While COVID has impacted the commercial real estate world in many ways, perhaps none is more profound than in the lending sector. Connect recently chatted with T.R. Hazelrigg IV, president and cofounder of nationwide direct lender Avatar Financial Group, to get insights into just how deep the impact has been, how the market dislocation compares to past recessions, the long-term impacts and what the future holds.
Connect Media: How has COVID-19 impacted the lending landscape so far?
Hazelrigg: At the start, there were quite a few lenders that just stopped lending all together. This was both out of choice and out of issues with their back room. In the private lending arena, a lot of lenders are leveraged mortgage funds. Some of those lenders operating off lines of credit had issues with access to capital so that sidelined them, not by reasons of their own choosing. We had quite a few other lenders that just hiccupped when COVID hit and left a lot of opportunity for bridge lenders.
Connect Media: Where are we in this disruption, what do you think lies ahead and how long do you think it will take for the CRE markets to recover?
Hazelrigg: This COVID recession is drastically different than what we encountered in 2008-2009. In 08-09, regulators came down hard on the banks to clean up their problem loans. Things were dealt with very rapidly back then. We worked through that, we bottomed out and came back. And even though it was difficult, it did cause that process to move forward at a rapid pace.
But what we’re seeing in the COVID-19 recession is the opposite mandate from the Fed and regulators. They’ve really pushed hard on banks and institutions to work with their borrowers so that’s created a state of suspended animation. That is, the lenders are playing a game of kick the can with problem loans. They haven’t been dealt with yet, so I think there will be an elongated and painful period that we’ll have to work through. We’re going to have to work through so many loans either in payment default like hotels or in covenant defaults.
Many of the multifamily loans are in the latter category because their occupancies or collection rates have dropped below the minimum covenant requirements in their loan documents. So they may be in default in numerous ways and some may not be easily cured. Some haven’t had the foreclosure trap pulled on them yet because of local statutes, and others because they are doing the bidding of other regulators and then trying to kick the can down the road of working with their borrowers. But eventually, it is going to come to a head.
Connect Media: What are some of the expected long-term impacts of the economic downturn due to the pandemic?
Hazelrigg: The most pronounced impacts right now are on the travel and leisure properties. Recently, I saw a report indicating that over 20 percent of hotel loans are currently in default. While those loans are the most troubled, that industry is going to come back and I think you’ll see a good rebound in travel and leisure properties once COVID is under control.
Where there is a systemic problem that isn’t going to bounce back is office and higher-end residential in major metropolitan markets. Many people have fled markets like Manhattan, San Francisco and Seattle. In addition, companies are realizing that their employees are very productive while working from home, so the need for expensive office space and the quality of life for employees has changed drastically. This makes lending in these markets problematic because it’s very difficult to evaluate. We just don’t know where the bottom is so we can’t put the V in LTV.
In many of these markets with tremendous building booms like Seattle, there are thousands of class-A apartments that have been built around Microsoft, Google, Twitter and Facebook in South Lake Union, and there are still cranes on numerous large mid-rise buildings. Those employers have basically told a majority of employees to continue working remotely and they may not need to return. So you’ve got a tremendous supply of a new office and multifamily but demand not there, and no V-recovery is expected. These are the property types and markets that are pretty frightening as a lender.
Connect Media: How does this market dislocation compare to past recessions? How did regulations and federal stimulus impact the previous downturn in 2008-2009 leading to recovery?
Hazelrigg: As we discussed earlier, I equate 2008 with a large storm that blew in, wreaked havoc and then departed. I look at COVID as a hurricane. The first part was frightening and painful. But then after we got through that, we got to where we are now, which is in the eye of the hurricane. People are sitting on the beach having a margarita and thinking that the storm passed, when in reality, just the first wall passed. And once the regulatory freeze on foreclosures and evictions is lifted, there’s a lot of pain still to come unfortunately.
Connect Media: In the current situation with loans in a state of suspended animation, what will help move the market forward toward resolution and recovery?
Hazelrigg: Resolution and recovery can’t happen until evictions and foreclosures are allowed. Until we work through the problem assets, you can’t really move forward. We’re currently in a position where problem assets are just lying there dormant. They are a hornet’s nest that hasn’t been shaken yet. With government measures suspending the operation of core commercial real estate fundamentals (and while there are definitely legitimate reasons for that), you’re stuck in neutral and not getting to a resolution.
Connect Media: What are the CRE sectors that have been hardest hit and what advice do you have for borrowers to prepare? What proactive measures can be taken?
Hazelrigg: The fact that we are in neutral and the timeframe of suspended animation, now is the time to take action … not when your lender commences a foreclosure … but now, before that happens. Reach out to explore all your options to save your property. A lot of borrowers are going to be invited to exit earlier than expected, so they really should at this time be looking at alternatives.
The easiest alternative, although the least profitable in a market like now, would be a sale. But if they want to hold onto their properties, looking at what kind of bridge loans that could bridge them for two to three years to re-tenant a building, stabilize cash flow and season it would be the answer. But now is the time to act, before they have a notice of default which makes it that much tougher to refinance. If you are in covenant default, it is only a matter of time before you are placed in foreclosure. Start reaching out and seeking alternatives now.
Right now, a lot of lenders aren’t putting people into technical foreclosure. You know if you haven’t made your payment. Covenant defaults are less obvious. You’ve got your debt yield, occupancy, etc.; there are many covenants built into commercial loans that can put you into default. And a default is a default, so it can cause a foreclosure just like a payment default. So if you know that, there’s a good chance your lender is going to be looking for you to move on and calling the loan. The best course of action is to explore alternatives before you have the actual foreclosure filed.