The year 2020 was truly a year like no other. As the year draws to a close, we would like to share our impressions of the current state of the real estate market and our expectations for the year ahead. We have broken our analysis down into four categories – (a) leasing, (b) lending, (c) acquisitions, dispositions, and development, and (d) private equity real estate funds.
The market for new commercial leases slowed to a halt in 2020. For existing office leases, landlords were generally hesitant to agree to rent abatements. We saw some limited activity in the office market consisting mostly of deferments of rent from two to four months, with varying payback periods, often with an interest component. Those office tenants fortunate enough to have leases rolling over during this period, instead of being offered deep discounts to renew, were often offered unchanged base rental rates for short term renewal periods. Longer term extensions (or the rare new lease) also maintained near pre-COVID rental rates, with breaks given in the form of outsized free rent periods and much more generous tenant improvement packages. This was done so that landlords and their lenders could maintain the appearance of their high pre-COVID level “face” rates, while limiting the possibility that their rents would be under market when the pandemic ends.
The most substantive change we have seen from office landlords is how they deal with their defaulting tenants. In the past, landlords would run to court to terminate the leases of their defaulting tenants so they could obtain possession and re-lease the space. Now, with the prospect of finding a replacement tenant challenging, and with courts reluctant to hear (let alone, determine) possession proceedings, landlords find themselves holding on to non-paying tenants and accumulating unpaid rental fees. Some security deposits are now being tapped and others are sure to follow suit. Landlords are again playing the waiting game and hoping their current tenants will continue to need their existing space once they “return to normal”, at which time deals will inevitably be cut regarding back rent. Landlords are implementing this strategy in the hope that, when things do return to normal, they will be able to retain a good percentage of their current tenants without having to incur leasing commissions and additional rental loss looking for new tenants.
Many office tenants who signed “good-guy” guarantees have surrendered their spaces. To limit liability, many guarantors took advantage of the “good-guy” provisions and vacated their office space, forfeiting their security deposits and, if they were able, closing their operations. It’s too early to tell what, if any, modifications landlords might make to future “good-guy” guarantees, or if they’ve soured on them. As with the rest of the commercial leasing market, we’ll have to wait to see what 2021 brings.
We anticipate that 2021 will be an extremely busy year for the commercial leasing market. An eventual market adjustment, pent up demand, deals to renegotiate existing leases, plenty of space to lease and some tenants in need of new office space, all point to a very active 2021.
Loans continue to be available for borrowers with prime, performing assets. Favorable loan terms are generally available for well positioned properties and borrowers as lenders compete to deploy capital in an environment where the number of financeable projects has thinned from typical levels.
Many lenders have updated their loan covenants to address the effects of the COVID and the associated pandemic, as well as to anticipate the possibility of similar catastrophes in the future. Areas of overhaul include force majeure provisions, environmental covenants related to health, bio-hazards and public safety, environmental indemnities and recourse carve-outs. Shortcomings in the existing language contained in loan documents to address these issues have come to light as borrowers and lenders alike have looked to their legal counsel to guide them as to how these provisions might be interpreted and enforced in the current COVID environment.
Another major theme of lending in 2020 has been flexibility in the adjustment of economic terms. At the start of the pandemic, lenders were overwhelmed as entire portfolios of loans went from performing to distressed overnight, with tenants withholding rent and owners struggling to service debt. In addition to temporary forbearance agreements, we have seen many amendments that temporarily or permanently reduce interest rates and soften or suspend various loan performance covenants. These include requirements to maintain reserves, debt service coverage ratios, loan-to-value covenants and other metrics. The goal has been to keep loans performing if possible, and carry borrowers with good long term economic prospects until more robust economic activity can resume.
As you may be aware, LIBOR will soon be phased out. New one-week and two-month US Dollar LIBOR rates will cease being published after December 31, 2021, and all other US Dollar LIBOR rates will cease being published after June 30, 2023. Although the publication of certain US Dollar LIBOR tenors will extend until June 30, 2023, it should be noted that the purpose of the extension is to allow most legacy US Dollar LIBOR contracts to mature before disruptions to US Dollar LIBOR are to occur. Borrowers and Lenders should be mindful of these changes in connection with both their new and existing loans.
We expect to see lending activity continue to increase in 2021 as the economy continues to stabilize and hopefully improve.
Acquisitions, Dispositions, and Development:
The market in 2020 has been one of evolution and it continues to evolve. The first half of the year saw significant market disruption, with many deals being broken or terminated prior to close, and disputes breaking out over earnest money deposits. As the pandemic has dragged on, an unexpected seller’s market has evolved for certain in demand assets. While deal flow in the office and retail sectors continues to be significantly muted, we are seeing transaction activity become increasingly concentrated in industrial assets, life sciences assets, properties net leased to tenants with strong financials, and middle to high-end multi-family assets. Investment funds and other institutional investors with capital to deploy are often encountering highly competitive bidding wars for these types of assets.
We have also seen parties cautiously proceed with construction projects, as developers, investors and lenders attempt to strategically position themselves by backing projects scheduled to achieve completion after the anticipated end of the pandemic.
We expect to see transactional activity increase in 2021 (particularly in sought after product categories) as the economy improves and institutional investors work to deploy their dry powder. We also expect that as pricing begins to stabilize for distressed properties, we will see deal flow for those asset classes pick up as well.
Private Equity Real Estate Funds:
The year 2020 saw many established sponsors continue to successfully raise new funds notwithstanding the pandemic. We have seen less established sponsors also have significant fundraising success in distressed, life science and industrial strategies. The economic and legal terms contained in the recent offerings that we have seen have not materially changed during the pandemic. We have also seen sponsors abandon largescale fund offerings and instead move their focus to separate accounts with existing investors.
From an investment perspective, many fund sponsors have spent much of the past year on the sidelines. These sponsors are sitting on large piles of dry powder which should make for a very interesting and active 2021.
With the anticipated distribution of multiple vaccines, we anticipate 2021 will bring more stability and focus to the real estate market, offering new opportunities for tenants, landlords, lenders, purchasers and sellers, fund sponsors and other market participants. Seward & Kissel’s Real Estate Practice Group is available to assist on your real estate and real estate fund formation transactions. Please contact Rhona J. Kisch (212) 574-1510, Adam D. Lesnick (212) 574-1393, Ian H. Silver (212) 574-1209 or Bryan D. Swiss (212) 574-1229 if you have any questions or would like any assistance in connection with your real estate needs. We thank you for trusting us and look forward to serving you in the year ahead.