It’s an open secret that commercial real estate owners take cash out of buildings.
When they do, unlike homeowners, criticism often is sparing. After all, hotels, shopping centers, office towers and other commercial buildings are run as businesses, where the whole point is to reap a profit.
“The real-estate industry is all about taking cash out, and on a tax-deferred basis, at that,” said Scott Tross, co-chair of real estate litigation and dispute resolutions at Herrick Feinstein, a law firm. “That’s nothing new. But in may respects, what’s happening now is reminiscent of what happened ten years ago or so.”
By that, Tross was referring to the deluge of late payments, defaults and foreclosures that swept up some of the biggest names in U.S. commercial real estate in the wake of the 2007-08 global financial crisis, and saddled their investors will losses.
“You had people borrowing as much money as they possibly could, none of it on a recourse basis. And if things move in their direction, that’s great,” he said. “If they don’t move in their direction, they just hand back the keys.”
“ ‘If you want the upside, you need to take the downside too.’ ”
That threat of borrowers walking away once again looms over the commercial real-estate market. But instead of financial institutions spreading toxic assets across the globe, it’s now because of the coronavirus, which forced much of the U.S. economy to shutter in March, and months later still is spreading unabated in many American cities, as well as in Brazil and is rising again in parts of Europe.
Another new twist is that borrowers, ahead of this downturn, pulled more equity out of U.S. commercial buildings than ever before, when they have refinanced in the commercial mortgage-backed securities (CMBS) market, a key source of loans for hotels, skyscrapers, warehouses and other business properties that end up packaged into bond deals.
MarketWatch asked credit-rating firm DBRS Morningstar for a historical look at cash-outs on properties refinanced in the CMBS market, a source of funding that took off in the mid-2000s.
They tracked $136 billion worth of total cash-outs, versus nearly $47 billion of equity put into refinanced properties over the last 17 plus years. The bulk was extracted not during the last decade’s real-estate boom as might be expected, but between 2013 to 2019, a period when CMBS financing came roaring back and commercial real-estate prices skyrocketed.
Why does any of this matter now? Debt relief conversations already started in April, a month into the first round of coronavirus lockdowns, between the hardest-hit commercial property borrowers and their lenders.
Since then, delinquent CMBS loans have climbed to nearly 10%, rivaling the worst levels of the global financial crisis, as shown in this Deutsche Bank chart.
And it’s likely not only borrowers with CMBS loans that are falling behind. Deutsche’s analysts said they expect bank-held commercial property loans to follow the delinquency spike already evident in CMBS, in a client note this week.
Furthermore, the commercial real estate finance industry, and now lawmakers wielding a draft bill from U.S. Rep. Van Taylor of Texas, detailed here, want the Treasury Department to help relieve commercial property stress by offering landlords direct equity injections.
But there are concerns that the proposed bill won’t be enough to shore up U.S. properties, nor prevent building owners in the future from being any less opportunistic with borrowed money.
“I think people by nature are greedy, especially developers, who always want to tap into equity from one project and use it for another,” said Stan Bril, chief executive officer of MCG, a private commercial real estate and small business lender.
He also thinks the equity investment proposal is “like trying to put a Band-Aid on a gash,” he told MarketWatch. “There’s nothing they can do to stop the hammer from coming down.”
Instead, Bril sees plenty of distress ahead, particularly after Covid-19 aid for small-businesses runs out and if the virus keeps spreading unabated, causing further local shutdowns and making it hard for landlords to collect rent.
Strategists at Cantor Fitzgerald & Co. had a different take, calling the proposed bill a “life line to commercial property owners,” in a note this week, but also warning that it likely will face challenges to becoming law, including that it may be construed as “a bail-out for large landlords, a group of rich and well-connected beneficiaries.”
Shlomo Chopp, managing partner of CPS, a commercial real estate workout specialist, said it is the prerogative of property owners to take cash out of buildings. “If you increase the value of the property, you have the right to take cash out,” he told MarketWatch.
“But we also live in a capitalist society. If you want the upside, you need to take the downside too.”