Leading in a Black Swan Event

In the second half of 2020, JRK Investors sold approximately $1 billion of apartment assets.

While many factors led to the dispositions, including a potential changing tax code, lessons from the pandemic were still fresh on executives’ minds. The assets had bridge floating-rate debt that matured in a couple of years. So JRK’s president Bobby Lee decided to pass on potentially better returns by selling the assets.

“We just felt like the uncertainty level went up,” Lee says. “I’m still very bullish on multifamily long-term, but I think the risk of something happening right now that you don’t foresee—something Black Swanish—is underpriced in the market today.”

JRK recycled the proceeds from those sales into about $700 million in acquisitions. The company put 10-year fixed-rate debt at an interest rate of less than 3% on the acquisitions. And, there is still room for some value-add improvements.

“Even if the cap rates were a little bit tighter versus the last couple of years, you’re locking in a high single-digit to low double-digit cash-on-cash returns out of the gate, and there’s a minimal downside,” Lee says. “We do feel like the pressure for inflation is in our favor now with all the stimulus that’s been introduced in this system. If the market backs up, we’ll buy more.”

Lee’s reaction to COVID-19 and its fallout is a natural one. Reducing risk is a tried-and-true strategy during recessions. And, many CRE companies and lenders will be following suit soon.

But are there any more profound lessons that CRE firms can take from the pandemic? Or was the pandemic just a once-in-a-century event that is really impossible to prepare for? By the reactions of many CRE leaders, that seems to be the case.

“This wasn’t an economic meltdown,” Billy Meyer, senior vice president of real estate lending at Columbia Pacific Advisors. “The driver that caused this was an unforeseen pandemic.”

A Short-Term Issue

While the COVID-19 pandemic has been a medical and economic crisis of epic proportions, it wasn’t caused by bad real estate decisions or too much leverage.

That may make it tough for real estate leaders to take real lessons from the experience. “This came from a Black Swan event,” says Xiaojing Li, managing director at CoStar Group. “Nobody can anticipate that.”

If real estate leaders viewed the pre-pandemic economy as healthy and believe that there will be a quick bounce back, some observers think they’re less likely to find tangible takeaways.

“The most overarching view is that people are viewing the pandemic as a short-term event,” says Paul Fried, head of equity capital markets at Greystone Capital Advisors. “It may be a crisis, but it is not a long-term issue.”

Fried isn’t alone in that opinion. “I think once we get a vaccine and everybody takes it, and there’s this herd immunity, it might feel like we go back to normal,” Meyer says. “Do people continue to use certain disciplines that they’ve learned from this? I want to say they do, but how do you plan for a pandemic?”

Fried wonders if a more prolonged crisis might have led to more concrete, permanent changes in real estate. As things currently stand, he thinks the worst of the crisis will be over soon. “We were wondering how we would muddle along through 2021 to get to the other side of the pandemic,” Fried says. “Now, with the vaccine, everyone is actually pulling in that horizon.”

If there are widespread vaccinations in 2021, it may save the industry from the usual soul searching that comes after such a cataclysmic event.

“Rather than spend a huge amount of time, money and resources rethinking how we do business, it is much easier to think that the current crisis is somewhat short term and it will be behind us before you know it,” Fried says. “So what would be the point of wholesale changes in the way we think? By the time we do that, this thing is behind us.”

Max Bosso, vice president of Real Estate Development for Ryan Cos., doesn’t know if the pandemic will change long-term behaviors. Even if there are lessons, people are likely to forget them over time. “It’s human nature to tend to forget about these things as time goes on,” Bosso says.

Tighter Underwriting from Lenders

It’s not a universal sentiment that the commercial real estate industry will look at COVID as a once-in-a-lifetime event. Some people do think it will cause some soul searching and prompt changes.

“If you want to talk about lessons learned, one of the things that will come out of the pandemic is looking in the mirror and asking yourself, are we prepared for that Black Swan event?,” Norm Nichols, national business leader of project finance and affordable housing divisions for KeyBank Real Estate Capital. “It’s hard to say what that is.”

For lenders, COVID exposed the vulnerabilities in the underwriting, much like The Global Financial Crisis did. Meyer thinks the pandemic will make lenders consider the “doomsday scenarios” in underwriting that weren’t imagined before it hit. They’ll consider scenarios for how they handle the virus and how they recoup their money.

“I don’t think anyone thought of what to do if a virus comes in and takes over,” Meyer says. “It has exposed lenders to deal with more vulnerabilities.”

If there is soul searching among lenders, it may revolve around more robust underwriting, including lower leverage and more liquidity requirements from their sponsors. But much of this will be doubling down on lessons from previous recessions.

“Some of this is not a new idea, but low leverage and high debt service ratios are a good thing,” Nichols says. “We’ve tried to stay very disciplined around targeting sponsors that are modest users of leverage.”

Others agree. “As an industry, there is more of a focus on the amount of equity needed to invest in a deal than previously, which means less debt taken on by ownership and therefore less risk to all parties involved,” says Al Brooks, head of Commercial Real Estate for JPMorgan Chase.

For borrowers, the COVID crisis has shown the importance of low leverage. That’s even true in multifamily, where the Federal government provides a debt backstop with Fannie Mae and Freddie Mac.

“I think I’ve been more conditioned to be a little bit more thoughtful about debt maturities,” Lee says. “There is a strong two-horse game here between Freddie and Fannie. When we felt their pull back slightly back in April and May, there were far less debt options in the market. I was reminded about how quickly financing options can be pulled back in a perceived upcoming downturn.”

The structure of loans will also matter a lot as lenders look to lower risk.

“For highly levered sponsors with a large contingent liability schedule, it will be harder for them to load money or to get excited and comfortable with the project that they’re entering in with that new sponsor,” Meyer says. “If they have large contingent liability schedules, maybe they’ll require more diversified contingent liabilities versus having all of their eggs in one basket.”

For lenders, the COVID crisis also points to the importance of working with the right sponsor. “As lenders, sponsor selection is probably the number one critical item to get you through a financial crisis,” Nichols says. “Our experience in both this current pandemic and the financial crisis 10 years ago was that we did disproportionately better with our best-in-class and top tier sponsors.”

At least, for the short-term, expect that trend to continue coming out of the crisis. Nichols says that lenders will focus on “folks that have been in the industry for a long time, have a track record of performance during economic slowdowns and have other financial resources outside of a project to lean on.”

Managing their portfolio by staying on top of asset performance, including rent collection, deferral requests and tenant performance in the case of retail, is also critically important for lenders. Nichols says the pandemic shows the importance of proactively working with clients and restructuring loans once extreme events pop up on the radar. In the case of COVID, the US market had a two-month warning before the trouble really hit.

“There may be a covenant waiver or some decision to make about covenant treatment,” Nichols says. “Being on top of your portfolio management is critical.”

Bold Plays

In previous recessions, many of the sectors of commercial real estate fell in unison. The COVID-19 crisis has been different. The industrial sector has been a real winner. For multifamily, the story is a little mixed.

Hospitality and retail have been hit exceptionally hard. Many hotel rooms have sat empty and, if retail has not been essential, it has been crushed. Those experiences are likely to stick with lenders and CRE owners long after this crisis ends.

That said, it should be noted that some CEOs took advantage of the changing dynamics to make a bold play.

When fundamentals were softening in the multifamily sector, for example, Joe Lubeck, CEO of American Landmark, actually raised rents by some 4% across his Southeastern portfolio, though he has had to work with some residents on payment plans. He had noted early on the migration surge to the southeast and was ready to make a bet on it.

“We have found as a result of the pandemic, there is a demand for the Sunbelt strategy,” Lubeck says. “Apartments are strong, and more and more people are moving here from the North to the South and from the coasts to the Sunbelt, which we think is obviously great for our business model.”

And for all the carnage in the retail sector,  Simon Property Group CEO David Simon says he’s bullish on leasing in 2021 even as he cautions it will “take some time” to return to heady pre-pandemic levels. Healthy retailers with a solid plan are back to dealmaking, he says, telling analysts during the REIT’s recent earnings call that well-known chains like Dick’s Sporting Goods and Kohl’s are currently in talks with SPG for new store locations.

“Are we back to normal? Not yet, but we’re working our way back,” Simon said. “Generally, it’s still a very serious, intense negotiation on renewals. Retailers are generally cautious. But the ones that want to grow their business are excited.”

Proper Portfolio Allocation

If there is soul searching, it may revolve around how to prepare your portfolio for the unexpected. For commercial real estate executives and lenders, that often starts with looking at their portfolio’s diversification, whether it’s by geography, property class or asset type. “If you have that diversity in your portfolio, I think you’ll do better,” Nichols says.

In the future, borrowers might need to be more vigilant about the asset classes that have underlying weaknesses. Even if it looks like those assets have a few solid years, real estate leaders will need to consider how they’ll perform in the event of a dramatic market dislocation.

“Even though the pandemic is short term, I think it’s exposed the underlying weaknesses in some asset types, within the retail category,” says Branch Properties’ chief investment officer Jesse Shannon. “Tenants have been impacted through the pandemic. And I think it shows how vulnerable they are to systemic market risk.”

While some of the struggles that have hit certain segments, like seniors housing or lodging, couldn’t have been anticipated, retail issues have been on the horizon for a while.

“I don’t hear people talking about pandemic as the cause,” Fried says. “It’s more the accelerant. Retail was in trouble to begin with. The pandemic came along and just exposed the flaws of brick-and-mortar retail. And so we’re seeing the acceleration of a process that some believe was playing out over several years.”

Shannon thinks lenders will avoid certain hard-hit segments, but he doesn’t think they will avoid all retail sectors in the future. “One of the things that has been exaggerated in this pandemic is a dependency on online retailing,” he says. “I think any lender today is going to be very cautious about lending and in the mall space, especially the B and C mall space or in the power center space where you have larger junior anchor formats.”

Li thinks lenders will focus harder on the stability of landlord’s rent and revenue collection.

“There will be a continued concern for conservative underwriting because there is still a lot of uncertainty, especially for hotel and retail,” Li says.

For instance, Shannon has long-term questions about whether retail landlords should rely on restaurants. In the future, it may not be important to understand a tenant’s sector and financial acumen, but also their ability to adjust when they run into problems.

“What we’re already seeing is that the tenants have been able to weather the pandemic are those that were able to quickly adapt to takeout, dining and or patio dining,” Shannon says.

Instead, the pandemic has shown the value of having essential services, like pharmacies and grocery stores. Branch has focused on deals with grocery-anchored tenants, like Publix.

Nichols sees the same trends. “Within the retail space, businesses such as grocery stores and drug stores, have been insulated for obvious reasons,” he says. “People need the products and services provided through those channels.”

But it’s not just essential retail that’s necessary. The pandemic has shown the value of owning essential real estate. Even with some questions about rent payments, Nichols says the multifamily story is positive regardless because people need a place to live. Though KeyBank is active across most property classes, it is heavily weighted towards multifamily.

“In this downturn, I think being heavily weighted in multifamily will provide insulation and a benefit to us,” Nichols says. ”Some of the other property classes are more discretionary in nature and more easily pulled away from a consumer or user perspective than housing. So portfolio composition is critical.”

A Life-Altering Event

Whether or not things like leverage or portfolio composition will change, the COVID-19 experience will change us. With this much loss of life and livelihood, how can it not? “This won’t leave our collective memories anytime soon,” Fried says. “But to the extent it sits in the back of our brains, what is the impact?”

Fried says the lessons coming out of a health event as explosive as a pandemic will probably be more about personal health and distancing than about business lessons. It’s understandable. When an event threatens someone’s life or the lives of their loved ones, it’s sure to leave an imprint on them.

“Everyone is going to have a pantry with canned goods and a box of masks, a bunch of gloves and a lot of alcohol wipes,” Fried says. “This doesn’t get forgotten quickly.”

But how does this relate to commercial real estate? There are a lot of guesses, but only time will tell.

Lessons Learned from the Global Financial Crisis

While the COVID-19 crisis has been tremendously disruptive, its impact on the industry is that different from past economic dislocations.

“There are some unique characteristics [to the COVID crisis], but it’s directly similar to prior economic downturns,” says Norm Nichols, national business leader of project finance and affordable housing divisions for KeyBank Real Estate Capital.

In fact, the COVID crisis is the second cataclysmic, “once-in-a-lifetime” event to hit the market in the past 15 years.

“While Black Swan events by definition are expected to be extremely rare, the commercial real estate industry has experienced several of these events in the last few decades alone,” says Al Brooks, head of Commercial Real Estate for JPMorgan Chase. “As a result, owners have taken a more long-term approach on their assets.”

For many, the important economic lesson learned well before COVID helped protect many companies during the crisis.

”The major bank participants in the market have treated leverage in a different way in the current run-up,” Nichols says. “Compared to the three or four years before the financial crisis, far fewer transactions have maximum first mortgage positions or some combination of the first mortgage and mezzanine debt that tries to leverage up. I think it is substantially different, and there’s less use of high leverage in the bank markets.”

Without that high leverage, the distress that has come from COVID has originated from complete shutdowns in specific sectors. It hasn’t been a product of risky underwriting. “This time around, with the pandemic, we expect to see fewer defaults and foreclosures across the industry compared to past Black Swan events because of this shift in how the investment community is viewing risk and return on their assets,” Nichols says.