Forever-Empty Offices and Malls May Mean Pain for CMBS Investors

(Bloomberg) -- The more-than-$550 billion market for bonds backed by U.S. commercial mortgages may face losses even after promising Covid-19 vaccines become widespread, as key parts of the real estate market may not return to full strength anytime soon.

That’s what some analysts and investors that look at the securities are cautioning as the pandemic potentially changes the way Americans work and shop for good. Demand for office space, hotels, and stores may drop permanently as people grow used to working from home, conducting meetings via Zoom, and buying more online.

When the dust settles, losses may creep up into all but the safest securities, analysts said. Many notes rated in the BBB range could end up paying investors well below their face value in a bear-case scenario, and even some notes rated in the AA tier might be hit in several transactions, said Richard Hill, head of commercial real estate research at Morgan Stanley. While it may take a year or longer for the losses to show up, pain is coming, he warned.

“For property types that are really struggling, I’m not sure vaccines are changing that,” Hill said. “There will be a wave of forthcoming liquidations as special servicers take steps to resolve distressed loans.”

The bank is projecting that losses for the most common type of CMBS -- bonds known as conduit deals that are backed by dozens of different loans on properties such as hotels, offices, and malls -- could average 5% to 8%, depending the year the CMBS was issued. But there are also scenarios where notes rated BBB could take losses of around 64%, according to a Nov. 16 report from Morgan Stanley.

Some property types, such as warehouses, are performing a little better in the pandemic, Hill said. And any investors that are betting against commercial mortgage-backed securities now are going against the grain. Progress on a Covid-19 vaccine has lifted the asset class in tandem with markets around the world, and the cost of shorting the debt has been falling in recent weeks.

But the gains may be more a reflection of investors’ demand for yield rather than a belief that the market is safe again, Hill said.

Money managers should be looking more carefully at the risks they’re taking now, according to Dan McNamara, a principal at hedge fund MP Securitized Credit Partners, which is using derivatives to bet against commercial mortgage backed securities. He expects CMBS originally rated as high as BBB, or two steps above junk, to get hit.

“Investors in these securities will definitely take losses -- it’s just a matter of when,” McNamara said.

AAA to Junk

Debt investors face at least two primary risks. One is that many property owners will face pressure on their revenue until a vaccine is readily available to the public, which could be months for the general population. The second is that even after most people are inoculated, demand for places like malls, hotels and offices will continue to drop from its peak because of permanent changes in consumer and corporate habits.

Malls are being hit particularly hard now, McNamara said. Many troubled regional malls are being appraised by special servicers, companies that work out struggling properties, at values more than 50% lower than when they were initially securitized, he said. And sales at department stores peaked about 20 years ago, meaning that even when the pandemic lifts, malls will face pressure.

In August the Walden Galleria, a large mall near Buffalo, New York, was reappraised at a value of $216 million, a whopping 64% decline from when its mortgage was bundled into bonds in 2012. At least one of its main tenants, Sears, has abandoned the shopping center, leaving its space vacant, and Lord & Taylor announced that it plans to close its store at the location, according to S&P Global Ratings.

The mall defaulted on its mortgage in May and the loan was forwarded to a special servicer. That servicer agreed to a modification with terms that included, among other items, deferring the monthly debt servicing payments from June through the December 2020, S&P said.

On Nov. 20, S&P slashed ratings on notes from a single-property Walden Galleria CMBS to a junk grade of BB- from AA. Those securities had already been cut from AAA in April.

Rating moves like these could potentially cause another problem for CMBS holders: even if bonds don’t take actual losses, numerous downgrades may force some investors to sell, pushing down prices, market observers say.

“The challenge is that, even if you have adequate protection in your bond, and technically you will not be touched by a certain level of losses, that bond will be severely downgraded, which could lead to forced selling,” said Deutsche Bank AG analyst Ed Reardon.

Extended Forbearance

CWCapital, a special servicer, has already taken over some hotels and malls and will likely have to take over more, said Chief Operating Officer Jim Shevlin. The firm has staffed up over the last nine months, mainly with hospitality industry experts, and has grown its asset-management side by nearly 30%. The company has over 100 employees now.

It can take a year or longer for a lender to start foreclosing on a hotel, mall or office building. The process usually starts after the borrower tries to work out a different payment schedule and easier terms. Many borrowers that have already sought forbearance are seeking additional time, Shevlin said. For now lenders are usually granting those requests, and property owners in turn may be more willing to invest more equity in their properties if they’re confident a vaccine will bring revenue from the buildings back up.

There are enough commercial mortgages that are sufficiently well capitalized to easily make payments to investors holding CMBS rated BBB or higher now, said Jen Ripper, an investment specialist at Penn Mutual Asset Management in Horsham, Pennsylvania. “However, all deals are not created equal and there will be cases of losses going higher up the capital stack,” she added.

And there are still many unknowns -- including whether urban office buildings will have to cut lease prices to fill vacant space. Experts agree that it’s too early to tell definitively what will happen.

But there will probably be significant pain for property owners and CMBS investors, said Richard Carlson, a ratings analyst at DBRS Morningstar who reviews the operations and policies of CMBS servicers.

“Nobody knows how this will shake out,” Carlson said. “But one thing is for sure: there will certainly be losses for bondholders.”

©2020 Bloomberg L.P.