Talk Your Book: No Bank Runs in Commercial Real Estate

0:08Today's show is brought to you by USQ. Michael Batnick and Ben Carlson work for Ritholtz Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast. Welcome to Animal Spirits with Michael and Ben. You know, Michael, one of the things people like to say after we're in the midst of crisis is, here's the next shoe to drop.

1:01I mean, not that it's wrong, but that is something people say because it seems like, I don't know, people have these things happen in threes or there's more dominoes, whatever it is. But the next shoe to drop, people do start to think about what the next crisis is going to be because a lot of times these things do happen in succession with one another. So commercial real estate, specifically office real estate, which is only a sliver of commercial real estate, has been in the news as to Ben's point, the next shoe to drop. is anybody unaware of the potential challenges that office real estate has going forward?

1:33I mean, for goodness sakes, SL Green, a prominent player here in New York City, the stock is on 82%. You know how much these stocks were down in GFC? This was down 94%. So I know there's a giant gap between 82 and 94. But my point is, we know, the market knows, and guess who else probably knows? I'm pretty sure management knows. What do you think? And the banks know. And maybe the idea is, well, there's nothing they can do to stop the bleeding at this point. But to your point, a lot of the pain has already been taken probably. My point is not, we want to go all in here. I only say that, yeah, we know that there's risks and so does the market.

2:11It's down 82%. It is one of those things where because a lot of people in the world of finance live on the East Coast and live in New York, those types of things, you see the signs or you hear the stories about people, you know, the subway stuff is still 60 % below peak, whatever, no one's going back downtown. I think you assume, okay, that means commercial real estate is dead at the moment, and something really bad is going to happen. Unless you have a 2008-like event where everything sort of happens at once, and all these risks that build up over the years really just come to the forefront at once.

2:45I feel like in a space like private real estate, it's the kind of thing where even if there is a secular headwind, it's not the kind of thing that happens at once. It's not an event. It's a process that slowly happens over time. And the pain is taken in bits and pieces, not all at once. So I agree with you there. Secular headwind. I do agree. I think that there is before and after COVID. I think there will be less demand for office space going forward. But how do you measure that against the fact that these stocks already got killed? Is there an opportunity? Is it at the bottom? Is it going to get worse?

3:15We don't know. But we spoke to Tom Miller from USQ, who is an expert on commercial real estate. And I hope you enjoy the conversation. The one point I thought he made that was interesting is people looking at, well, rates are up. So that means investing in real estate, you're screwed because of refinancing risk. If you have to roll your debt over at some point, that's staring you in the face. His offset to that was, yeah, but people have been able to raise rents 15 to 20 % in multifamily housing, which I just want to have him, you know, I talked to our producer Duncan about this a few weeks ago.

3:45Winnie the Pooh meme. Apartments, regular Winnie the Pooh. Winnie the Pooh with a monocle, multifamily housing. Fair? I know townhouses are in there too, but don't you think multifamily housing is a really good way of saying apartments? Are they the same thing though? I feel like multifamily housing is like a two-family home. I think most commercial real estate in multifamily housing is apartments. Hang on a minute. Sorry. No, no. I'm a big proponent of the Winnie the Pooh meme. It's cute, but apartments are apartments and multifamily housing is multifamily housing. I'm sorry. You think that's two different things?

4:15Those are two different things. Yes. Maybe multifamily housing could be like townhouses then and rentals, you think? Yeah. Yeah. Condos. Not condos. I'm sorry. Townhouses. Townhouses. Yeah, sure. I thought the apartments were lumped in with multifamily housing. Okay. Meme off the table. Anyway, but he was saying that, yes, these higher rates are going to hurt at some point, but they've also been able to raise rents higher than a rate of inflation. So there is some back and forth there. Anyway, yes, it is the space where a lot of people are concerned and in many cases for the right reasons. What if the chute doesn't drop?

4:49This is their glass half full side of me, right? So anyway, interesting conversation with Tom. No, no, no. What if the glass is only a third full, but the market thinks it's 80 % empty? Maybe the glass just has a really big square ice cube in it, like all the bars you go to in Manhattan and it's less liquidity than you think. I don't know. All right. Here's our conversation Tom Miller from USQ. All right. We're joined today by Tom Miller. Tom is the CEO and CIO at USQ. Tom, welcome to the show. Yeah. Thanks for having me, guys. I'm a big fan. Thanks for coming on. All right. So real estate, what is it?

5:26That's me doing my best Ali G impersonation. I like it. There's a lot of negativity around it in the press right now, but it's not like that. We're a couple of real estate today. I know, Obviously, real estate is not monolithic. There are several different variations of it. It's been in the news lately. Why? Obviously, COVID upended everything, interest rates, office vacancies. So let's start out talking today about commercial real estate. When I think of commercial real estate, I maybe unfairly think about the office and how potentially effed it is going forward. But you tell me, why should I think broader than just the office?

6:00Commercial real estate is really so much more. It's industrial properties, it's multifamily properties, it's retail. And retail is more than just malls too. It's grocery anchored necessity-based retail. As a matter of fact, the index that we follow is the NFI Odyssey Index. Office makes up less than 20 % of it. And so when you look at it in that context, yes, we understand and we see that office has some challenges. People haven't returned to the office quite as quickly. That said, even within office, Class A office is doing just fine. You're seeing leasing activity in Class A office. You're even seeing some of the big headlines you're reading where people are walking away from office buildings.

6:39They are deploying new capital into highly desirable state-of-the-art Class A office that's highly amenitized. And so it's a tale of two cities here in that Class B and Class C office, would I want to be there? No. There's definitely some challenges in the short term. But I think in the longer term, as people get back to work and we're seeing those headlines emerge right now, people are coming back to the office. So it's not as doom and gloom, and it's certainly not as big of a part of the commercial real estate markets as many of the articles in the journal would lead you to believe. I think part of this is Michael is a coastal elitist, and he's in New York all the time.

7:13But is a place like New York really screwed in terms of, of course, real estate, or are they going to be fine? No, they're going to be fine. They're coming back. Listen, this isn't the first time that office has taken it on the chin. Not to bring up bad times in New York's past, but you look at there's been things that have happened in New York where people said, oh, there's never going to be a return to the office again. That has obviously since waned and people are back. I would also say that the local economy of cities and the infrastructure that having a downtown community supports is very real.

7:42And so what I think you'll see in time, you'll see incentives for people to get back down into downtown office space. And when you think about all of that, having office workers come in every day supports, it's all the local restaurants, It's the local pubs, bars, whatever it may be, local industry. It's very real that office workers drive that. Not to mention real estate taxes support things like infrastructure in the major cities and schools. And so when you're saying that commercial real estate is dead in a city like Manhattan, I don't buy it. I think there's definitely short-term headwinds ahead, but Class A, I think, is still doing well.

8:17And like I said, you're seeing it lease up even in this environment right now. All right. So a few things there. I will take the other side of it a little bit in that, yes, Manhattan has had challenges in the past, but not like this. I do think that COVID was a watershed moment. I am never going back to work five days a week. And I think that there's a lot of people that are in that category. So I think that company's footprints will shrink. Now, that being said, this is not news to anybody. I'm looking at SL Green. The stock is down 82%. You're not going to surprise anybody by saying commercial real estate is challenged or office space is challenged.

8:49If you look at the bonds, I'm sure they're trading just as bad as the equities. So is there, and maybe I'm asking a barber if they need a haircut, and credit to you, you're bald as am I, is the fears overblown? I mean, an 82 % drawdown is not nothing. I think there's definitely the paranoia of the public markets. If you think public markets don't overreact, I have some data I can share with you. Public markets overreact almost every time. And that's to the upside and to the downside. And so, you know, Michael, the interesting thing, and I'm just looking at my note here, Nobody was screaming for private real estate or real estate.

9:23Publicly traded REITs in 2019 were up 30%. And that was overdone. And then they came back down in 2020. And then 2021, again, explosive return. So public markets overreact. We know that. There's been a Nobel Prize for the gentleman, Richard Baylor, that proved markets overreact. So I don't think you can just draw all of your conclusions from how a stock is trading on any given day, week, month, or even year. Sure. Markets are crazy, no doubt about that. They overshoot in both directions. But how do you see this playing out? Because it's not as if all of the debt matures at once, where it did in the GFC, where when the teaser rates went away, everybody woke up and realized that the music stopped playing.

10:02Are we going to have a rolling set of mini blowups for the next eight years as these leases come out? Or again, are those fears overblown? I think they're overblown. And I think commercial real estate owners and operators knew this. COVID happened in 2020 and rates were still very low. So you've seen a lot of borrowers that needed to borrow in commercial real estate, take on debt and push it out as far as they can at low interest rates. When we look at what we're tracking, the NFI Odyssey, the amount of debt is almost, I mean, it's de minimis that's going to actually mature in 2023. And so I think you have to give some credit to the commercial real estate operators.

10:39Some of the office buildings, they've moved to multi-use. They've also been very smart about taking debt when they took it and tried to push it out at five, seven, 10-year terms where it was available. And so I think with that being said, you really have to think about it. And I think to some extent, it's overblown. Obviously, you don't want rates to go... If your 10-year goes up to 5.5%, I think you have more problems than just commercial real estate. You have other companies that are taking on debt, regular publicly traded companies taking on debt at huge levels and that have taken on debt at huge levels.

11:10If that all came due tomorrow, you'd have a calamity on your hands across the United States, probably across the world, but certainly within the United States. So I think right now, you're still seeing the overreactions. And I think over time, you'll see that come back. We are seeing, I think the last workers remaining to come back to the office have been information services, and you're starting to see that reemerge as well. Well, ChatGBT is going to get them back in the office. That's exactly right. And a fear of a recession too. When the employee has all of the power and says, you know what, I'm not coming in and there's nothing you can do.

11:44Well, put a recession in the mix there and have mass labor. Joshua said that paradoxically, a recession would be the best thing for New York real estate. Ironically, that's probably the truth. I was thinking through the refinancing risk. You mentioned that sometimes they push the terms out to five, seven, 10 years. So obviously this is not in commercial real estate. It's not like a regular homeowner taking out a 30-year mortgage. Are the rates pretty similar too, if for the places that do have to refinance? So I don't know, it's six and a half percent on a 30-year mortgage right now. Is it pretty similar when you're borrowing in this space or does it a little different?

12:14The last time I looked at it, so spreads were about 200 basis points. So it's your 10-year plus call to spread. And this is office. It's actually much more attractive in multifamily and industrial. So if you think about it today, office, and this is not highly levered. So again, you have to be careful of what real estate you're talking about. But if you're in that less than 60 % LTV, you're probably at 550, 600 basis points. Can you explain for the audience who might not know what you're talking about? What does that mean? For the spreads and the 10-year? Yeah. And the LTV. Oh, sorry. Loan to value ratio.

12:48So how much debt you have relative to the value of the property. And so why that matters is low LTV, what that means is you're still secure. Even if the price of the property were to drop, you still have more equity than you do debt in the building. What you really don't want to happen is you don't want an LTV of 80 % and then your real estate value to take a hit by 30 to 40%. That's what you saw in the GFC. And that's when real estate owners have no incentive to stay in. They literally can hand the keys back to the bank and walk away from that. But as long as you're in that lower leveraged, good real estate that is amenitized, I think, again, the fears might be a bit overblown.

13:26All right. I promise we're not going to spend the entire episode talking about commercial real estate, but I have one more question on how this works. So, all right, I'm in a building. I'm Brian Park. Is the building owned by a company or financed by a company that has a relationship with the bank. They take out a loan and then they're trying to fill this and make sure that the office is fully occupied. Can you explain the dynamics of that? So let's say that we choose to leave after our lease is up in 2028 and they can't find people to replace it. How do those dynamics between, in often cases, regional banks with commercial landlords and their tenants, what does that triangle look like?

14:01I think what you have to remember, Michael, especially in the higher quality commercial real estate, it's not all banks. And I know you see the headlines of commercial real estate makes up 70 % of these regional banks' books. And that is true to some extent, but oftentimes your bigger buildings, your highest quality real estate has plenty of financing options. So it's not just the banks. And if it is the banks, it's generally the larger banks. Insurance companies, it's a prime example of insurance companies, their general accounts, they love to lend on core commercial real estate that's highly stabilized because it's better yields than they can get in the market and it's backed by really good core assets.

14:36And so I think the media paints this picture of, oh, the only place that commercial real estate owners have to go for refinancing are these small regional banks that seem to be blowing up right now. And that's just not the case. There are other levers to pull. Will it have ripple effects when the regional banks tighten down? Absolutely. But when you're the highest quality core, I think you're still going to be okay because you have other levers to pull on where to take that debt and get that debt refinanced. Everyone pays attention to the bad stuff because that's what we do in finance. So people have been hammering on the offices and that stuff.

15:09What are the portions of the commercial real estate market that are actually holding up pretty well and looking good in this environment? Industrial is the biggest sector, about 40 % of the NFI Odyssey, and it's red hot and it continues to be. It's because the dynamics, we all want things delivered to our doors within an hour. And those dynamics, that means you need industrial space for logistics to get there. So Amazon has to put your good that before they get it to your door, it's probably going through three or four logistics buildings. And so that insatiable demand for people that just want our stuff, we're all guilty of it.

15:43We all want to put our order in on Amazon and have the product within an hour. At this point, we get jumpy if it's going to take 24 hours. So I think certainly rent growth is going to be moderating in the space, but it's been very, very attractive. And it's probably been the darling of commercial real estate for the last 10 years. Second area that's doing very well is multifamily. Again, rent growth is starting to moderate there. You're not seeing double digit rent growth anymore. That said, I'm sure you guys have covered this. We haven't built enough homes in the United States. We have a problem.

16:15We are probably 10 million homes too short for the current situation that we're in. And new home builders are just not bringing that much new supply to market, nor should they. They see their models and they're saying, hey, at a 30-year fixed rate mortgage of 6.5%, 7%, nobody's going to to be buying. And so multifamily has a place for the next decade here as we try to fix this supply shortage in homes. So when you think about it, you may see some headlines short-term, a lot of multifamily supply coming online. But I think, again, that's overblown. Rent growth moderating, but people need a place to live.

16:48And multifamily is going to fill that gap, at least for the foreseeable future. Who are the players in the multifamily space? Is that the usual suspects of homebuilders or is it somebody else? It's typically others. I mean, so a lot of private developers and multifamily. Your big firms, obviously, that you know and love in private equity real estate are big owners of multifamily. NFI Odyssey. So by the way, the Odyssey represents about 300 billion of commercial real estate, and about 30 % of that is in multifamily. So I think those two are definitely your sectors that you want to be in. And believe it or not, retail is finally starting to come back.

17:24Michael, I can almost replace malls with what you were saying about offices five years ago. The mall is dead. The mall is dead. Everybody hates malls. But the mall is dead. Isn't the mall dead? Class B and Class C malls again are dead, sure. But go to a Class A mall. And again, the largest publicly traded REIT for mall operators is Simon Property Group. Well, they own Roosevelt Field. I went there the other day. I had to go to Dick's to get my kids some sporting equipment. And I couldn't believe it. Absolutely slammed, like slam, slam, slammed. I live outside of Philadelphia. We have the King of Prussia mall.

17:54and the other day I went there and there was security directing traffic. Part of me wants to take a picture and send that in to say, once everybody said that malls were dead. By the way, weird name for a mall. King of Prussia? Yeah, no? It's just the town that the mall's in. It's the only mall I think we have left in the Philadelphia. All right, my bad. Weird name for a town. Yeah, weird name for a town. I like it. So you mentioned the dichotomy between private marks and public marks and Michael and I talked about this a few months ago. So if you look at just like the Vanguard REIT index, a lot of people use that as like an index fund proxy.

18:28It's not necessarily, but to your point, in 2021, it was up more than 40%. And then in 2022, it was down 26%. A lot of people were saying last year, well, REITs are getting slaughtered this year. How come private marks haven't come down? And my answer was they're probably both a little right and a little wrong. To your point, things go too high and too low. And so you can't say that private stuff should be marked down to 30 % in 2022 if it wasn't being marked up 40 % in 2021. So is it just that in a transaction like real estate, it's not like the stock market where millions and millions of shares are trading hands every day.

19:03It's hard to get a good sense of what the actual prices are from either public or private listings? Tom, sorry, before you answer, just put some meat on this. So we haven't even spoken about your product yet, which we're going to, but you guys launched us in late 2017. So since then, VNQ has had six down quarters. You guys have only had two. VNQ has had three down years since 2018. You have none. So I'm sure this question comes up all the time. What do you say? It just prices differently, Michael. I bet you hit the nail on the head. There are a lot of factors that drive prices of commercial real estate.

19:39And we actually have a paper coming out on that that after this podcast, you can get at usq.com slash animal spirits. And it talks about this exact dichotomy. And the bottom line is public markets overreact and private markets, you need transactions to happen. You haven't seen a lot of transactions happening. So things have definitely slowed down, but that doesn't mean marks aren't being taken. Marks are certainly being taken and there's some negative marks in there, but rent growth has been so strong. So rent growth has been so strong that it naturally yields a higher cap rate. And that cap rate is nothing more than NOI over purchase price.

20:14So NOI is net operating income over purchase price. So it's like the earnings yield for stocks. Correct. And everybody loves to compare that to the 10-year and say, oh, there should be a 200 basis point premium. Okay. To some extent, that's true. It doesn't hold in the short term, but over the longer term, I think that's fair. But that cap rate changes for two reasons. The media loves to paint this picture that cap rates must go up, meaning prices must come down. And that's just not the case. If NOI is going up, and that's what we're seeing, and this is talking about an inflation hedge, when you see inflation take hold, rents push, period.

20:49I mean, multifamily rents were up double digits in 2022, heading into the, well, the beginning of 2022, basically through the year, you saw 15 % rent growth. Industrial was even better than that. There were certain parts of the market that were up 25%. And so, if you're growing your NOI, you're naturally taking your cap rate out anyway. And so, there's more dynamics at play than just simply, oh, cap rates need to go up, so prices must come down. That's where it kind of gets sideways as people don't understand the dynamics between the two markets. Now, to your point, Ben, is it certainly true that both public and private probably are imperfect mechanisms?

21:26Sure. You could definitely argue that, which is why we say there's no one perfect solution. If you're going to make a real estate allocation, you shouldn't put it all in private and you shouldn't put it all in public. You put it together and you get a much better risk adjusted return over time. And that's what we're talking about. I think to the point last year, our strategies were up about 6 % last year when everything else was down. And I think that is true diversification. That helps you guys as advisors to have assets going up when other things are going down because everybody talks about correlation benefits until everything goes bad and then everything comes to one and you have no diversifiers left.

22:02So that's what's different about this and you need to be given access to private real estate. So can you talk about the structure of the way that you run this portfolio? It's an interval fund, which some listeners might not be familiar with. There was big headlines over the last couple of months as one of the largest private real estate investors have this vehicle that's not all too liquid as it should not be. This is private real estate. It's not publicly traded. It shouldn't be that liquid. But there was some maybe confusion or people wanted their money and they couldn't get it because there are clear rules about how much money you could.

22:35Anyway, how does that differ between your structure? Can I just talk about one second on that? They did exactly what they should have done. They should have gained. They did exactly what they should have done. And it actually helps the commercial real estate markets not have to draw down in a period when you don't need to. You don't want a fire sale in that market. So when you buy these products, you have to understand there's limited liquidity. The interval fund is different that we look and feel much like a 1940 act open-end mutual fund. As a matter of fact, we are regulated under the 1940 act.