Expect Higher CRE Default Rates During COVID-19 Recovery, Trepp Warns

COVID-19′s economic downturn will trigger rising defaults and losses in the commercial real estate lending sector during a speedy recovery or second-wave, according to a new report released by Trepp.

The cumulative default rate across commercial mortgages will increase to 6.5%, up from the current 0.5% default rate, Trepp wrote in the report, which analysed 13,000 commercial mortgages from various banks.

While a dreary what-if analysis, Trepp noted its latest forecast isn’t as severe as its March’s estimates that predicted significantly higher cumulative default rates in the commercial sector.

Notably in March, Trepp wrote lodging default rates would reach nearly 35% and 16% of retail businesses would default on their loans. This week Trepp updated its default projections to 21% of lodging entities and only 9% of retail. The modified predictions were based on REIT share prices rallying in April and May, leaving the year-to-date figures less severe than March’s earlier estimates.

Despite the brighter outlook, Trepp noted the new projections still underscore a broader economic downturn that many businesses will struggle to rebound from.

Trepp created a “default model” to test how COVID-19 impacts the economy and the commercial industry’s default rate. According to Trepp, the default rate for lodging loans will jump sharply, reaching a peak of 6.1% by the end of 2020. But as stronger economic and market conditions occur in 2021, Trepp wrote the lodging industry’s default rate would drop to below 1% by the end of 2021.

Retail defaults will also peak in Q4 2020 at 1.5% and office and multifamily defaults will also rise, but not as severely. Trepp wrote the default rates for office loans will creep up to 0.7% and 0.8% for multifamily loans then recover by the second half of 2022. Industrial mortgage defaults will also rise in Q2 and Q3 2020, a result of some loans starting out with “weaker” current LTV and DSCR metrics, Trepp wrote. Industrial mortgage defaults—however—should reach minimal levels by late 2020-early 2021, Trepp added.

Still, predicting the economic impact of the coronavirus outbreak is difficult, as surges may occur and states’ responses will differ, Trepp noted. As such, Trepp analyzed how default rates could fluctuate during a fast recovery and a second wave of the coronavirus.

If the economic recovery proceeds briskly and unemployment falls at a rapid pace to single digits by Q4 2020, commercial real estate price and NOI declines are half as severe as in Trepp’s main COVID-19 scenario.

Specifically, lodging defaults would peak at 0.9% in Q2 2020 and drop to the 0.5%-0.6% range during 2021 in a fast recovery scenario, Trepp wrote. Retail defaults would also peak at 0.8% in Q2 and remain above 0.2% until early 20202. Other property types, including office, multifamily and industrial, would see an uptick in default rates in Q2  but later experience rapid declines with default rates under 0.2% by late 2020 and early 2021.

While a speedy recovery would be ideal for many, Trepp noted a resurgence in COVID-19 could exacerbate an economy still reeling from the first wave of COVID-19. In its second wave scenario, Trepp found high and prolonged unemployment rates led to a surge in defaults in late 2021 through early 2022. Lodging and retail defaults would reach new highs in Q1 2022 and office and multifamily default rates would hit new highs at 3.9% and 3.4% respectively in Q1 2022. Industrial default rates, however, would rise modestly during a slowed economic recovery, Trepp wrote.