In the face of the current market uncertainty, we wanted to provide our users with insights into trends we’ve observed in our marketplace and database of properties. We hope these insights will provide value and context as we navigate the changing landscape of commercial real estate together.
Commercial real estate — just like every industry — is waiting with bated breath to comprehend the impact of the coronavirus on its future.
Businesses remain closed and, despite hopeful murmurs of plans to reopen, tenants nationwide are struggling to pay rent. Many landlords are working with their tenants, but landlords aren’t the topmost rung on the financial ladder. They are indebted to the parties that provided them with the capital to buy their properties in the first place — namely, lenders.
Most transactions in CRE aren’t completed with cold hard cash. Instead, developers or buyers use financing to acquire properties, typically through commercial real estate loans: mortgages secured by liens on the property. Borrowers take out a loan to purchase an asset and are required to pay back the amount, plus interest, over a set period. The document detailing these terms is called a loan note.
What is a loan note?
A loan note is essentially a contract between a borrower and lender in which the borrower promises to repay a certain amount of the loan within a specified time frame. Often, a loan note will include explicit terms such as interest rate, penalties for late payments, etc.
Banks and private lenders are active members of this part of the CRE process, providing loans to buyers and making money via collected interest. Insurance companies, pension funds, and other sources, including the US SBA’s loan program, also all provide capital for commercial real estate buyers.
Lenders usually have a portfolio stocked with loan notes, which fall into one of two categories: performing or nonperforming.
- Performing notes are where the lender is paying the borrower on time each month, and the lender is making gains on its initial investment.
- Non-performing notes are the opposite: the borrower isn’t paying back the amount owed, and the bank or lender is losing money on the note.
Loans in the time of coronavirus
Amidst the uncertainty and massive closings due to the coronavirus, many lenders find themselves with a stack of non-performing notes.
Tenants are unable to afford rent payments, and most analysts are warning of more dire developments to come. These developments inevitably will cause near-term credit issues and long-term adjustments in the CRE business. After CRE spent years climbing in valuation, Green Street’s Commercial Property Price Index saw values slip 1.3% in March. The index also predicts the hardest-hit sectors — such as retail and hospitality, and maybe offices — to tumble 30% in valuation.
When a lender encounters a non-performing loan, they face a few different options.
First, the lender can foreclose on the property. This isn’t the most desirable option for banks: it costs them more money and time than the alternatives. A defaulted loan is not only not generating income, but requires lenders to spend money on court fees and complying with local laws pertaining to foreclosures. Not to mention the time it typically takes to set up a property auction – though CREXi’s auctions platform simplifies this process.
Lenders make money lending – they don’t want to manage a property where they can lose money on a sale and general upkeep during the sale process. They’d rather find an alternative to that option.
Despite coronavirus, money needs to keep moving
Federal agencies and government leaders have instructed lenders to work with their borrowers, given the unprecedented nature of the coronavirus. The nature of the crisis differs from that of the Great Recession: lenders had plenty of funds in Q1/20. Therefore, conventional thinking suggests there’s room for borrowers to work with landlords on a case-by-case basis, including providing forbearance, fee waivers, and delays on foreclosures.
Despite all attempts to compromise, the reality is that the economy needs to keep moving to survive. Banks need to keep making money to stay afloat, and this has led to an onslaught of loan sales.
Per a recent interview, Brandy Smith, Institutional Advisor at CREXi, had this to say of loan notes in the coronavirus climate:
“There is generally a sales cycle during economic downturns. When a borrower stops paying, and a loan becomes non-performing or even sub-performing, the lender generally goes through a loan-by-loan analysis. They decide whether to sell the loan, take it through the foreclosure process, approve modifications or forbearance, or hold to maturity.
There are several factors in determining whether to hold the loan versus selling the loan. These factors include the cost of foreclosure, reputation risk of foreclosing on certain property types and/or borrowers, and the amount of loan loss reserve associated with the respective loan. Since it takes time to foreclose and ultimately take the property to market, the market generally sees loan sales earlier in the cycle. I think we will begin seeing more loan sales once lenders and owners are able to go through credit/risk analysis of their portfolios.”
Loan notes are trending upward
We evaluated our internal CREXi metrics and observed a 157% increase in loan note user activity since January. From April to May, we saw another 64% increase in loan notes on our platform.
Too, Google search trends have shown a jump in searches for “loan notes” over the last three months, reaching a 12-month high in late April.
These metrics indicate that most banks and lenders anticipate a continued economic downturn and are undergoing the aforementioned analysis of each loan to prepare for the unpredictable. One recent example is TPG Real Estate Finances’ sale of $1 billion worth of CRE debt earlier in May.
Too, opportunistic institutions are looking to take advantage of buying loan notes – which could provide a decent source of revenue should a loan convert from non – to performing as the economy starts to reopen. Eastern Union recently launched its Distressed Notes Initiative to pair sellers with investors willing to purchase distressed mortgages.
What this exchange means for CRE lenders remains to be seen. As the impact of coronavirus continues to reveal itself, the transfer of loan notes from hand to hand may prove a high-traffic avenue of CRE transactions.
Search for loan notes on CREXi.