Foreclosures are back in a big way since the federal foreclosure moratorium ended June 30, 2022, for single-family residences, without this protection foreclosure starts are increasing. The foreclosure process begins after homeowners are delinquent on 90-days of mortgage payments. Once this occurs, the mortgage lender issues the homeowner a Notice of Default (NOD). When the homeowner is unable to rectify the monetary default to reinstate the loan, the lender may initiate foreclosure proceedings. The housing market recession has arrived.
California has the highest number of foreclosure starts in the nation with 7,368 foreclosure starts during Q3-2022. There were 2,275 foreclosure starts in Los Angeles according to ATTOM. California encompasses ~11% of the total national foreclosure starts, Los Angeles metro area ranks third nationally in number of foreclosure starts in metro areas. These numbers indicate a dire situation for many California residents going forward as the housing crisis deepens.
FHA Delinquencies Hit 2009 Levels
The U.S. housing market continues to implode with a record drop in pending home sales amid cancelled transactions and price cuts. According to a recent analysis by Black Knight research there are ~450,000 homebuyers that currently owe more than their house is worth at the end of Q3-2022. Of those ~60%, ~270,000, acquired their homes in the first 9 months of 2022. About 8% of mortgages taken out in 2022 are now underwater, with an additional 20% having low equity.
Black Knight found that excluding the 2020 government imposed pandemic moratorium
response, the ‘early-payment default’ (EPD) rate which tracks mortgage delinquencies within six months of origination, has hit its highest level since 2009 for FHA loans. 80% of homes acquired through FHA or VA loans have less than 10% equity.
U.S. homeowners lost a staggering $1.3 trillion in home equity in the Q3-2022 during a major slump in the housing sector, according to Black Knight. Home equity has plummeted during a rapid market correction. The equity losses in just three months were “by far the largest quarterly decline on record by dollar value and the largest since 2009 on a percentage basis,” according to Black Knight.
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Serious Office Space Vacancy
In a report from Fitch Ratings, if the Work from Home (WFH) trend continues it could cause a permanent decline in demand for office space and have a severe impact on property values. They see average market-value declines from at-origination appraised values of ~44% to 54%. Already property values have fallen 38% on average in Fitch’s current rating analysis. A sharp decline in the value of commercial properties is expected to take a big bite out of city budgets when those empty buildings are assessed in the coming months. Large companies in San Francisco are appealing for reassessment of major commercial properties. Uber has appealed its headquarters building from the current assessment of $83.7 million down to $42.9 million. Dropbox, like just about all tech companies and many other companies in San Francisco, went on an office leasing binge in past years, leasing far more office space than they needed at the time. The logic was that there was a permanent shortage of office space in San Francisco, that rents would always go up, and that it was better to grab all you could get now, and sit on it vacant, and hope to grow into it over the years, thereby warehousing office space for later use. This leasing of massive amounts of unneeded office space caused the office shortage. Last November, Dropbox put about 472,000 square feet of its new 750,000- square-foot headquarters building in San Francisco on the sublease market.
As of Q1-2021 office space in the Los Angeles area has ~25% vacancy rate, the highest since the GFC in 2009. Available sublease space has increased over 90% since the pandemic hit last year and is at +9 million square feet and growing. In addition, so-called “shadow space” (space that is available but not yet advertised) is becoming a big issue as companies reconsider their office space needs with WFH more prevalent. Leasing activity in Q1-2021 fell by ~50% from Q1-2020. Street rents have not dropped significantly; however, effective rents are dropping as landlords are offering increased concessions.
According to Savills, a real estate service provider, “with the glut of available office space on the market, expect additional declines in coming quarters, as landlords shift from a ‘closed market phase into a repricing stage once tenants appetite for space begins to re-emerge in full and the sublease market becomes real competition. They predict a tsunami of sublease space coming to market. Sublease space rose to a new historic high in Q1-2021 of ~9 million square feet. Overall asking rents have dropped ~15% over the past year, along with lease concessions increasing. Total available office space on the market is approaching 25%.
In San Diego total available space on the market hit the highest level in 9 years at +20% in Q4-2020. The office market will remain soft and there will continue to be downward pressure on lease rates for the next few years. In Orange County office availability is ~22%, with sublease office space of+3.2 million square feet available, the highest since 2008. Asking rents are continuing to decrease and lease concessions are increasing. With the amount of lower priced sublease space hitting the market there will be continued reduction in effective rents in the foreseeable future. It’s a tenant market.
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Is the CRE Party Over?
The rate of delinquencies in commercial properties has increased quicker than ever. Commercial mortgage backed securities (CMBS) have tripled in three months to over 10%. In one quarter delinquency rates have already reached their peak in 2012. It took over two years for CMBS delinquency rates to reach the same historic levels in the aftermath of the housing crisis in 2009.
Given all of the new risk factors facing commercial real estate investors some major underwriting adjustments are being applied. Increasing the vacancy percentages from 3-5% to 9-10%; increasing cap rates; decreasing rents and future rental increases; increasing certain operating expenses including property taxes. These are major changes that will cause commercial real estate to be revalued lower over the next several years.
Rent concessions are prevalent in the San Francisco Bay area, some landlords are offering 2 months free rent and some are offering $2,000 gift cards. According to Zumper rent year-over-year a one-bedroom in San Francisco dropped almost 12%, it’s the first time San Francisco’s lease rate has fallen by double-digits. Throughout Silicon Valley rents have dropped by double-digits. Mountain View 15%; Menlo Park 14%; Palo Alto 11%; Cupertino 16%.
From Market Watch:
“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 many 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.’”
“That threat of borrowers walking away once again looms over the commercial real-estate market. 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.”
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The Troubled Commercial Real Estate Market
U.S. commercial real estate transaction activity plunged in the second quarter according to a Real Capital Analytics (RCA) report a near 70% drop in transaction volume, the lowest level of a second quarter since the global financial crisis.
There is a huge gap between CRE buyer’s interest and sellers expectations on what a fair valuation should be since Covid-19. Property owners still have a perception that their property is worth what it was prior to March 2020, while buyers aren’t inclined to buy anything until they feel the market has reached a lower level based upon new assumptions in their financial forecasts.
Despite a record number of loans going into special servicing and some lenders preparing to proceed with action, many are still trying to work with borrowers who have a possibility of overcoming the situation. As lenders begin to decipher which companies and borrowers have a better chance of making it out of the crisis, and which aren’t, that’s when more activity will kick off in the distressed market. Lenders in many jurisdictions are still not able to foreclose. When those restrictions end and lenders are able to enforce their rights, it will become obvious which borrowers will be in a seriously distressed situation, which will result in lower valuations.
There will be a lot of distressed loans and properties that will need to find a fair market value for new equity to enter. A couple of the CRE sectors currently challenged are hospitality and retail, however, as the economy continues to drag on with no hope for a quick rebound expect others sectors to be hit like apartments and office buildings.
It’s clear the pain from the COVID-19 pandemic has not been experienced across all property types. RCA reported more than $30 billion in second quarter’s inflow of distress, with retail and hotel assets accounting for over 90% of that. Industrial represented less than 1% of all new distress, and Faber says student housing and office are still big question marks. The level of potentially distressed assets far outweighs that of outright distress and is distributed more evenly across property types. RCA says apartment assets accounted for more than 20% of potential distress in this quarter, while offices represented about 15%.
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California Commercial Eviction Moratorium Extended To March 2021
Gov. Gavin Newsom signed an executive order Wednesday allowing cities and counties across California to pause evictions for coronavirus-affected commercial tenants through March 2021. Offering stability to commercial tenants is key to stemming the financial impacts of the pandemic and a public health issue, allowing businesses to make decisions based on worker and customer health instead of concerns about making rent, Newsom’s order said. The previous order was set to expire this month.
Rebounding from the mandatory closures hasn’t been easy for the state’s businesses. Closure data from Yelp shows that as of this month, 7,500 businesses in the LA metro area remain temporarily closed, with another 7,500 shuttered for good. San Francisco has approximately 3,300 temporarily closed businesses and at least 2,900 that won’t be reopening.
The state’s action sets a baseline for local jurisdictions, which can choose to take those protections further. The city and county of Los Angeles have their own commercial anti-eviction measures in place. The county has said it would extend its safeguards, which apply to unincorporated areas within county lines, on a month-to-month basis as needed. Los Angeles’ anti-eviction measures are in effect for the duration of the city’s local emergency period, which is ongoing.
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Pandemic on Main Street
The immediate consequences of the pandemic on Main Street and decline in local tax revenue have been historic. As some cities and states begin to reopen after the government shut-down it appears that the “V-shaped” recovery many were hoping for has not materialized. There are several reasons that the economy and tax revenue will not quickly recover. There have been massive layoffs with over 40 million having received unemployment benefits in the past 10 weeks. There are a large number of over-leveraged zombie companies attempting to stay afloat. Including property owners who have seen unprecedented declines in rent collection and suffering serious cash-flow issues. The number of corporate bankruptcies is increasing and will continue to climb as the economy attempts to reopen.
A recent survey of small business owners indicated that nearly half of think they will eventually have to close their business for good. Forty-one percent of the small business owners surveyed said they are looking for full-time work elsewhere. This is on top of the small businesses that have already closed to never reopen. The economy will struggle to recover since it was not in good shape prior to the pandemic.
Many analyst think that the damage that’s been done by the government lockdown will have long-term consequences, the government spending and debt won’t go away. The lockdown may have helped flatten the curve but the virus is still out there and authorities have destroyed the economy. The government’s solution to the consequences of the quarantine has become part of the problem.
Local tax revenues are based on sales taxes, income taxes, business license fees, and property taxes. At this time the sales, income and business license fees have already plunged throwing local and state governments budgets into disarray. If cities and counties respond to the drop in tax revenues by increasing property taxes it will hasten the collapse of businesses. The hit to local tax revenues is permanent. On-line sellers don’t pay local taxes. Most small businesses have supported local tax revenues are services: bars, cafes, restaurants, etc. As businesses close for good, the likelihood of new businesses taking on the same high costs (rent, fees, labor, and overhead) is near-zero.
What’s the value of vacant commercial space? If the demand is near-zero, the value is near-zero. At some point valuations will adjust down to reality and property taxes collected will slide down accordingly.
The core problem is the U.S. economy has been fully financialized and operating costs are unaffordable. The commercial property owner overpaid for the properties with cheap borrowed money and now the owners must collect high rents or they cannot make the mortgage and property tax payments.
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The Decline of CRE Valuations
In a recent Trepp research report the consulting firm took a detailed look into how appraisals are determined. The shutdown of the economy has suddenly set all time records for unemployment, income and cash flow for businesses. The report looks at what the recent shutdown and soon to be closures of many businesses, including layoffs at large companies, will have on commercial real estate valuations.
“Market value is representative of a transaction where no exceptional factors influence the parties (buyers, sellers, lenders). The concepts of market value as previously defined do not contemplate how short-term occupancy and revenue declines caused by external factors, beyond the control of the owner/property manager, should be treated by the appraiser. Until the pandemic surfaced, many CRE property sectors were pacing above the previous year’s performance metrics. Employment and other market-level indicators such as interest rates and the availability of financing were favorable and readily available across all major metros in the U.S.”
According to Trepp, “the types of CRE properties whose values are most likely to be negatively impacted are hospitality, retail and apartments. Hospitality and retail properties have already had to face the immediate reality of lost revenue due to the pandemic. Hotel operators in hard hit areas have seen occupancies plunge from their stabilized 70% range into the high single digits, or in some cases, have been forced to close their doors all together until the crisis subsides.” Additionally, the report shows the percentage of hospitality properties that did not make their April mortgage payment stands at approximately 20%. Financed retail properties that did not make their April payment increased to 10%.
Conventional apartments are out performing hospitality and retail for now due to the government imposed forbearance programs providing a lifeline. However, with rising unemployment there will be increasing rent collection issues leading to increased vacancies and lower overall valuations.
According to Trepp, “In April and May, 354 apartment and office properties started missing payments on $7.1 billion in mortgages which only includes loans packaged into mortgage bonds. That is just the start as more tenants miss rent payments in the coming months, leading to an increase in mortgage defaults throughout 2020 and into 2021. There will be a large number of distressed commercial real estate assets.
Real Capital Analytics tracked over $462 billion during the Great Recession, that was ~13% of outstanding commercial mortgages at the time. They determined that valuations fell 35% erasing the equity in many properties. Lenders also saw significant losses and were able to recoup only 67% of defaulted mortgage value.
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Self-Storage Impacted by COVID-19
The Self-Storage industry generates approximately $39 billion annually and there are an estimated 60,000 facilities in the U.S. Recent financial reporting from the largest publicly traded owners and the industry overall indicate they are being impacted by the shut-down of the economy. Vacant units are increasing and rental prices are declining. These are signs that the industry will suffer as the economic downturn extends throughout the summer months. The busiest time of year for storage units is between Memorial Day and Labor Day each year when people are moving and have a need to store their items.
In some markets it is being reported that lease rates for self-storage rentals are down 45-50%. This is a result of over supply from increasing development and the increasing vacancy. In 2018 the industry saw a record 67 million square feet of storage space delivered. In California available units have increased by 75% year-over-year and rents have declined 16%.
Public Storage, the largest self-storage company, had 20,600 available units last year at this time; the number of available units now is 47,100. In addition, the average price for units has dropped from $127 to $96. According to the CFO of Public Storage customer demand has been severely weakened, down 17% year-over-year during the month of April. In an effort to boost volume the company has discounted rates on average 20%.
In Pasadena, CA the City Council recently voted to amend the city’s eviction moratorium to include protections for self-storage tenants. It prohibits landlords from evicting tenants for non-payment of rent due to financial impact from COVID-19. Currently tenants are required to repay any back due rent within six months of the expiration of the emergency period. Provisions were also added to ban charging interest or late fees on unpaid rent and to encourage landlords to establish payment plans or allow partial rent payments. The moratorium will remain in place until the declared state of emergency has been lifted.
The government response to the COVID-19 pandemic in shutting down the economy is having a sudden negative impact on all asset classes of commercial real estate. The longer this persist the further the erosion of property values.
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CMBS Borrowers Request Forbearance
The values for existing commercial mortgage-backed securities (CMBS) have plummeted and there has been no relief from the federal government. Many commercial properties are experiencing cash-flow stress. This will lead to serious distress and ultimately as a result a significant number of defaults over the next few months.
In the U.S. CMBS borrowers continue to request relief from mortgage payments with almost 5,500 asking master servicers to renegotiate terms and delaying payments. According to Fitch Ratings the past month saw requests for almost 20% of CMBS totals loans exceeding $100 billion. Loans secured by hotels, retail and apartments represent about 75% of the total request for forbearance. In addition, loans securitized by Freddie Mac borrowers increased 500% by borrowers seeking government assistance.
Some borrowers are requesting more than one year of forbearance which appears unreasonable at this time. Most forbearance terms are for a 90 day delay of payments, unfortunately 90 days will not be enough time for most businesses to recover and begin paying their contract rent. Borrowers cite non-payment from tenants and closed businesses due to government restrictions as the cause.
A return to the old normal way for landlords, borrowers, banks and holders of CMBS is not going to happen. The valuation of income producing property is based upon the accuracy and viability of future income streams. The projection of future rents has now changed so that current real estate values are not in-line with the future income streams. With the decline in lease rates coupled with an increase in vacancy due to less demand and tighter lending requirements the value of properties will decline. The Covid-19 pandemic has drastically impacted the viability and valuation of all types of commercial real estate. The days of buyers and lenders paying inflated prices are over.
The Green Street Commercial Property Price Index declined by 9.4% in April. Prices of every type included in the index were adjusted lower, some more than others. The index is down 10.4% from its peak reached at the end of last year.
