CRE Loan Defaults Soar Under Trepp Stress Test But Won’t Be as Bad as Great Recession

Under the scenario Trepp used, the cumulative default rate across commercial mortgages overall will rise to 8%, up significantly from the current 0.4% default rate.

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NEW YORK—To gauge the impact of the COVID-19 disruption, Trepp has applied an economic and real estate forecast scenario to a portfolio of 12,500 commercial real estate loans.

The findings were perhaps to be expected: defaults are expected to increase, in some cases significantly.

Under the scenario Trepp used, the cumulative default rate across commercial mortgages overall will rise to 8%, up significantly from the current 0.4% default rate. The impact will be most immediate and severe in the lodging sector, with a cumulative default rate approaching 35%. The retail sector will also experience elevated defaults, with an estimated cumulative default rate of 16% in the scenario. Other major real estate sectors analyzed, such as office, multifamily, and industrial, will experience more measured increases in distress.

The scenario Trepp used is a modified version of the bank regulators’ Severely Adverse scenario, with changes to capture the more significant expected declines in prices and NOI expected in the lodging and retail segments. This scenario assumes that GDP falls precipitously, the unemployment rate rises (peaking at 10%), interest rates plunge, and asset prices fall. Commercial real estate prices fall 35% over the first two years of the scenario.

Trepp applied this scenario to a portfolio of 12,500 commercial real estate balance sheet loans held by commercial banks that have an aggregate outstanding balance of $77.5 billion. It is a good quality loan portfolio, with a median LTV of 40.9 and median DSCR of 1.82.

This is what Trepp found:

The impacts of these higher periodic default rates over the 5-year forecast horizon will mean much higher cumulative default and loss rates for all types of loans, particularly lodging and retail loans.

Not as Bad as the Great Recession

Trepp does note that while these defaults will be severe, they are not as bad as the defaults and losses experienced during the Great Recession. For example, peak default rates in the Trepp COVID-19 Scenario are 2.7% for commercial mortgages and 0.4% for multifamily mortgages. Those rates compare to 4.4% and 4.7%, respectively, for the Great Recession.

There are a few reasons for that, Trepp says.

The scenario happens over a shorter time frame, which can lead to somewhat less severe impact when applied in a model. Perhaps more importantly, the portfolio of loans Trepp used for this analysis has good current credit quality, so the loan portfolio is starting out the forecast with overall healthy LTVs and DSCRs. “In the lead up to the Great Recession, lending and transaction volume was very high and underwriting standards had slipped significantly,” it noted.