Experts once thought that the COVID-19 pandemic would spare multifamily commercial real estate, but that’s not true—at least not according to a recent report from financial intelligence company Moody’s Analytics published last September 3, 2020.
You can find the entire forecast on Moody’s website, but we have also summarized its main points in this blog. The gist? The credit quality of CRE loan portfolios that are made up mainly of multifamily assets will deteriorate from the economic fallout brought on by the COVID-19 pandemic. Read on to get some insights on how you can position your investments during this time.
Multifamily is not Recession-Proof
Hotel and retail are two commercial property types that have been hit hardest by the economic slowdown from the public health crisis. Because housing is considered an “essential” business, experts initially believed that it will be spared or less impacted by a recession. However, the recent Moody’s Analytics report indicates that this is not accurate. Multifamily mortgage holders are expected to default on their loans.
In a Moody’s chart showing the portion of CRE loans in nonaccrual* state over time, it can be seen that historically, the performance of multifamily loans in recessions is not materially different from the performance of other types of commercial loans. However, nonaccrual rates on multifamily loans are markedly lower in good times. For instance, while multifamily property loans represented 31% of the outstanding commercial loan value in the 4th quarter of 2019, they made up only 6% of nonaccrual loans in that period.
*Nonaccrual loans are what lenders call unsecured loans whose payments are overdue by 90 days or more. These loans no longer generate their stated interest rates because the borrowers have made no payments. These loans are sometimes called troubled loans, bad loans, or doubtful loans.
The Moody’s Analytics report also states that from the last quarter of 2019 to the second quarter of 2020, the value of nonaccrual multifamily loans rose by 67% while the same metric for nonfarm nonresidential property loans grew by 59%. The report also clarifies that nonaccrual rates are “suppressed” at the moment due to mortgage forbearance and modification policies, so these numbers may not be accurate representations of the real levels of distress in this CRE segment. Additionally, nonaccrual rates don’t generally peak until two or three years after the start of a downturn—which means that what we see right now is just the beginning of a continued rise of nonaccrual rates.
Here’s another noteworthy trend from Moody’s examination of historical credit cycles: While multifamily loans are often considered to have lower risks than other CRE loan types, history doesn’t convincingly prove that this is true. In the last three economic recessions, it was only once—during the dot-com bust—that multifamily loans outperformed others in terms of credit risk. In the two other recessions, nonaccrual rates on multifamily loans (at peak credit events) were slightly higher or at least on par with different CRE loan types.
Possible Loan Losses
The recent Moody’s Analytics report examines potential CRE loan losses under three scenarios.
The first scenario is Moody’s baseline estimation of how COVID-19 will most likely play out. The scenario assumes strong economic activity levels in the third quarter of 2020, followed by low but positive economic growth until the last quarter of 2021. Growth is expected to pick up afterward, reaching 10% for several quarters.
In the second scenario, the report uses the US Federal Reserve’s postulation that the economy will show a U-shaped recovery—that is, continued contraction in the third quarter of 2020, followed by low but steady growth in the next several years.
The third scenario—also suggested by the Fed—is when the US economy shows a W-shaped recovery because of a COVID-19 resurgence in the fall. Strong growth is predicted in the third quarter of 2020, followed by negative growth in the second quarter of 2021. A slow recovery is expected from that point, with the first quarter of 2022 showing positive growth.
Interestingly, the two Fed scenarios assume starkly different degrees of economic activity in the third quarter of 2020. The fundamental difference? One scenario expects a resurgence of the pandemic in late 2020, and the other does not. Because this resurgence would happen after the third quarter, it doesn’t account for the disparity in economic activity shown for this period. These scenarios were not developed based on their probability of occurring; they simply represent two outcomes possible as the pandemic plays out.
The expected total losses on multifamily property loans for each scenario is as follows:
Scenario 1: Moody’s Analytics baseline
- One year (Q2 2021) – 1.8%
- Two years (Q2 2022) – 2.6%
- Three years (Q2 2023) – 3.0%
Scenario 2: Fed U-shaped
- One year (Q2 2021) – 5.0%
- Two years (Q2 2022) – 6.4%
- Three years (Q2 2023) – 6.7%
Scenario 3: Fed W-shaped
- One year (Q2 2021) – 3.7%
- Two years (Q2 2022) – 7.0%
- Three years (Q2 2023) – 8.1%
An 8.1% loss in multifamily loan portfolios in a three year Fed W-shaped scenario seems like a big number. Still, it’s smaller than the expected 26.1% loss for hotel loan portfolios in the same period. On the other hand, industrial property mortgage portfolios in the same context are expected to lose only 4.4%.
This blog is a summary of a comprehensive 16-page report that discusses other economic factors under these three scenarios, including interest rates, credit spreads, credit rating shifts, and unemployment levels. The report also talks about nonaccrual rates for other commercial property loan types.