Although Wall Street was still experiencing volatility as of this past June, the U.S. financial markets were on their way to recovering their losses after the shock of the COVID-19 outbreak. The prospect of a quick recovery for Main Street businesses, however, was shakier.
The fortunes of the so-called “small-cap” commercial-property and mortgage markets — typically defined as properties of less than 50,000 square feet and deals valued at $5 million or less — depend on healthy small businesses and local economies. As the summer began, Main Street USA was still locked down in large part, with shuttered restaurants, shops and small offices. According to reports from this past May, the federal government had lent small businesses more than $500 billion to keep them afloat.
“The outlook for Main Street businesses is a lot different than what Wall Street is foreseeing,” says Randy Fuchs, principal and co-founder of commercial real estate analytics company Boxwood Means. “The major looming question is, what proportion of these small businesses are going to be able to open for business? And that’s the major question for our times right now.”
Smaller commercial properties experienced nearly a decade of rising rents, declining vacancies and strong price growth. Small-cap mortgage originations, including purchases and refinances, has topped $200 billion annually for the past seven years, Fuchs says. By the end of last year, however, leasing activity was beginning to flag, an early warning sign of a slowdown. Many commercial real estate analysts predicted a quick and mild recession sometime in 2021, but then COVID-19 struck the entire market with a hammer blow this past March.
“We’re in a kind of a fog right now in terms of what we can really see on the small-cap commercial real estate landscape, but I think it’s going to be a lot worse when the second-quarter [2020] data comes out,” Fuchs says. If the Great Recession of 2008-2009 serves as a guide, Fuchs says, leasing activity, rents and prices for smaller properties will fall significantly, and it will take a long time for these to recover. Assets also will stop trading hands for several months. Many property owners will default on their loans, although banks will likely negotiate payment extensions with their borrowers rather than foreclose.
What occurred with the pandemic was like a national earthquake that just stopped everything in its tracks.
—Randy Fuchs, Principal, Boxwood Means
There is a caveat, however, to any predictions that use the Great Recession as a road map, Fuchs says. Nothing like COVID-19 has happened before. “What occurred with the pandemic was like a national earthquake that just stopped everything in its tracks,” he says.
After a brief hard stop for commercial financing, lenders were entertaining loan proposals again by the latter part of this past April. But lenders are more cautious now, says Pat Jackson, CEO of Sabal Capital Partners, a private lender specializing in longer-term commercial mortgages that it holds and services. Jackson says that the typical lender will not consider a closed nonessential business, such as a shoe store, as part of the property income, potentially causing the rejection of a loan proposal.
“Let’s say two weeks ago, you saw a sign: “Closed until further notice,’” Jackson says. “How else could you underwrite that? We’re underwriting the economic occupancy of those properties. If that lease is either nonperforming, or you have a lot of questions about whether or not that particular property will stay in business and whether it is a rental stream that you can count on, prudence would say either disallow it as an income in your underwriting, or certainly heavily discount it.”
Jackson says the terms for viable commercial mortgages will likely be more rigid until the outlook for the U.S. economy becomes clearer and there is confidence that the nation can control the health crisis. Shorter-term loans may become more of the norm. During the recovery, a lender may lend drop their loan-to-value ratios from, say, 75% to 60%.
“A lot of lenders took a knee during this cycle, saying, “I just don’t want to be lending. And that leaves a [mortgage] broker really exposed, especially if they had a deal in the works,” Jackson says. “We’ve been lending all the way through the cycle and we actually had a huge funding month [in May 2020].”
Although the crisis has forced many commercial mortgage brokers to work from home, the shock hasn’t necessarily been bad for business. David Kotter, president of Phoenix-based brokerage Integrity Capital, says he has gained new clients from the Midwest — outside of his usual territory in the western states. He also says it’s possible to arrange financing for struggling businesses. Although some lenders have stopped making loans altogether, others are aggressively trying to gain market share.
“I’m doing a deal right now where a guy has a restaurant-retail deal downtown,” Kotter says. “They’re limping along, but they’re still paying [rent]. And because the [property owner] has a lot of cash, [lenders will] kind of make concessions because they have a little bit more flexibility on the variables.”
Kotter says he believes the fortunes of the small-cap market will ultimately be tied to how quickly the U.S. can control COVID-19. But he noted that a lot depends on the type of business and the location in question.
“If you’re in downtown New York and the surrounding areas, you’re just getting pummeled,” Kotter says. “But that’s different than if you’re in Phoenix where you’ve taken a little bit less of a beating. So, I think it’s regional, depending on where you’re at.” ●
