The pandemic has created or exacerbated stress in commercial real estate markets, providing opportunities for investors that could be amplified if the global economy rebounds strongly. John Murray, the head of PIMCO’s global private commercial real estate investment team, and Devin Chen, who oversees commercial real estate investment strategy, talk with Carrie Peterson-Brown, product strategist for our alternatives business. They discuss the current state of the market and where they see opportunities in commercial real estate assets.
Q: Could you briefly describe the current state of the commercial real estate (CRE) market?
Chen: The U.S. commercial real estate market is in a period of heightened volatility as owners, lenders, and renters continue to navigate the impact of COVID-19. While the CRE public markets, including the equity real estate investment trust (REIT) market and the commercial mortgage-backed securities (CMBS) market, are well above their pandemic lows from the spring, uncertainty persists. This is reflected in private transaction volumes, which are down 40%Footnote[i] since the end of the first quarter of 2020 with wide bid/ask spreads between would-be buyers and sellers. We estimate overall CRE values are down on average from 10% to 15%. However, there is substantial divergence across asset types, both in terms of operating fundamentals and valuations. While most property sectors have been negatively impacted by the recession, some have held up or even thrived.
Retail and lodging have been the clear losers. Retail has faced headwinds from e-commerce for years, and the fundamental pressures are particularly challenging in the U.S., which simply has too much retail – five or six times the retail space on a per capita basis compared to other developed countries like the U.K., Japan, and France. The pandemic has accelerated this downward trend. In contrast, we expect hotel to eventually recover, with some market segments, such as drive-to-leisure, recovering sooner than others.
The winners have been multi-family and industrial. Industrial has benefited from the same e-commerce trend that’s decimated retail properties, and we continue to see strong tenant and investor demand for warehouse assets. Multi-family has held up relatively well outside of the more dense urban markets: The sector is benefitting from the government stimulus programs and reduced consumer spending overall.
The office sector is the wild card. Current utilization rates of office buildings vary widely around the country. In some markets, like Dallas, utilization rates are around 50%,Footnote[ii] while in denser markets, like San Francisco and New York, utilization rates are in the low teens. How does that translate longer term after we return to the office? Most agree working remotely will persist to a degree, but that will be somewhat offset by tenants requiring more space per employee. Office performance is likely to experience significant dispersion in the coming years based on markets and the quality of asset; but generally speaking, buildings that cater to smaller tenants will face the more significant headwinds as smaller tenants tend to be more sensitive to rental expenses, and thus more prone to re-evaluate their space needs after realizing that they can work remotely without sacrificing too much productivity.
Q: Where do you see opportunity in public real estate markets?
Murray: The public side is where the distress and the opportunity was this summer, both in the REIT sector as well as in CMBS. Even investment grade CMBS was down over 20% at the lows this past spring in 2020. Indeed, we were rather active this summer, taking advantage of those dislocations, acquiring distressed REITs and CMBS positions.
We have seen a significant recovery in the public space, but with two lingering takeaways. First, the dispersion of performance between different REIT sectors has been sizeable. Second, on the CMBS side, low rates and government-led capital injections have benefitted senior, investment grade CMBS; however, liquidity pressures deeper in the capital structure (i.e., closer to the equity value) persist, resulting in a steeper credit curve.
Thus, while the beta in REITs and CMBS is not as compelling as this past summer; the dispersion between REIT names, and the steeper CMBS curve suggest alpha opportunities in the public space. We’ll also note that there are nearly $30 billion of loans in delinquency in CMBS,Footnote[iii] which foreshadows some of the distress and the opportunity that has yet to play out.
Q: With the major dislocation in the public markets largely behind us, are opportunities shifting to the private sector?
Murray: Essentially, at the same time massive liquidity-driven dislocations were playing out in public markets, the private side called time-out. This includes typical retail asset tenants who couldn't open for business and asked for a time-out on their rent with landlords; landlords turned around and asked their lenders for a time-out on debt service. The same occurred in the hotel space. The challenge is that lenders used other reserves – maybe capital reserves in the loan – to fund some of these operating shortfalls. Unfortunately, that only bought about six months of time, and now reserves are depleted, and the time-out is over in many cases.
This past fall we entered the second stage of the opportunity, which I would characterize as the liquidity shortfalls stage, which is a combination of capital injections and balance sheet “clean-ups.” Hotels are the obvious example of where capital injections are most needed; assets in this sector are generally experiencing negative cash flow even before debt service. In many cases, borrowers cannot simply raise new capital from their existing investors. Instead, a restructuring needs to occur, and perhaps new capital needs to be injected. This situation provides an opportunity for private investors to come into restructurings and provide rescue capital, whether it’s in preferred equity, or new debt, or some sort of a hybrid with an exchange for paying down some of the existing debt.
While hotels are the obvious sector in need of rescue capital, it’s not just hotels. We have also seen the same dynamic play out in levered lending platforms, whether it’s public mortgage REITs or private platforms that were borrowing on a short-term mark-to-market basis, but have long-term loan obligations.
Q: In terms of balance sheet clean-ups, should we expect a wave of non-performing loans?
Murray: We do not expect to see the same amount of non-performing loans (NPL) as we did in the global financial crisis, with all the residential distress that sat on U.S. banks’ balance sheets. Instead, today we are seeing lenders looking to get ahead of their problems and sell loans that are challenged – not necessarily non-performing – before any potential risk-rating downgrades or mark-to-market calls or margin calls on their lending facilities.
In Europe, we still see a healthy flow of non-performing loan activity, some remaining from the global financial crisis and some spurred in part by regulation. Around 2014 or 2015, thanks again in part to regulation, European banks began cleaning up their nonperforming loans, including some holdovers from the great financial crisis. While that trend continues, we estimate the current crisis has added another $1 trillion of nonperforming loans on European balance sheets, which roughly equates to the amount of nonperforming loan balances that were sold over the last six years. So in essence, this distress has wiped away the last five or six years of nonperforming loan sales, or deleveraging, in Europe. At the same time, regulatory changes like CECL (Current Expected Credit Losses), are forcing banks to account for expected losses even on loans that haven’t technically defaulted yet, which will accelerate bank loan dispositions.
Regarding the opportunities that will emanate from these bank pressures, it’s important to acknowledge that the cost of capital disconnect between a bank and an NPL buyer has slowed the pace of NPL transactions. Through complex structuring, however, we have been successful at bridging some of that cost of capital disconnect by creating separate CMBS-like structures, where the banks contribute loans into this structure that we manage, and we in turn contribute capital as well but charge higher rates for our share of tranches within the structure.
The other balance sheet clean-up opportunities we have seen, particularly this past summer, were in corporates. As the crisis unfolded we saw over $10 billion worth of corporate-related transactions, in which distressed corporates, such as retailers and cruise lines, were looking to pledge some of their own real estate to raise capital, whether it was through secured loan issuances or even sale leasebacks.
Chen: In the U.S. market, we are seeing an uptick in CRE loan sales. We recently acquired sub-performing loans at a discount to par as part of an $800 million loan pool being sold by a large international bank. We negotiated for accretive seller financing as part of the purchase. Most of the loan sale activity to date has involved performing and sub-performing loans.Footnote[iv] As John said, we have not seen as many sales of non-performing or distressed notes. Lenders are trying to avoid taking losses in this environment if they can. A couple of things likely need to happen for us to start to see an uptick in distressed loan sales. First, liquidity has to dry up for borrowers and lenders such that they can no longer afford to carry the underlying assets. Second, we have to continue to see more price discovery. Once there’s more clarity on value, it will make the decision to sell easier.
Q: How long do you think that will be before we start to see that true distress play out?
Murray: I would say the third and final phase of the opportunity is likely to begin in 2022. Deeper distress will take time to play out, just as we saw in the global financial crisis. The typical catalysts are longer-term leases rolling over, or loans maturing, as well as new regulation, which will certainly create dislocations in the commercial real estate sector. This time around, we also have secular pressures from demographic and ecommerce trends.
There are more than $2 trillion of loans in the U.S.Footnote[v] maturing over the next three years, including more than $40 billion just in CMBS of retail loans. In each of the last three years, we have seen over $100 billion of loan originations on transitional assets, such as an office building with a lease-up plan, or a repositioning of a retail development. These are properties that are facing some short-term cash flow shortfalls and need short-term loans to stabilize – these are also known as bridge loans. A lot of those loans are three-year floaters with a business plan embedded in them. We expect to see numerous borrowers not hitting their original business plan targets, creating additional pressure on the maturities front.
And we expect a lot of activity in office space over the next two to three years as leases mature and some businesses need less space. Certainly in the retail sector we have already seen this happen over time through ecommerce and the slow degradation in the retail space.
Q: So the transitional loan space is one area where there’s a persistent flow of origination opportunities, regardless of market cycle. Has the pandemic changed the opportunity set in that market?
Chen: COVID-19 has had a meaningful impact in three ways. First, it has created a supply and demand imbalance for capital. Due to uncertainty around the market and credit and liquidity concerns, a lot of lenders, particularly nonbank lenders, are focused on preserving liquidity and not providing new loans. This is happening in the face of a large wave of CRE loan maturities – over $400 billion annually.Footnote[vi]
Second, the pandemic has disrupted tenant demand and asset cash flows, and that is creating significantly more transitional asset profiles that require flexible capital. Finally, with CRE values down many owners prefer to refinance instead of selling in a down market. The combination of (i) a supply/demand imbalance for capital; (ii) an increase in transitional assets; and (iii) a desire by owners to avoid selling at a loss in this environment, means investors who are able to extend credit and provide liquidity for transitional assets today will likely have pricing power. And for the most part, lenders will be investing at a last-dollar cost basis that’s well below pre-COVID-19 levels.
Q: What are some things that investors should be mindful of as they are thinking about investing based on property type?
Chen: It’s important not to paint too broad of a brush when we talk about the outlook for a certain sector. Although a sector may be performing poorly in the pandemic, it may still present attractive investment opportunities. The lodging sector has arguably been more disrupted by the pandemic than any other property sector, with most hotels experiencing revenue per available room (RevPAR) declines of over 50%. But unlike the retail sector, we do not see a structural problem for hotels and believe these assets will eventually recover. Overall, we anticipate a return to 2019 RevPAR levels in the 2023/2024 time frame. With the price declines that have occurred, the hotel sector can offer compelling investment opportunities both in private equity and credit.
Murray: The industrial sector is the other side of the coin. It has been the darling of commercial real estate, particularly during this pandemic, but we note a couple things to be aware of. First, not all industrial is created equal. Certainly, the big-box, long-term Amazon-leased assets are in high demand, but a lot of industrial, including so-called last-mile industrial, are smaller footprint, older buildings. Smaller buildings imply smaller tenants, which can be of lower credit quality or more vulnerable during the pandemic, like restaurant or hotel suppliers. Second, industrial is not immune from shadow supply. This past summer, as many corporations looked to raise capital, we often saw them pledge their owned commercial real estate collateral, including a surprisingly large amount of warehouse space in many cases. This type of space does not appear in broker vacancy reports of the industrial sector, because it has been owned and housed, essentially, from some of the distressed corporates, including retailers.
Q: Any final thoughts on how to think about the risk versus opportunities?
Chen: While the opportunity set is robust, it can be quite complicated, whether it’s European non-performing loans that need a more structured solution, or distressed CMBS positions, bank sales, or even just complicated restructurings of traditional equity deals. In this particular distress cycle, integrated debt and equity platforms can potentially benefit both from a sourcing and an execution perspective, as the opportunities will emanate from multiple sources, including banks, levered lending platforms, and CMBS.
At PIMCO, we have the benefit of a platform that spans both public and private debt and equity, and infrastructure that includes proprietary analytics, a strong liability management platform, macroeconomic insights, and a dedicated group of more than 60 credit analysts who can offer insights on tenant profiles.