Credit, Covid-19 and Financial Engineering Have Disrupted CRE
On a recent afternoon a commercial sprung up on television advertising 0% APR for seven years and no money down for well qualified new car buyers. This is an example of just how disjointed credit has become in the U.S. economy but the machinations for how we arrived here are complex. It seems safe to say, for a slug of society, credit is no longer an issue and flows freely. This trend is no more apparent than in the bumpy but upward trajectory of major U.S. stock indexes since their lows in late March 2020. Since those fateful days, we all began to comprehend just how disruptive the coronavirus would be.
While many traditional economic indicators and politicians signaled that the U.S. economy was strong, credit markets were telling (and had been for years) a vastly different story. Historically low rates were a hallmark of the economic recovery from 2008, and while they had the desired effect of stimulating parts of the economy, they are a medicine with troubling side effects. Our decade of low interest rates drove assumptions across nearly all asset classes that rates would remain relatively low, despite nominal increases beginning in 2016.
One of the major side effects important to commercial real estate is tenant risk. The low cost of borrowing, ideally, stimulates borrowing for capital investments.In reality, many large companies used low rates as an opportunity to recapitalize and payout dividends or buy back shares of stock, effectively increasing leverage. Growth in capital expenditures in 2019 of 2.1% in North America lagged far behind earnings growth more broadly in the S&P 500, which saw nearly 20% growth per year since 2015. Anecdotally, we can assume then that companies are short on investment ideas and are plowing money back to their shareholders.
As we have noted in prior posts on our website, non-public companies are also increasingly risky. Private equity and venture capital have flooded capital into companies globally to the tune of $4.1 trillion. These firms are inherently risky due to their increased debt and utilization of cash to fund operations. These companies are ticking time bombs when confronted with the challenges related to Covid-19.
Over the past few months, we have seen some painful trends play out, and just as in the car buying example mentioned earlier, credit is tight for many less qualified commercial tenants.To date, we have seen the fallout manifest in the following major ways:
Increased debt and risk has ultimately weakened the durability of the WALT (weighted average lease term)
Tenants are looking to owners to help finance their businesses through deferrals, abatements, and other concessions
The gap is widening between the quality of the real estate asset and the tenant credit inside the asset
Commercial real estate companies across the country are confronted with many challenges regarding their tenants as a result of Covid-19. The current focus is and should remain on putting out as many fires as possible through creative lease structuring, providing ownership greater transparency and visibility into their tenants’ financial condition and operations. But longer term, surviving companies will largely be financially weaker than they were before entering our current crisis.
In our next edition, we will discuss the Fed’s response to the economy since the early days of the lock downs and evaluate how this will impact tenant credit longer term. Check back again with us regularly.