What Will a Second COVID-19 Wave Do To U.S. CMBS?

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Hotel and retail have been the most impacted by the coronavirus pandemic thus far. Fitch Ratings expects the hotel sector to ultimately recover once leisure and corporate travel and events resume; values will start to improve with increasing occupancy and daily rates in 2021. Secular shifts in retail that were already underway prior to the crisis and the post-pandemic transformation in the way we utilize office space have the potential for extended reductions in cash flow and property valuations.

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Working from home (WFH), which is currently the rule rather than the exception in many cities, will continue on a much larger scale than prior to the pandemic. A long-term shift to at least some WFH post-pandemic will place greater pressure on office demand for new space and elevate lease renewal risk and/or reduce rental rates; tenants want the flexibility to assess longer-term implications of the pandemic and any resulting economic contraction.

Landlords will need to invest in space reconfigurations to adjust to density expectations, and offer free rent or higher tenant improvements and concessions to retain and attract tenancy. Those properties that are able to successfully retrofit to the higher standards and adherence to local health and safety department guidelines will become more desirable, while older Class B properties that are costly to retrofit may become obsolete. Longer term, office cash flows may decline as operating expenses rise alongside lower occupancy and lower
negotiated rents.

Coworking operators will face increased scrutiny as the viability of their business model, which has long-term leases but are exposed to lessors on shorter-term leases, is less certain. However, longer term, companies may look to coworking space as an alternative to traditional office space as they balance flexibility and space demands.

The secular shift in the retail sector away from physical brick-and-mortar stores toward e-commerce over the past decade has already accelerated bankruptcies and increased store closures. Retailer bankruptcies and deteriorating sales will allow tenants to negotiate lower rents with friendlier lease terms, thus creating cash flow volatility and long-term value decline for non-core property owners.

Mall owners, in particular, are not shying away from handing back their keys to lenders on struggling or non-core properties in their portfolio. Trophy malls will benefit at the expense of secondary malls and weaker competition being eliminated and repositioned over time. Grocery-anchored shopping centers and power centers with tenant profiles that skew toward essential services have exhibited stronger performance.

Hotel revenues and occupancies have seen the most sudden and immediate declines at the onset of the pandemic. Fitch expects hotel recovery to be slow and fragmented, given the continued uncertainty of near-term virus containment and long-term effects on business and consumer travel. Fitch projects an average 45 percent decline in hotel revenue per available room (RevPAR) this year, with the rebound to be around 75 percent of 2019 levels in 2021.

Fitch does not expect a recovery of the trailing 12-month RevPAR to its prior cycle peak in nominal terms until 2025. Domestic leisure travel demand has been resilient and business travel will follow as conferences resume. Face time cannot be fully replaced by videoconferencing in establishing business relationships and social connections.

Not surprisingly, limited-service hotels in secondary markets have outperformed full-service hotels in large markets. A meaningful recovery in the luxury and upper-tier hotel segment is not likely in the near term as performance, particularly in urban locations, has lagged given large group, and business activity remains low.

Multifamily, which has enjoyed many years of positive cash flow growth and supporting demographics, will see added stress in 2021 without additional government stimulus and support if unemployment rates prove sticky. In addition, the WFH trend will result in some degree of exodus from larger cities,
reducing demand for urban multifamily properties. The coronavirus will exacerbate already weaker performance on the student housing subsector relative to traditional
multifamily pre-pandemic.

A second wave of infections could prolong the downturn and stall economic recovery. If this scenario materializes, Fitch expects some properties will not recover from a prolonged stress, and classes with negative rating outlooks in multi-borrower CMBS transactions and bonds in hotel single-borrower transactions, which are all on Rating Watch Negative, may be downgraded with classes rated non-investment grade most at risk.

Melissa Che is a senior director in Fitch Ratings’ U.S. CMBS group.