By the Numbers

Gauging the impact of recession on commercial real estate

Mary Beth Fisher, PhD | July 22, 2022

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Commercial real estate performance during recessions historically has been weak, with the time to full recovery varying from one to three years after the trough. With the Fed tightening, recession risks have gone up. CMBS delinquencies ticked higher in June after generally declining steadily from the pandemic peak of June 2020. And commercial real estate prices this year have stagnated. Both delinquencies and stagnant pricing look likely to continue.

CMBS delinquencies ticked 7 bp higher in June from 2.5% to 3.2% (Exhibit 1). Although modest, a backlog of 4.9% of loans remain in special servicing due to pandemic. The proportion of loans in special servicing is expected to rise in the coming months as maturing loans find it difficult to refinance at higher interest rates, according to the recent report from CREFC and Moody’s. Projections are that up to 3.5% of the CMBS loan universe could experience a maturity default over the next 18 months.

Exhibit 1: CMBS delinquency and special servicing

Note: Includes both conduit and SASB.
Source: CREFC, Intex, Trepp

Weakness in CMBS would probably flow from a broader downtrend in CRE performance due to a recession that has either technically already started, or is likely to emerge as the Fed continues to battle inflation.

CRE performance and prices typically weaken during a recession

The National Bureau of Economic Research (NBER) has declared recessions four times over the last 35 years:

July 1990 – March 1991 (8 months)
March 2001 – November 2001 (8 months)
December 2007 – June 2009 (18 months)
February 2020 – April 2020 (2 months, the shortest US recession on record)

The rising unemployment and negative economic growth typical of recessions impairs the performance of most asset classes, and commercial real estate (CRE) is no exception. CRE property performance tends to deteriorate as demand flags and vacancy rates rise, causing cash flows to weaken. This cascades into declining property prices, reflecting not only cash flows but rates and risk premiums.

The primary method for valuing CRE is the discounted cash flow approach (DCFA). The DCFA is similar to valuing a bond or stock or any other financial assets in that it computes the net present value of future cash flows based on a discount rate. The discount rate is the sum of a risk-free rate and an investor risk premium. During a recession both the expected future cash flows can decline, and the discount rate is likely to rise. This typically occurs because the investor risk premium increases, or the Fed hikes interest rates causing the risk-free rate to rise, or both. The result is that CRE property valuations tend to decline during and after recessions (Exhibit 2).

Exhibit 2: Composite change in CRE valuation (%)

Note: Shaded areas are U.S. recessions.
Source: MSCI, Office of Financial Research

Weaker cash flows also put downward pressure on debt service coverage ratios (DSCR). The lower property valuations cause loan-to-value ratios (LTV) to rise. This is a negative for CRE investors in securitized products where credit metrics are declining and may be subject to credit rating downgrades, and for CRE lenders who can be required to hold more capital against the deteriorating loans.

Historically, CRE loan delinquencies and losses have increased during recessions, putting stress on commercial banks, life insurers and other financial institutions which had significant exposure. This caused lending to the sector to contract, financial conditions to tighten, and in isolated instances contributed to the failure of some small banks.

The 1990 recession is notable in that CRE prices continued to decline for several quarters after the end of the recession, taking 12 quarters for valuations to fully recover. There were two complicating factors that contributed to the long recovery time:

There had been a substantial run-up in CRE prices in the late 1980s
The 1990 recession is often referred to as the “jobless recovery”, because the unemployment rate continued to rise even through economic growth rebounded into positive territory.

The CRE weakness was particularly evident in the office sector, where the rebound in prices lagged in several major cities, creating a drag on the recovery.

A complete analysis of the performance of the commercial real estate (CRE) sector during these four recessions can be found in a recent paper, U.S. Commercial Real Estate Has Proven Resilient, but Emerging Risks Could Generate Losses for Lenders, published by the Office of Financial Research.

Mary Beth Fisher, PhD
marybeth.fisher@santander.us
1 (646) 776-7872

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