5 Questions with Curt Spaugh: Special Servicing Update
In June 2023, CMBS delinquencies rose for the fifth straight month to the highest level since the end of 2021, according to Cred iQ, the data and analytics firm. Some $4 billion in aggregate CMBS debt became newly delinquent in June, with maturity defaults or refinancing issues causing more than 80% of the loans, based on outstanding balance. We spoke with Curt Spaugh, SitusAMC Senior Director and Head of Special Servicing, about the trends driving the delinquency rate and special servicing rate.
What's behind the rising CMBS delinquencies, and what are the key trends across asset classes and urban markets?
In June 2020 during the Covid-19 pandemic, delinquencies spiked to their highest levels since the Global Financial Crisis, nearing the 10.34% record set in July 2012. Around mid-2021, delinquencies and special servicing rates came down. But in the latter part of 2022, interest rates started to tick up, and delinquencies and special servicing rates began to rise significantly again, beginning in the first quarter of 2023. The primary driver is the office market and retail properties, including urban markets and regional malls. Hospitality seems to be steady and has certainly improved since Covid-19, with a pickup in resort demand. Hotels catering to business travelers are still struggling, especially in cities like San Francisco, where a large number of assets have gone to special servicing.
Talk about the impact of interest rates and maturities.
Maturities are a huge issue. That's what triggers a lot of transfers to special servicing. You have leases in place on office assets, and the monthly loan payments are getting paid because leases may not expire till 2024 or later. But when the loan maturity comes up, few lenders are willing to refinance, because there's so much uncertainty. Historically, office valuations have been based largely on how much income the property throws off. Now it’s difficult to rely on the past. You can't look at historical norms for figuring out turnover or the cost to sign a new tenant. How do you figure out which tenants are going to stay and which aren't? If a tenant decides to stay, how much space will they retain? It's challenging for the lender to say what the property is worth.
What impact is remote and hybrid work having on CMBS, given that office comprises a significant portion of the underlying collateral?
San Francisco is a microcosm of the urban markets. Over the last decade or so, the city's financial district shifted from a banking center to more of a tech hub, with Bank of America, Wells Fargo and Charles Schwab departing. Tech employees, some of whom had commutes of up to two hours before the pandemic, can work remotely more easily. Meanwhile public transportation is considered by locals to be less than desirable, and downtown also has crime issues. So people are not coming back to the office.
That's hurting downtown San Francisco quite a bit, with related impacts on retail and hospitality. The Moscone Convention Center is seeing fewer conferences, and San Francisco has been hit hard by lack of tourism, which tends to be Asian based, versus New York, which draws more visitors from Europe. Asian travelers haven’t gotten out as much since the end of the pandemic. Sub-leasing is adding to these woes. For example, Google recently announced it would put 1.4 million square feet of its office space in Northern California into the sublease market. Essentially, everything that could go wrong has gone wrong in San Francisco.
We see bits and pieces of these trends in other urban areas, such as downtown Los Angeles, which has similar issues with crime and long commutes. The Century City market in Los Angeles has grown much more desirable and acts as mini-CBD. New York definitely has been hit hard but appears to be coming back faster than the West Coast.
Is the dislocation we see in the office market a permanent one?
As JPMorgan Chase CEO Jamie Dimon and others have said, working from home doesn’t facilitate corporate culture or productivity. Collaboration over Zoom is not the same as working together in person. I think over time we will see productivity decline, which will require people to go back into the office. It won't be five days, but it might be three or four; and if you get there, you'll be using a lot of office space. Some companies might do hoteling, where you sign in to book space, but if you get to four days a week, it’s not possible, and generally speaking people don't want to share. I think over time we will evolve to a new normal, and when it comes to restructuring loans, it will no longer be a Band-Aid approach, but a longer-term issue.
With Class A product, it's all about a flight to quality in every market, and some will do better than others. It's all about the amenities that entice employees to come to the office, whether it's high-end gyms, ground-floor brew pubs or outdoor terraces -- the kinds of the amenities tech workers have enjoyed for years. We may see some conversions of office buildings happening in places like New York and Chicago, particularly among Class C properties, because they tend to have smaller floorplates. Class B properties built in the 1980s are more difficult, because they are a little more sterile, and have bigger floorplates which are more difficult to convert.
I think it's a reset, not a complete disaster. It's going to be a longer-term workout and reset of the bases. I believe things will come back -- just at a different level.
In what ways have workout and modification strategies shifted as the pandemic recovery has progressed?
In 2020 when the pandemic hit, suddenly no one was traveling and hotels and resorts and malls were subject to lockdowns, so we saw a lot of hospitality and some retail assets coming into special servicing. Office tenants were still paying their rent, so that had yet to become a problem, though we saw it looming. We viewed hotel as a short-term problem: When Covid ended, hotels would re-open and things would get back to normal. So instead of pursuing major restructuring or foreclosure, special servicers worked to put forbearance agreements in place, in which the borrower could make payments out of reserves and get by for a while. If reserves were not available, special servicers would either defer or reduce the requirement to pay debt service, which could be made up down the road when the property reopened. Those agreements worked very well.
But in 2022 and 2023, we are no longer in a temporary situation. The Covid pandemic has changed the way we do business in the U.S., especially with regard to office buildings. We've gone from a short-term, put-a-Band-Aid-on-it approach to a more complex, long-term problem. Special servicers may have to pursue long-term remedy strategies and solutions that will include loan restructurings, assets sales and the pursuit of legal remedies.