centers appear to be among the few sectors holding up given that more employees are working from home and social-distancing guidelines have increased demand for bandwidth. 

Here is a look at what the lingering impact of COVID-19 will have on financial institutions (FI) and their customers.

Subleases

There will be an increase in subleased space, particularly office space. Sheltering at home has forced many companies to rethink their approach to letting employees work from home. Technology has made it possible for employees to be nearly as efficient working from home as in the office. The practice of social distancing is much easier when employees continue to work from home. By having employees continue to work from home, the office footprint will be smaller, giving rise to subleasing of office space.

Impact on customers: By subleasing some of their office space, reducing their office footprint and having employees shoulder the costs of their own office space, operating costs will decrease, which will also improve their cash flow.

Impact on FI: FIs may also be able to take advantage of subleasing office space that was utilized by operational areas. This too will improve the cash flow and increase other operating income for the FI. By customer’s subleasing their extra space and improving cash flow, it reduces the risk of default on any loan secured by real estate that is subleased.

Renegotiated leases

The weakness in commercial real estate makes this a lessee market. Lessors want to maintain current tenants in most cases. The greatest pressure to maintain tenants will be in the retail market. The retail industry has been under pressure for several years and COVID-19 has made it much more challenging. From regional shopping centers and strip centers to free standing retail and restaurant facilities, the challenge has never been greater. In order for many tenants to survive, cost controls will be key, and at the top of the list is rent expense. Landlords have already been bombarded with rental deferment requests and should be preparing for requests for renegotiated leases. Retail landlords are not the only ones who should be preparing for such requests, many CRE landlords have or will be receiving similar requests to renegotiate lease terms.

Impact on  customers: Losing a tenant during recessionary times is difficult on cash flow and renegotiating their lease may be a better option in the near term. Conversations must be made with your lending customers who are in the office/retail leasing space to determine if, in the long run, it is better to have a tenant at a reduced rate than no tenant at all.

Impact on FI: Like subleases, FIs may also be able to take advantage of renegotiating office space that is utilized by operational areas. If the FI has determined that it is more effective for its employees to work from home, then they may need less space for the future. Conversely, if it is necessary to have all employees back in the office or branch, this may be an opportunity to take advantage of new lease terms and concessions to make space more effective for social distancing. For any new/renegotiated leases, the impact of the new accounting rules for leases (when adopted) should be considered for its impact on capital.

Missed rental payments/vacancies

While many landlords have reported receiving April rent payments, there is concern about May and June rent payments. Many retail/restaurants tenants were unable or unwilling to pay rent in April. Many more anticipate not being able to make payments in May and June, and other business sectors may be unable to pay as well.

Vacancy levels will rise as businesses are unable to continue operating in the new environment. In addition, businesses with multiple locations will consolidate with more employees working from home. Business expansion will slow, at least in the near term. Construction projects will slow, and speculative projects will find it harder to fill space — at least at the initial projected rental rates.

Net Operating Income (NOI) will decline as vacancies increase, payments are missed and leases are renegotiated. The expense side won’t decrease much if at all. Distributions will decrease and some property owners will be forced to contribute capital to some projects. Capitalization rates may increase. The result is lower property values.

Impact on  customers: Property owners are turning to their landlords (your customer) requesting payment relief in the form of payment deferrals. As a result, your customer is requesting deferment of payments or other loan modifications. The hope is that the Payment Protection Plan (PPP) and Economic Injury Disaster Loan (EIDL) programs will help bridge the gap for businesses to survive and assist with rent payments.   

Impact on FI: If the FI has tenants that are delinquent on rent, accommodations may be necessary, therefore reducing other operating income. On their borrower’s sides, as noted above, there may be requests for loan modifications. If the borrower was able to take advantage of PPP or EIDL or other modifications as agreed to by the FI, the FI may not have to classify this credit as a troubled debt restructuring. If the customer did not receive PPP, EIDL funds or modifications during the COVID-19 crisis emergency timeframe, an analysis would be necessary to determine if it is a troubled debt restructuring and any related impact on the allowance for loan losses.

On a more global basis, the FI should be performing deep analysis on its loan portfolio at this time. With lower cash flow payments from its borrowers in terms of rental payments or reduced occupancies, stress testing on the market value and related collateral should be made. Concentrations should be drilled into, paying close attention to retail sectors and speculative construction projects and its impact on liquidity, credit and capital risk should be evaluated.

Risk/reward

Lower NOI will put increased pressure on lenders to modify or outright refinance many commercial real estate loans. This is an opportunity to strengthen your relationship with a borrower. The increased competition over last few years has caused lenders to give up on things which are just prudent lending. As a result, lenders cut rates and waived fees and terms to woo borrowers. In addition to current financial information from the borrower and guarantors, documentation should include increased financial reporting information such as rent rolls and operating statements on a quarterly or even monthly basis. Refinance penalties should be enforced if in place; if there are no refinance penalties, this is the time to consider them.  Another consideration is collateral coverage. If coverage is tight, or below policy, this is the opportunity to bolster your position and take additional collateral, if available. Consider the opportunity to pick up a guarantor on non-recourse loans.

Are lenders getting paid for the risk? These are also conversations to be discussed with your borrower. Rates are low, loan-to-values are high now and may increase due to lower rents, vacancies, etc., amortizations are being stretched, and yields are down. Discuss options with your borrower such as interest rate floors and loan fees. 

FIs need to be aware of what is transpiring with commercial real estate and be proactive with borrowers. Liquidity levels are key. As we learned during the Great Recession, highly leveraged borrowers are likely to struggle the most as they have few options to deal with the current crisis.

More conservative borrowers with good liquidity will find themselves in much better position to work with tenants and lenders to navigate the current situation as well as the lingering aftermath from this pandemic.  

Author(s)

Eric Van Doren
Eric E. Van Doren, CRC
Director, Loan Review
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Mikuta_Sara
Sara Mikuta, CPA, CGMA, CIA, CRMA
Risk Advisory and Forensic Services Partner
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