Bank failures, CMBS delinquency surge pressure debt, spreads

NATIONAL REPORT – Just days after last week’s collapse of Silicon Valley Bank, Signature Bank and Silvergate Capital and a near miss for Credit Suisse, it appeared that U.S and European regulators had firewalled the contagion effect of these failures. But was it enough?

Some hospitality industry experts had been expecting this since Q3 2022, but especially since Q4 when it became more apparent that Federal Reserve interest rate hikes might not end with a pair of parting shots at the close of Q1 2023. Reports on CMBS activity at the end of February should have been a wake-up call for a broader investor audience that an “event” was on the near-term horizon.

After humming along at a fairly even keel for months, CMBS delinquency rates jumped 18 basis point in February, the second highest single-month increase since the outbreak of COVID. That left borrowers with a new round of concerns about further narrowing in the debt markets, the impact of interest rate hikes, inflation and the possibility of a deeper recession. Concerns turned to outright worry with the bank failures and near-failures the week of March 10.

The dust is still settling

How much the contagion effect will cloud the outlook for the $5 billion in CMBS securitized lodging loans maturing this year is unclear. “Given the recency and fluidity of the bank failures, I cannot comment on what that will mean for CMBS default rates at this point,” said Zachariah Demuth, global head of hotels research, JLL.

However, he did point out that although lodging loans maintained the second highest 2022 default rate among the various industry sectors with CMBS loans (hovering in the 4.45% to 4.64% for the final quarter of 2022, well behind retail’s average default rates in the low-to-high 6% range over that period as measured by the Trepp CMBS Delinquency Rate), delinquencies in the hotel sector remained stable throughout last month’s 18-basis-point  delinquency climb, edging up a single point at a time when the office delinquency rate rose 55 basis points to 2.3% and multi-family delinquencies jumped 27 basis points to 1.83%, according to Trepp’s analysis.

“The stability in the number of hotel loan delinquencies in February was a function of accelerating fundamental performance, particularly in urban markets,” Demuth said. “But, if you’re trying to get the big picture for this year, rather than looking at one month, the important factor to look at is the level of distress, whether that’s default per se or non-servicing of debt. That has fallen considerably since its peak in the middle of 2020. Almost 15% of securitized lodging loans were in distress at that point, with many of them approaching default. Now we’re looking at 4% or maybe 3.5% and that’s continuing to drop since hotels are performing quite well. The actual number of truly distressed hotel assets is actually quite small.”

First-round exceptions could be more market-driven than performance-driven. “We do continue to see some levels of distress in the Northeast as well as in the Midwest. And as we know, these are two kinds of the regions that have been a little bit slower to recover. These areas could have levels of distress that could potentially approach default,” Demuth said. ”We keep hearing about these waves of distressed sales and they just haven’t happened. We’ll be talking about a handful of hotels [pending further events such as bank failures].”

No need for panic yet

Rod Clough, president – Americas, HVS, also doesn’t see what he calls a “Lehman Brothers size event” creating a tidal wave of distress in the wake of the bank failure. “It is unlikely that these select bank failures will impact the lodging market performance dynamics in a meaningful way that would cause specific hotels to move faster into a default status. With Credit Suisse securing funding, and other lending fundamentals generally positive, we hope that nerves can start to calm as we move beyond what is hopefully isolated incidents. Time will tell.”

That outlook is much the same from the brand side.

“While there is a significant amount of capital sitting on the sidelines waiting for debt-induced distress, other groups are pursuing opportunities to recapitalize properties and facilitate refinancing in this higher rate environment,” said Dan Thorman, senior vice president, development, full service, U.S. & Canada, Aimbridge Hospitality. “Given the sheer volume of capital waiting to pounce and active underwriting both on- and off-market opportunities today, those who wait the longest are likely to be left sitting on the sidelines.”

Other factors will impact the possible outcomes. “If demand and employment hold, and lenders and servicers continue to work with borrowers, the [CMBS] default rate has the potential to stay muted,” said Brian Quinn, chief development officer, Sonesta International Hotels. “The CMBS market is sensitive to broad economic trends: it forms up, occasionally gets locked up, and then reforms. There are cross currents regarding demand, unemployment, recession risk and upward pressure on interest rates. Lenders, the master servicers and special servicers are going to have to look at each situation and decide where the risk is, if any.”

What Clough and Emil Iskandar, senior vice president, capital markets, Los Angeles, HVS, do see as risk for potential distress is less about the downfall of Silicon Valley Bank or slow-recovering markets than a longer-term failure to adapt to the post-pandemic realities of lodging demand.

They said hotels that were long-dependent on higher levels of corporate transient demand will need to pivot to a new story. They added that if they haven’t successfully done so yet, lenders are now more willing to step up and bring hotels into foreclosure or negotiate a deed-in-lieu (DIL) with the borrower to take control of the asset. They expect to see a lot more of this in 2023 as the pandemic becomes more distant in the rearview mirror and the local realities of demand are accepted.

Sector strength cuts collateral damage

The underlying fundamentals of the lodging industry and its current performance make a flood of CMBS defaults unlikely despite the impact of macroeconomic and bottom-line pressures.

Then there are the dual factors of market and strength and performance metrics. “If we look at the CMBS’s securitized lodging loans, only 3.5% to 4% are in some sort of distress or non-performing status. Some may result in actual distressed sales but, again, we’re not talking about a material number,” Demuth said.

Although 2023 is not expected to keep pace with 2022 performance, borrowers have a good long-term story to tell. “The continued demand for lodging creates the potential for lenders working with borrowers to rework loans, and the fact that most assets have appreciated with the snap-back in demand in 2022 will be part of that calculation as well,” Quinn said. “In our space were always looking to maximize the business. That means managing the costs to develop and cost to operate.”

That performance record could give borrowers bargaining power with their banks or at least buy them time to avoid panic selling. As Quinn pointed out, unlike retail which “is suffering from the Amazon effect” or office “which is facing a reset as more people work at home or are in hybrid situations,” the demand for lodging is not threatened in the same way.

The overarching issue of capital dislocation could add another layering of cushioning. “It is hard to predict where default rate will be in Q3, however, with the abundance of capital in the market we think borrowers will figure something out to avoid a default,” Iskandar said.

Part 2 of this report will look at how to play the opportunities of the assets that do come to market as their CMBS loans mature in an environment of high interest rates, inflation and possibly a deeper than expected recession.