As coronavirus concerns seize economies the world over, Tom Barrack, chief executive of private real estate manager Colony Capital, has issued a stark warning that the damage to commercial real estate could be: “exponentially worse than the economic effects of the 1987 crash, September 11th attacks and 2008 recession, combined.”
Barrack flagged potential repercussions for the real estate sector such as cratering occupancy rates, massive layoffs and widespread defaults, in a Medium post last week. He also endorsed a number of solutions ranging from a half-trillion-dollar federal relief fund – like the one agreed to early last Wednesday morning – to banks tapping reserve liquidity to hold delinquent properties in forbearance. You can see our coverage of Barrack’s comments and all other coronavirus-related insights and analysis on the real estate finance market on our dedicated page here.
But most striking among his prognostications was the impending havoc of mass margin calls based on mark-to-market accounting. He suggests a temporary holiday for these requirements might avoid an unforced financial catastrophe.
Since the global financial crisis, banks have been limited in their abilities to lend on commercial real estate directly. Mortgage REITs and debt funds have filled the void, issuing hundreds of millions of dollars of real estate debt since 2013. But these mortgages are financed in part through repurchasing agreements with banks, in which the originator agrees to buy the debt back later. Key to these arrangements are banks’ abilities to enforce mark-to-market standards.
This practice is designed to protect banks by providing real time transparency and helping them maintain adequate liquidity. As with any asset-backed security, when equity values fall below a certain threshold, borrowers – in this case, the REITs and funds – can be called upon to make up the difference promptly or face forced sales.
Mass external disruptions, such as the current public health crisis, demonstrate the limits of these requirements. Property values are likely to drop across the board and, starting at the turn of the month, some owners around the globe will become delinquent on their mortgages, either by necessity or opportunistic choice. Were banks to issue margin calls to every affected originator, they would risk draining them of liquidity at a time when their capital might otherwise be used to prevent a destructive chain reaction.
Marking to market is a fraught exercise for private real estate even during the best of times. Commercial properties are subject to what Cyril Demaria, head of private markets at the Zurich-based consultancy Wellershoff & Partners, describes as the “echo chamber” effect, in which illiquid asset owners can do little except look at their peers to determine values. Transaction prices are poor gauges for strategic value, he says, with value-add or opportunistic outlays being particularly difficult to factor into models. When disruption is driven by non-market factors such as government-imposed shutdowns, it is near impossible to block out the noise of the moment and determine real value.
As the head of a company active in both real estate debt and equity, Barrack would, of course, benefit from a mark to market reprieve. However, that does not diminish the premise he posits. Tenants, landlords and mortgage issuers are all likely to experience some level of pain in the coming weeks and months. Margin calls based on distorted valuations executed with pre-coronavirus methods would only pour gasoline on the fire.
In the short term, with much of the global economy on pause, regulators would be wise to do the same for potentially punitive accounting practices. Fannie Mae and Freddie Mac, the US government-sponsored mortgage issuers, have created a sound blueprint in their policies toward multifamily owners. The agencies are allowing landlords to defer loan payments for up to three months, provided they can prove coronavirus-inflicted hardship and they do not evict tenants. In other markets, even that proof is not being called for. A similar stopgap measure for commercial borrowers has got to be appropriate, maybe not for the duration of the covid-19 crisis, but at least until a new normal is reached.
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