Where is the next area of pain for commercial property markets? Ask analysts, investors and even the debt collectors responsible for chasing unpaid mortgages and there is usually one common answer: apartment buildings.
An end to the US government’s stimulus programmes, they say, alongside a moratorium on landlords evicting tenants, will lead to severe losses for investors.
The logic is straightforward. Tenants, deprived of government stimulus, are finding it harder to pay their rent. Landlords in turn will have less income to pay their mortgages. This is then amplified by eviction moratoriums in many states, which prevent landlords booting out tenants who can’t pay their rent.
Finally, reduced payments will hit investors that ultimately finance the properties through the commercial mortgage-backed securities market, where property loans are bundled together to back payments on new bonds. But, crucially, this hasn’t happened yet.
The first round of government stimulus, which included an additional $600 a week in unemployment benefits, ended in July. Democrats and Republicans have been locked in a contentious battle to secure a second round of funds since. But while hotels and retail properties have come under severe strain from the effects of the pandemic, the data suggest apartment buildings have largely held up so far.
The number of tenants that have paid their rent this month remains only 2.4 percentage points below the same period last year at 86.8 per cent, according to data from the National Multifamily Housing Council.
Nonetheless, NMHC president Doug Bibby’s warning this month is stark. Congress must pass further stimulus “to avert a future housing crisis”, he said.
Financial markets haven’t flinched. CMBS deals underpinned by apartment buildings — known in the industry as multifamily — account for a big chunk of the total $1.4tn market. The vast majority — close to $800bn — are guaranteed by government agencies like Fannie Mae and Freddie Mac.
These bonds are considered to be a very safe investment because they come with the implicit backing of the US government. It means that even if tenants are unable to pay rent and landlords fail to pay their mortgages, the agencies will step in and bondholders will receive the money they are owed.
So far this year the difference between the yield on Freddie Mac’s apartment bonds and US government debt has actually reduced, indicating declining risk for the bonds since the pandemic struck. So why are so many players in the CMBS market concerned? And why isn’t their concern reflected in the value of the bonds?
The concern is explained by the movement in interest rates. Mortgages, especially government-backed mortgages, are closely tied to interest rates. After coronavirus spread in March, the Federal Reserve cut interest rates to make it easier for people and companies — including property owners — to borrow.
The rapid decline in rates pushed the value of existing bonds — which pay a higher interest rate to investors — up. For example, bonds issued by Fannie Mae in October last year with a coupon of over 2.5 per cent now trade at a price of around 110 cents on the dollar, according to data from Wells Fargo.
Widespread mortgage defaults across apartment building owners would mean investors in the bonds would receive 100 cents on the dollar from Fannie Mae. That’s a sizeable loss from where most of the bonds are currently trading.
“The issue is about when you get your money back and how much you get,” said Lea Overby, a CMBS analyst at Wells Fargo. “Because of how far interest rates have come down a lot of these bonds are well above par. If you only end up getting paid back 100 cents, then that’s pretty painful.”
The market has yet to reflect this potential loss, in part because the data simply haven’t sunk in line with expectations. That could change.
A clearer picture of the extent of the pain within multifamily CMBS will crystallise towards the end of the year as more information is released. It could also be informed by third-quarter results from real estate investment trusts.
The timeline on further stimulus from the government will also make a big difference. Until then, investors remain cautious, even if markets aren’t showing it.