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A Wave Of Distress Didn’t Come In 2021, But Debt Markets Changed Anyway

It wasn’t a question of if, but when. As the world went into lockdown in spring 2020 and the economies of the U.S. and UK fell off a cliff, real estate investors dusted off their playbooks and waited for the flood of distressed opportunities to come. 

They’re still waiting. 

In spite of the severe recessions of 2020 and the continued emergence of new variants of Covid-19, there has been very little in the way of debt distress in commercial real estate. In Q2 this year, just 1.3% of U.S. real estate sales came from distressed situations compared to a high of 9.8% in Q1 2009 after the collapse of Lehman Brothers, according to Real Capital Analytics data. And experts predict that unless there is another severe and prolonged recession, that number is unlikely to tick up. 

A wave of distressed asset sales never arrived.

The reasons why highlight the extent to which the fortunes of commercial real estate have become intertwined with decisions taken in the headquarters of the Federal Reserve and the Bank of England. But the lack of distress also shows how the real estate lending world adapted after the last crisis and how it is adapting again, even though the pain in 2020 and 2021 is far less than that of 2008 and 2009. After the pandemic, who you borrow from is going to continue to change. 

“People set the wrong expectations early in this downturn,” Real Capital Analytics Senior Vice President Jim Costello said. A large cohort of those working in CRE today will have worked through the Great Financial Crisis or its aftermath, he said, and that moulded their preconceptions of what a downturn in real estate looks like. “But that ignores the historical context.”

Financial recessions like the GFC or the U.S. savings and loan crisis, or downturns caused by overdevelopment like in the early 1990s, cause severe price falls and distress in real estate lending markets, he said. But this wasn’t that. 

This was a crisis of income that was concentrated in a couple of real estate sectors, primarily retail and hotels. And in these sectors, there has been distress — data from Trepp showed that among securitised loans, delinquency in the lodging sector spiked from 1.3% in January 2020 to a high of 23.5% in June of that year. Retail loan delinquency went from 3.6% to 17.8% in the same period. 

Delinquency rates in both sectors remain elevated, at 9.4% and 8.2%, respectively. But the pain was not widespread, and crucially, the financial system is better equipped to deal with distress. 


Why did this happen? A combination of central bank and government stimulus and post-GFC behavioural change insulated real estate from any real distress. 

“As soon as we went into lockdown, you saw the speed and scale of the policy response,” PGIM Head of Real Estate Debt Investment Research Henri Vuong said. “They didn’t want companies and people to get into distress. There was never going to be a credit crunch similar to the GFC.”

Data from McKinsey showed that compared to the post-GFC response, governments and central banks provided more than 10 times the amount of economic stimulus in the wake of the pandemic. That stimulus came in the form of low interest rates, pumping money into the system through quantitive easing and providing direct economic support for citizens. 

"If you're using the GFC as context, at that point, there was no real equity in the system,” Eastdil Secured Managing Director Riaz Azadi said. “This time around, both the banks and borrowers are much better capitalised.”

That meant lenders had more cash on their balance sheet to absorb potential losses on loans, so they did not need to take a hard line with borrowers that did go into default and call in loans to get their money back. 

Borrowers were in a better position as well thanks to the way lending changed post-Lehman. Loan to value ratios were much lower than during the boom period that ended in 2007, typically around 60% in the UK for prime property, according to data from Bayes Business School’s annual survey of CRE lending. That compares to 75% or more in the last cycle.

But the low interest rates held by central banks also meant that, even in sectors where income was affected by the pandemic, borrowers were not always put in a terrible position. 

“Because interest rates are so low, interest cover ratios are high, and borrowers could lose half their rental income and still not breach covenants,” Bayes Business School Senior Research Fellow and Project Director at the Faculty of Finance Nicole Lux said.

Going into the GFC, interest rates in the U.S. and UK were about 5% to 6%, meaning that if rental income dropped even slightly, covenants that said income had to exceed interest payments by a certain amount were breached pretty quickly. With interest rates close to zero, income had to almost disappear for the same covenants to be breached.

The pandemic has not brought about the same level of pain as the last crisis, but it is bringing about changes nonetheless — some short-term, and others that might be here to stay. 

In the short term, lenders have become even more conservative, data from RCA showed. While government stimulus helped economies in the U.S. and UK rebound sharply in 2021, risk appetite among lenders remains muted. The proportion of loans in the 65% to 80% LTV category in the first half of 2021 was 8.4% lower than for the same period in 2020, a time frame that includes the pre-pandemic period. 

The number of unique lenders in the U.S. market dropped significantly in spring 2020, RCA data showed. While in the industrial and apartment sectors, the number of lenders is now higher than the pre-pandemic peak — and is about the same for suburban offices — the recovery has not been seen across the board. For CBD offices, the number remains below 2019 figures, and for retail and hotels, the number is far below 2019. 

Yet it is the type of lender in the market and the type of deal those lenders are willing to finance, that may bring the most long-lasting change in the real estate finance sector.

Banks are likely to undertake fewer distressed sales than after the collapse of Lehman Brothers.

“We are seeing some lenders becoming very strict in terms of what they are lending on,” Lux said. “Banks in particular are going to be more selective. That is where debt funds are supposed to step in, but there are not enough of these funds to provide the finance needed, particularly for repositioning projects.”

For property that needs to be repositioned because it needs to be upgraded to re-let or its sustainability credentials are not up to scratch, for instance, there is far less financing available than for deals involving fully leased investments, Lux said. RCA data showed debt funds have grown their market share in the construction finance space, but for Lux, in the UK at least, that is not enough to bridge the gap for borrowers that have projects involving some element of refurbishment and leasing risk. 

This is exacerbated by the fact debt funds often have very high return requirements, in some cases 10% or above, which can make them prohibitively expensive for borrowers. 

This is a particular issue in the office sector, Lux said, where there is huge uncertainty about future demand as a result of Covid-19-related societal changes in the way we work. Regional banks are one of the only games in town now for owners of secondary offices that may need to upgrade their assets before they can re-let them. And there are a huge number of such offices. 

“These banks have a policy of supporting local customers, and that is what they should be there for,” Lux said. “But there will still be a gap.”