The Commercial Real Estate Reckoning Is Here
The best argument against the contention that the next financial crisis will be triggered by commercial real estate can be summed up in just three words: That's too easy.
Generally speaking, crises stem from underappreciated or hidden risks, fanciful or wishful thinking, willful ignorance, complacency or all of the above. The CRE story has almost none of those features.
The CRE "reckoning" narrative has been a fixture of the mainstream financial media landscape for the better part of two years
Perhaps it is like house prices circa 2007. Many people could see house prices were too high and set to decline. It was the magnitude of the price decline and the far-flung effects that surprised.
Investors have been mostly focused on banks and office CRE. Suppose investors start panicking about non-banks and non-office CRE?
CRE debt is about $4.5TR (not incl $0.50TR construction loans). By holder: 38% is held by banks, 20% by agencies/GSEs, 14% in CMBS-CDO-ABS held by a wide range of investors, 15% by life insurers, 12% by other. By property type: 44% is multifamily, 17% office, 8% industrial, 10% retail, 7% hotel, 15% other.
Investors who thought the risk was $0.3TR bank x office (38% x 17% x $4.5TR) might come to think the risk is also $0.75TR bank x multi and maybe insurer x office, insurer x multi, and other permutations as well – in other words, a many-fold larger risk.
As price discovery restarts, mark-to-market declines may accelerate. There’s anecdotals of office towers selling for 30% to 40% of the previous sale price. I don’t think that should happen to multifamily, since even in over-supply regions occupancy rates are in the mid-90s%, but if banks won’t lend then the buyer pool shrinks (the public REITs and private equity will get bargains, though).
More info here https://www.cohenandsteers.com/insights/the-commercial-real-estate-debt-market-separating-fact-from-fiction/ although they naturally think things are copacetic.
I’m the Trustee of a trust that holds a small position in a $2 Billion non-public multi-family REIT. Its buildings are valued once a year- the revaluations are spread out pretty evenly throughout the year. Since peaking in Dec 2022 the share valuation has declined 13 straight months. Meaning all the buildings have been revalued once, and a few twice. The drop in NAV in Jan 2024 was the largest yet. Overall, the REIT’s value has dropped 30+ % in the last 13 months.
The REIT holds quality properties in growing markets and has high occupancy. The distribution has remained the same throughout the 13 months.
It’s only one example, but anecdotally I think it suggests even multi-family drawdowns could be fairly high even in high occupancy units. Perhaps this is correcting previous over-valuation, but as John’s link suggests, risks may be quite high for multi-family buildings purchased near peak valuations.
Some of the public MFD REITs are down -40% from the 2022 highs. Valuing REITs is not my forte but on simple forward P/AFFO they look cheaper than early 2020 pandemic lows.
Thanks for the color John. That’s pretty surprising. When I think what early 2020 was like, I’d have had much greater trepidation then having a position than I would now.
On the non-banks, Blackstone Mortgage Trust (ticker BXMT) reports 14 February. It was the target of a Muddy Waters short presentation in mid-December. They pushed back hard on the MW report but their numbers are going be highly scrutinized given the office and multifamily exposures.
I’m not getting the problem w multi family – unless all those non boomers who can’t afford houses keep living either with parents or roommates- hard to reconcile lower apartment demand and unaffordable houses. Can both be true … Any help?
Limited to Sun Belt states it seems. Overbuilding funded early on. It was a layup investment! So many people moving down and those youngsters aching to get out of their parents basement — what could go wrong?
From anecdotal stories, it also may be a function of disillusioned new arrivals in Florida and Texas moving back out. In the case of Florida, many move to South Carolina. So they should not impact overall demand I suppose.
As derek says, and exacerbated by the developer’s need to move from construction loan to other financing when the project is completed if it’s not promptly sold. Many developers in 2021 probably figured they’d get the construction loan, build, easily leaseup, then quickly sell the stabilized property at a nice profit.
Then the project took longer, construction costs were higher, rents didn’t increase in the meantime as much as they expected, leaseup at the lower-than-expected rents took longer, loan rates went up, taxes went up, management costs went up, and some buyers can’t get financing because banks are leery of CRE or want low LTVs or are cutting back on lending/limiting to “relationship” lending, trying to meet capital ratios, etc.
So now the developer is carrying the construction loan which has a limited term, and can’t replace it with permanent financing at a cost that works, he’s bleeding red ink, was thinly capitalized to start with, and isn’t really in the business of managing a big apartment complex anyway. Turning keys over to the construction lender means losing the land value, even if the loan is non-recourse. Developer is desperate to sell.
The public REIT or PE fund see the blood and sharpen their pencils to draw more. They don’t need bank financing.
Right now, in my city, developers say that “nothing [new projects] pencils out”. The ones with existing projects in construction are probably anxious.
Short of capital available to suffiently pay down a loan to get the LTV (loan to value) correct, or comparable sales data, the banks will do what they have been doing for at least the last 30 years when a property is in trouble- “extend and pretend”.
This works (see 2007) until it doesn’t (see 2008). Maybe the comeuppance doesn’t happen this cycle, but history says it probably will.
If you believe that we are entering a period with declining interest rates, then terminal cap rates will also be lowered. When the banks revalue the real estate , using lower terminal cap rates (in a declining interest rate environment), the property valuations go up. This is why I think banks will just slow walk the process until rates start to decline.
In the 1990’s, when the RTC existed, banks ended up taking back the real estate, then selling it to the original developers for 25 cents on the dollar. The developers then leased up the properties and doubled the value. Banks looked foolish- the banks won’t do that again.
Thanks to JL for his analysis and your memories of the RTC. Unlike private real estate lenders, I’m not convinced that banks are anxious to staff up to manage residential properties.
It brings to mind a similar narrative back when many loans to shale oil drillers soured. Folks rightly asked if banks really wanted to start managing oil drilling operations. I never paid much attention to the major oilfield lenders, but I’d wager that they opted to “extend and pretend”.
My first book was a real estate textbook. I used to always get asked about my holdings. Those who asked were always surprised to learn the answer was that I didn’t have any. Real estate players are like Golden Retrievers. They have this habit of falling prey to waves of unfettered optimism. Real estate cycles are generally large and very nasty. A colleague once called me and said I hear you know real estate. He said he had three brand new duplexes he wanted to sell and wondered if I would be interested. I told him all my cash was tied up. He said, “Oh you don’t understand.” “I’ll give you $20k each to take them off my hands and assume the debt.” Ya’ gotta love crazy college professors. This was going to be his “can’t miss” retirement.