As the COVID-19 pandemic has suddenly driven unemployment and hobbled or closed many businesses, people have less cash to meet rental and mortgage obligations. Missed lease and mortgage payments across residential and commercial properties could have far-reaching impacts throughout the economy. In addition, this all too human challenge could profoundly affect the fundamentals of investments linked to property.

With many workplaces closed, some businesses have been unable to meet lease obligations. Delayed data about commercial property limits our real-time view; however, there are some early signals. Surveys conducted by the National Association of Real Estate Investment Trusts (Nareit) indicate that rent payments across industrial properties, apartments, and offices have slipped only modestly so far, while the retail sector has seen rental payments plummet (see chart: Share of Typical Rent Received). In April and May, 354 apartment and office properties started missing payments on $7.1 billion in mortgages, according to data from Trepp LLC, which only includes loans packaged into mortgage bonds. That is up from around $4.2 billion in February and March.

Homeowners have taken advantage of short-term flexibility from banks and the Federal government to make mortgage payments. Under the CARES Act, government-backed loans from the FHA, VA, USDA, Fannie Mae, and Freddie Mac are automatically granted forbearance¹ if requested, while many banks have been granting forbearance directly and without government mandate. The share of mortgage loans in forbearance rose from 0.25% at the beginning of March 2020 to 8.16% in the week of May 18.² Early indications are that mortgage payments have slipped only modestly, with on-time payments slipping from 97.7% in April 2019 to 94.6% in April 2020. May 2020 also is on track to see only modest declines in payments.³ While government stimulus likely is helping keep payments current, persistent high unemployment and wage cuts could more negatively affect mortgage payments over the months ahead.

While some investors have become more skeptical about investing in Real Estate Investment Trusts (REITs) or private real estate funds, many forget that the bond market includes considerable real estate exposure. Commercial and residential mortgage securitized bonds have provided investors a steady income stream backed by real estate assets; however, missed lease and mortgage payments will affect these securities directly. Mortgage-Backed Securities (MBS) make up 27.1% of the Bloomberg Barclays US Aggregate Bond Index, while Commercial Mortgage-Backed Securities (CMBS) comprise 2.2%.⁴

Investors in these securities include 401k participants, pensions, insurance companies, endowments, and other investors who rely on the historically steady stream of income with relatively little perceived risk. However, because coupon payments to MBS and CMBS investors are supported ultimately by the mortgage payments of homeowners and commercial property owners, those interest payments now are at risk and the value of the bonds has dropped accordingly.⁵

Comparing the performance of Agency vs. Non-Agency CMBS highlights this difference. Agency securities are issued by Ginnie Mae, Fannie Mae, and Freddie Mac, and thus backed by the US Government. Non-Agency securities are not government-guaranteed. Therefore, Non-Agency CMBS investors are exposed to the credit quality of the US commercial borrower. Year-to-date through May 22, 2020, the Bloomberg Barclays US Agency CMBS Index has returned 6.01%, whereas the Bloomberg Barclays Non-Agency Investment Grade CMBS Index has returned (0.29%). That 6.3% gap is a powerful reflection of just how worried markets are about commercial real estate.

The Federal Reserve’s March 23 announcement of its willingness to make unlimited purchases of Agency MBS has helped stabilize that sector; without that central bank support, performance of the sector likely would be worse. On April 9, the Fed expanded support under the Term Asset-Backed Lending Facility (TALF) to include top-rated CMBS, backed by government-sponsored entities. Although the liquidity and value of these securities are supported by the Fed, mortgage servicers still are required to pay investors even if borrowers stop mortgage payments. This tension creates a cash crunch within the plumbing of the mortgage market.

In addition, REITs could be impacted by the potential wave of missed lease payments. Performance of REITs fell further than broader equities at the onset of the pandemic and have failed to rebound as effectively as investors question the fundamentals of REITS going forward. (see chart: Market Performance⁶)

Fundamentals of the REIT market were strong before the onset of the pandemic. Leverage was near a historical low of 31.8%, compared to 63% in 2008⁷ and most sectors showed relatively healthy occupancy rates. Prior strength enhances the sector’s ability to weather the crisis; however, hotels and retail REITs are likely to be hit much harder as demand supporting these sectors has collapsed.

Demand dynamics going forward will impact fundamentals longer-term. Office demand may shift as more and more companies require, encourage, or at least support working from home. In a late-April survey among corporate real-estate users by trade group CoreNet Global, 69% of respondents said they would use less real estate because of remote work, up from 51% in March.

Still, it appears there will be winners and losers within the REIT sector. Office space could see reduced demand due to sustained job losses. Those job losses also could hurt apartment REITs as residential tenants come under greater and greater stress. On the other hand, industrial demand is likely to be strong as fulfillment centers support online shopping. And at least some office tenants will need to rethink the pre-COVID trend toward open flex spaces, potentially resulting in a shift toward safer, more segmented, and potentially larger office spaces than before.

Moving into summer, real estate is one of the asset classes most on our minds. We will continue to monitor real estate within equity and bond portfolios while also analyzing the risks and opportunities in REITs and private real estate markets. Only rarely in our lifetimes do we see secular shifts in the economy that could fundamentally change the long-term prognosis of an entire asset class. This may be one of those times. We will keep you posted.

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1. Forbearance allows borrower to defer principal and/or interest payments for a fixed period without reducing the overall debt payment responsibility.
2. Mortgage Bankers Association
3. National Multifamily Housing Council
4. Bloomberg, based on iShares Agg ETF asset exposure as of 4/30/2020
5. US Bonds representative of Bloomberg Barclays US Aggregate Index, US MBS of Bloomberg Barclays US MBS Index and US CMBS of Bloomberg Barclays CMBS ERISA Eligible Index.
6. Large-Cap US Equity representative of S&P 500 Index, Global Equity of MSCI ACWI Index, US REITs of FTSE EPRA NAREIT US Index and Global REITs of FTSE EPRA NAREIT Global Index.
7. Sourced from Green Street Advisors through Cohen and Steers, as of 2/29/2020.