That’s right: 145 million.

Since April 2020, our lives have changed in myriad ways. We’ve become accustomed to our kids being home while “at school.” We’ve stopped eating out, going to the movies, and vacationing. And, many of us have turned our homes into our workspaces. When you combine this factor with the massive job losses resulting from the pandemic, physical office space requirements just won’t be what they were in the past.

A new study finds that the work-from-home increase resulting from the coronavirus pandemic could result in about 145 million fewer square feet of office space by the end of 2021. Global commercial real estate company Cushman & Wakefield have issued a report based on data covering widespread job loss during the pandemic combined with work-from-home mandates that demonstrate a significant decrease in the need for workplaces to provide office space. Their findings indicate a 50% baseline probability that space requirements in the US workforce will decrease by 145 million square feet during 2020 and 2021.

The study also found that the main driving force for this decrease in demand is job loss, and not the work-from-home trend – although both factor in. When compared with past recessions, these findings mean that this is the largest decrease in demand for office space ever. It outpaces the demand decrease from job loss in the Great Recession of 2008 by 30%.

Even when factors such as re-opening the workplace with six-foot distancing rules in place, the study finds that job losses and work-from-home will outstrip the need for physical square footage in the office. And, this trend was actually in place before the pandemic turned our lives upside down. Companies have been looking for ways to decrease spending, and, as a result, have been buying less office space for years.

The report’s 50% probability baseline for the 145 million square foot decrease is bookended as well with other potential scenarios. Depending on the pandemic’s impact on public health, and on the US government’s economic stimulus response (or lack thereof), those other potential scenarios could look better for commercial real estate – or, they could look a lot worse.

The study predicts a 10% possibility that job losses continue longer than anticipated, that Congress does not enact stimulus or economic relief legislation, and that the result is a loss of nearly 300 million square feet of office space – or, a 20% vacancy rate. That’s the worst-case scenario prediction. On the other hand, the scenario could work out with public health improving and job losses being staved off, and there could even be more governmental relief made available. If all goes in this optimistic direction, the study predicts a loss of a mere 69 million square feet of office space, and a vacancy rate that peaks at about 15%. The study gives this outcome a 10% probability rate as well.

If that’s the good news, then the only thing to be concluded from C&W’s findings is that commercial real estate is looking forward to massive decreases in the years, and maybe even generations, to come.

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Commercial real estate is currently in a state of great uncertainty, as is commercial activity in general. Because we do not know what we are facing in the long-term regarding COVID-19, business and property owners are dealing with very negative numbers in the moment that may or may not continue.

During a TreppWire podcast, the Vice President of Commercial Real Estate Product Management, Lonnie Hendry,  shared his ideas around accurately evaluating commercial properties during the COVID-19 pandemic. Will it ever be possible for appraisers to accurately value commercial real estate during COVID-19?

Landry explains that one of the largest challenges appraisers are facing is how to provide a view on a property that can be verifiable with hard, timely data. “That opinion has to be based on facts,” Hendry explains further adding that the data is used to calculate property values during periods of market stability including revenues, cap rates, occupancy, and expense ratios. These all come into question during a period like the current one, where sales are non-existent and comps from the last two months are mostly worthless.

Hendry suggests a few potential methods for generating accurate valuations. First by treating COVID-19 as a short-term proposition and valuating the property as stabilized, as he explained, “we’re going to attribute some form of economic obsolescence to this short-term downturn in the marketplace.”

The second approach Hendry offers is dividing a single year’s NOI by a property’s cap rate and reinforcing that calculation with a discounted cash flow analysis. Hendry says, “where you look at maybe the first couple of periods of that discounted cash flow being very negatively impacted by losses in revenue and corresponding cash flow and then ramping up stabilized operation over the remainder of the holding period.”

The third potential scenario includes collecting a store of data that places a distinct emphasis on past downturns and the quantifiable impacts they had on the value of commercial real estate.  This may provide some guidance for the rest of this pandemic once the data is collected, organized, and analyzed – and be even more beneficial for the possible next pandemic.

Wheeler Capital Partners President, Joe Wheeler, says “I think this is an unprecedented event where you basically have a total market collapse across most asset types across the nation. And so logic has to come in as well to say, ‘Nobody really knows what the answer is in terms of where that stabilized market is.”

The numbers around commercial properties will continue to be perilous for the foreseeable future. To gain an appropriate appraisal, longer trends will need to be studied. The collapse of 2008 led to a severe new construction contraction, but the market for existing structures didn’t suffer as severe a hit. While uncertainty about new buildings will continue for a time, existing buildings may come back up in value as the nation adjusts to coronavirus challenges.

The after-effects of the subprime mortgage crisis are still being felt across the lending industry. While recovery may not have been necessarily swift, there is ample evidence that the industry is recovering well and is even entering a boom period. A national housing shortage has led to a critical need for multi-family housing, creating a favorable economy for commercial real estate investors. Both investors and lenders have responded to the need, leading to a record year for commercial real estate and multifamily lenders. In 2018, closed loan originations rose eight percent to reach a peak high of $574 billion, with loans for multifamily properties accounting for nearly half of all originations.

In spite of the surge of originations, CRE loans for some of the nation’s largest banks are actually tapering off. Contributing factors include a resurgent CMBS market as well as increased competition from smaller banks and even life insurers. Smaller banks, in particular, are seeing a significant increase in holdings across three key categories: construction and development, nonresidential and multifamily.

In January, construction and development loans were up from the previous year-end by an annualized 11.9%; multifamily was up by an annualized 6% and nonfarm, nonresidential was up an annualized 4.7%. Numbers for the top 25 banks in the US, however, showed a marked decline in the same categories, with construction and development loans dropping by nearly $700 million in January, contributing to an annualized decline of more than 7.5%.

Traditionally, the first quarter of the year shows a significant seasonal decline over the last quarter of the previous year and this year was no exception. While originations in the first three months of the year were 34 percent lower than the fourth quarter of 2018, according to research from the Mortgage Bankers Association, commercial and multifamily mortgage loan originations rose 12 percent in comparison to the same period last year. This points to the momentum gained in 2018’s record year of borrowing and lending showing no signs of slowing down any time soon. According to Jamie Woodwell, MBA’s Vice President of Commercial Real Estate Research, first quarter volumes were higher in nearly every property category.

Among capital sources, Freddie Mac and Fammie Mae led the way by showing double-digit loan volume growth. CRE continues to be an attractive market to borrowers thanks to continued low interest rates and strong property values. In the commercial/multifamily category, a 73 percent increase in originations for industrial properties, a 41 percent increase in health care and a 14 percent increase in hotel properties led to an overall increase in lending volume. In fact, that only dollar volume that remained unchanged was for office property loans, with all other categories seeing anywhere from a marginal to a significant increase. With no end in sight to housing shortages across the nation, there is no reason to believe that the last three quarters of 2019 will show an end to the momentum gained in 2018. In fact, 2019 might even be poised to shatter the records set in 2018.

Understanding the Current State of Commercial Mortgage-Backed Securities

At one time, commercial mortgage-backed securities were very popular. In recent months, however, lenders offering this option are having a hard time retaining market share in this area. The market is just so competitive right now, and it also doesn’t help that conduit lending is suffering as a whole.

Trepp, an analytical securities and investment management company, is forecasting that CMBS issuance will decline in 2019 by about 5 to 10 percent. This declining trajectory is following the same path in 2018 when CMBS issuance totaled $77 billion in the United States as compared to the $87.8 billion in the same time frame of 2017.

What is Causing this Rapid Decline?

As unfortunate as these facts may be for lenders, the truth is that CMBS lending is down. The important thing is to determine why. After all, that is the only thing that’s going to bring about any kind of change.

One cause industry experts propose is fewer maturities being readily available. In the future, the volume of maturities is likely to increase. Hopefully, that will help the state of CMBS, but as of now, the market is really suffering.

Increasing competition is also a problem affecting the CMBS scene. While CMBS was once the most popular type of higher leverage loans, capital is more commonly moving into higher yielding options these days. These include options like private equity debt funds or mezzanine loans. Not only are such loans typically higher-yielding, but they are also more flexible, which makes them appealing to more and more diverse investors.

Due to that competitive landscape, CMBS lost traction in 2018. Shorter duration loans were more interesting to borrowers last year, perhaps because of late stage business plans. Per Joe DeRoy, a senior vice president and CMBS program leader for KeyBank Real Estate Capital says, “We saw a lot of five to seven-year requests in 2018, more than we had seen in years prior.” Borrowers were able to obtain more leverage through the CLO market than the CMBS market by going with the three-year/plus one/plus one route on non-recourse floating rate debt.

Reference: https://www.nreionline.com/cmbs/cmbs-issuance-might-decline-5-10-percent-2019

Credit Quality is Deteriorating

Moody’s Investors Service is expecting that debt service coverage ratios of loans that are newly originated will continue to decline in 2019 coupled with rising interest rates. They also expect CMBS exposures to interest-only loans, single-tenant loans, and loans with subordinate debt will remain high. Because of the moderately rising interest rate environment and refi valuation, interest-only loans are viewed as riskier. According to Moody’s research, more than half of the 2.0 CMBS loans are interest-only which reminds everyone of 2007 levels.

Can Anything Be Done to Improve the CMBS Scene?

In 2019, the fate of CMBS will be linked to performance in other markets such as residential, high yield, and corporate credit markets. While things are not looking great for CMBS lenders at the current moment, there are things that could help change that in the future.

Already, many in the CMBS market are making the smart move of sourcing low leverage loans to help balance out the losses they are experiencing and to make this type of lending more accessible for more people.

Offering interest-only loans is an other strategy that is proving very helpful for CMBS lenders. Furthermore, CMBS lenders that differentiate themselves by offering new products or services also stand a good chance of “staying afloat” and riding out this tough time for CMBS loans.

There are key issues to watch for in 2019 such as major corporations like GE being downgraded, large ETF outflows, and how the leveraged loan market will function. These factors may cause CMBS spreads to widen and at some point, the other asset classes become very competitive with CMBS, which usually prompts investors to recalibrate.

The important thing to remember in the financial sector is that fluctuations are common and always will be. The key is to predict these fluctuations as well as possible and then to work hard to combat and protect against those that may have a temporarily negative effect.

Over the last 10 years, the floodgates of capital have opened dramatically in the real estate market, and continue to remain open, providing borrowers and investors with more options and opportunities.

How We Got Here

In the immediate years following the Great Recession of 2008, capital was severely limited. Institutional lenders had practically frozen new lending activity, and the investments of most legacy private sources of capital had crashed as a result of the rapid loss of value in real estate assets, poor credit decisions and highly-leveraged investments.

New private lenders that entered in the market during this time lent on assets whose values had readjusted to the existing market conditions, and as a result, increased their equity positions with a lower cost basis. Meanwhile, federal regulation, spurred by the 2010 Dodd-Frank law, weighed heavily on banks and other traditional lenders, further limiting the availability of capital

Then market started to adjust. It didn’t take long for conditions and subsequent actions resulting from the recession—historically low interest rates and low construction costs, combined with new monetary and fiscal initiatives—to stimulate the economy. Even before the institutional world took notice, and as they reeled from the recession, private investors had started buying and developing again, especially in emerging submarkets like Brooklyn on the East Coast, and in the West, the Arts District of downtown Los Angeles.

Institutional capital soon followed, as did private lending. The lower cost of capital in the market allowed newly-formed debt funds backed by private equity, hedge funds and life insurance companies, to deploy capital on commercial and residential lending opportunities, while arbitraging the increasing spreads. The combination of more available capital, low borrowing costs, depressed valuations and attractive pricing on raw materials, started heating up the real estate market again.

Fast Forward to Today

The tax cut passed earlier this year also has been a boon for financial institutions. The larger banks and institutions are only now selectively returning to construction lending, due to the HVCRE rules that impose higher loss reserves and increased direct equity contributions from sponsors of development projects.  Consequently, banks and institutions are providing less financing of the total construction budget for these projects, and developers have had no choice but to seek private money to bridge the gap.

Interestingly, many institutional owners and developers have created debt funds to invest in subordinated tranches of construction loan debt to cover the shortfall on bank construction loans. While it is challenging to find development sites that make sense at today’s cost of entry, banks are providing mezzanine debt to 75% or 80% of the capital stack—a viable basis should they have to step in and take over the asset.

Debt Fund Market is Too Hot

The debt fund market is as hot and active as ever.

Debt funds have had no trouble raising capital from both domestic and foreign investors, as they are finding cheaper sources of capital which often can be very competitive, especially for financing transitional properties. The bridge loan space, in particular, is very competitive, with debt funds competing head-to-head with commercial banks. Quality sponsors in this space are seeing multiple bids on financing requests, with a race to the pricing bottom. Many insiders with whom we spoke also are starting to see pressure on covenants, as more lenders try to find ways to win business.

As debt funds overheat in this highly competitive market and are forced to deploy capital to avoid depressing yields, investors are taking on more risk by capitalizing lesser-quality collateral in blind pools of highly-leveraged loans that are cross-collateralized by bank debt with onerous covenants.  This hapless by-product of an overheated capital market environment is resulting in a growing deterioration of investors’ equity positions that in previous, cooler economic years, helped protect their downside risk.

Private lending opportunities have increased due to the changes in institutional lending. As the number of loans issued by private lenders increases, there was a decline in loans issued by traditional banks. During 2011, there were three banks that issued 50% of the loans. Currently, private lenders are the ones issuing the majority of loans.

A Better Dwelling report recently revealed that private lenders originated more than $2 billion nationally last year and currently have about 7.87% of the national mortgage market. Another source said that private capital has grown steadily over the past few years and accounted for 51% of all real estate purchases in 2017

So, Is Private Lending the New Normal?

There are several salient, key competitive advantages to consider when looking at private lending.

• Private lenders are nimble, much more so than larger institutions, and can move quickly to fund…in days, instead of weeks or even months, especially through new digital platforms that streamline the process.

• Private lenders have the ability to fill voids and meet needs that are caused by short time horizons, impaired credit, limited liquidity, and transitional property scenarios or business plans that are more complex than regulated lenders can undertake.

• And, given the monumental shift in the availability of capital, the private lending industry is looking more like the institutional world in terms of pricing. How long this will last in view of the current economic outlook over the next few years is anyone’s guess.

Where Do We Come In?

Investors who seek private debt funds can benefit from using the services provided by Wheeler Capital Partners. We can assist investors or borrowers with the development of strategic financing plans for banks, insurance companies, CMBS placement and private lenders or debt funds.  We as intermediaries work for you work in an independent manner presenting your project to multiple funding sources which will provide multiple solutions to achieve your goals.

The team at Wheeler Capital Partners has considerable experience in the lending industry to assist clients with achieving the funding they desire.  With over three decades of banking experience and an awareness of the requirements of various lenders to expedite the process for clients, a private lender could be the right choice.