Lots More on the Big Can Kick in Commercial Real Estate

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1:08Bloomberg Audio Studios. Podcasts, radio, news. You know, one of the things that kind of surprised me is there was all that concern about commercial real estate and specifically office buildings. And instead, it feels like we've seen more stress in the multifamily space. Yeah, that's a good point. I don't know. I'm still worried because I still see these numbers, at least an aggregate of vacancies not improving. And I sort of thought, you know, about six months ago, there was another rash of headlines about companies calling workers back to the office, but I'm not sure if there's improvement. Like, I'm still anxious.

1:46I'm not comfortable saying coast is clear yet, but what do I know? You're caveating yourself. I feel like that's what you're doing. I did a deadlift. One, two, three. Hegemony. Okay, good. Hegemony. Barges. This is an after-school special, except... I've decided I'm going to base my entire personality going forward on campaigning for a strategic pork reserve in the U.S. Where's the best squid ink pasta? These are the important questions. Is it robots taking over the world? No, I think that, like, in a couple of years, the AI will do a really good job of making the Odd Lots podcast. And people will say, I don't really need to listen to Joe and Tracy anymore.

2:26We do have the perfect guest. You're listening to Lots More, where we catch up with friends about what's going on right now. Because even when the odd lots is over, there's always lots more. And we really do have the perfect guest. So Rich, we had you on basically a year ago talking about where stress is in the massive market for commercial real estate. What have we seen since then? Yeah, well, first of all, it sort of feels like deja vu all over again for me. there was a bunch of three bank failures this time last year. Fast forward a year, we didn't have any, and then suddenly we have another bank failure or another bank stress test, if you will.

3:05So look, maybe I'll start with office. I think I'm certainly tired of talking about office. I think most people understand that office valuations are down rather significantly. We think office valuations generically are down around 35 % or so, and peak to trough, they'll probably be down closer to 50%. So I think most people understand that at this point. I do think there's still a little bit of debate and a little bit of misunderstandings about, well, not all office is bad. New clean and green office, even in New York City, is doing exceptionally well. And then maybe some of the Sunbelt office properties where you're seeing strong demographic shifts, those are working as well.

3:40But are people willing to step their toes in? Probably not. I think they share your views. They share Joe's tendency towards self-caviation. That's a word that I just came up with. We are speaking with Rich Hill. He is the head of real estate strategy and research over at Cohen and Steers, formerly of Morgan Stanley, which is how I met you and read your research for a number of years. One thing I wanted to get your sense on. So we have seen a rally in broad CRE since sort of November, December. How much of that is just echoing the expectation for rate cuts? And I feel like I should add a caveat here, which is that we're recording this on March 20th, the day of the Fed interest rate decision.

4:24So who knows what will happen? But the expectation is still for cuts. So how much of that is feeding into the rally? Yeah. So maybe just to level set, the trough in listed REITs, listed real estate, was October 25th of 2023. Since that time, listed REITs were up more than 20%. November was one of the best months ever. December was pretty strong as well, top 10 month ever. So you bring up a good question. How much of this is just driven by rate cuts? So let me unpack that a little bit for you. And I think I'm going to be a little bit wonky here, but I think that's probably okay. That's what we love.

4:58First and foremost, listed REITs do really well in the aftermath of the Fed stopping hiking interest rates. Usually on the next 12-month basis, they put up double-digit returns. So what we've seen happen is consistent with what we've seen happen with history. But I also think there's a few other things that are maybe not as well understood where I would say this is not all about rate cuts. And I'll come back to that in a second. October 25th marked the high for the 10-year treasury rate. It peaked a little bit above 5%. At that point in time, people were really concerned that the 10-year treasury rate was probably going to be closer to 6 % than 4%.

5:34Fast forward, and the 10-year treasury is now closer to 4 % than 6%. So I think that took a lot of fear off the table. The second thing that we've seen is we've actually seen lending conditions not begin to loosen because lending conditions are still tightening, but they're not tightening as much as they used to. And so that basically means lending conditions, the worst for lending conditions are behind us. The second derivative has started to improve. The third point I would make to you is that, guess what? NOI growth, net operating income growth for real estate is holding up really, really well.

6:06It's actually one of the few sectors of the S &P 500 where you're seeing revisions higher, not lower. That's interesting. And there's a couple of reasons for that. But I think what I would ultimately say here is listed REITs are a leading indicator in downturns and recoveries. And what I think we're starting to see is maybe some of the fear that was in the market was turning out to be not as bad as feared. And that's led to a rally. So it always helps even if things are bad, if they're going to be less bad, because that's how markets work. The direction of travel is good. Yeah, the direction of travel is good, better than expectations, all the worst not being priced.

6:40And one of the things that's come up in our past CRE episodes, just this gap between where people think the market might be and where the market actually is, which we have a hard time knowing because there is just not a lot of transaction period. So you can have these models and you can have expectations or maybe price something off the one building that did move. Are we seeing on the non-listed side, on the private side, are we seeing any sort of pickup in transaction activity? Yeah, it's a super fascinating conversation that we're having right now. I think it's the very most important question that people can be asking right now.

7:13Let me explain how the transition mechanism usually works in prior cycles. Transaction volumes fall. They trough because when they're falling, there's a big spread between where sellers want to sell and where buyers want to buy. There's no transaction activity. Then as transaction volumes trough and begin to rise, property valuations begin to fall. Transaction property valuations begin to fall. And then about 12 months later, appraisal valuations follow. What we're seeing this cycle is dramatically different than that. It's actually flipping on its head. Appraisals are actually leading transaction volume significantly right now.

7:47You are right. There's very little transparency in the transaction market. I just got some updated numbers for February of 2024 and the number of transactions that sold. It looks like it's back to COVID lows. So there is still a pretty big bid-ask spread. But appraisals, appraisal valuations, we think are down generically around 20 % right now, peak to trough. We think they'll be down 25 to 30 once everything goes through. But why are appraisal valuations leading right now? Well, it has everything to do with higher interest rates and higher discount rates. An appraiser has no choice but to deal with that.

8:22So this cycle is a little bit different where transactions are just now beginning to catch up to where appraisals are. So we're talking about sales transactions. But the other thing that's happened in the market is you've had a lot of new financing. So call it what you will, extend and pretend or amend and extend. There's different names, different pseudonyms for this activity. But that feels like it's one of the things that has really given the market a little bit of breathing room. So it's OddLot's tradition to talk about the looming maturity wall. But the looming maturity wall is not so looming anymore.

8:58It's more of a three-foot privacy shrub. I think I've joked before. Yeah. If you guys can see me on the podcast, I have a big smile on my face because this is one of my favorite topics. First of all, look, I push back on the idea of a maturity wall. Earlier in my career, I always talked about maturity walls because it gets a lot of clicks. But let's be clear. Commercial mortgages have a seven-year wall. That means 15 % of loans come due on average every single year, which means over a three-year time period, you should expect 45 % of loans to come due. Guess what? 42 % of loans are coming due over the next three years.

9:32Not shocking at all. That's just sort of math. Is it great that they're coming due right now at this point of like distress in the commercial real estate market? No, but that was inevitably going to happen at some point in the cycle. So that's point number one. Point number two is a statistic that's getting a ton of headlines right now, that there's almost a trillion dollars of loans coming due in 2024. That is factually true. But this time last year, there was only a little bit more than$600 billion of loans coming due in 2024. You don't just make up$400 billion of loans. Why did that increase?

10:04Well, lo and behold, a lot of loans that were maturing in 2023 were amended and extended into 2024 and beyond. Now, we actually think that same strategy is going to play out in 2024 as well. But what you're starting to see is this prisoner's dilemma being solved. Borrowers are not in a good position. Lenders are not in a good position. They're sort of forced to work with each other right now. And I think your point about, call it what you will, modifications and extensions, what it's doing is it's providing a little bit of a safety net for commercial real estate valuations whereby we think valuations are going to be down 25 % to 30 % instead of like 35 % to 40 % like we saw during the GFC.

10:44And it's because this is a little bit more orderly process than what people feared a year ago. By the way, I just want to say, Tracy, that I'm really glad and thank you, Rich, for saying that when you're on the sell side and getting clicks because I've always had this intuition that journalists and sell-side analysts are basically in the same job and we sort of compete with each other for people's scarce attention. It's not that different. In fact, I would say as I progressed in my journalism career, I felt I learned a lot from reading sell-side research, both in terms of content, but also in like, yeah, your job is, you know, people have a million emails and you want them to open yours instead of the next guy's.

11:20So I feel - No one will know your research is good if they don't If they don't read it. Yes. You got to. An inordinate amount of time is spent on titles. Oh, yeah, I know. They're getting really. They've got they've gotten so good.

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13:47You want rate cuts. First and foremost. First and foremost. We had this debate internally at Coden Steers relatively recently. What are we rooting for? Yeah. And I think everyone in the room said rate cuts. And so let's maybe explain what that means. Commercial real estate is inherently a levered asset class. Very few people buy commercial real estate building and don't put debt on it. So the cost of financing actually really matters. I would much prefer right now a hard landing scenario, believe it or not, where real rates, interest rates go much lower and growth slows and credit spreads widen than a no landing scenario whereby rates sort of stay where they are and growth and credit spreads are just eh.

14:28I know that's weird to get your arms around. No, I believe it, but it still blows my mind. It's inherently a level asset class. What matters more than anything else is the cost of financing. Wait, so on that note, I want to go back to what we were talking about, the refinancing, the amend and extend dynamic that we've seen in the market. Who is refinancing? Is it the existing financiers? Because as you mentioned, they basically don't want to take the marks on their portfolio or they don't want to have a catalyst that causes them to record that loss. Who's actually doing it? Yeah. So let me, first of all, give you a stat that's, I think, really remarkable.

15:02If you looked at commercial mortgage-backed securities, the loans that were maturing in 2023, 80 % of them paid off at or before their maturity date, 80%. Now, some of them obviously paid off before their maturity date. You'll hear a much lower statistic for loans that were still outstanding at their maturity date, but those loans still outstanding have inherent negative selection. If you didn't pay off your loan prior to the maturity date, there's probably something wrong with it. So let me answer your question directly though, and I'm going to focus on banks first and foremost. Why would a bank want to extend a loan?

15:35Particularly after March's banking drama and the expectation that there was going to be more pressure in terms of regulation. There's two reasons. Well, three reasons. First of all, they're not in the interest of owning properties. That's one. Number two, they actually don't want to sell a distressed property into a distressed market. But there's an even more important point here that I don't think people are focusing on. The capital charges for modifying a loan at a new 90 % LTV are actually lower than owning that property on your balance sheet. So they're incentivized, assuming that they have appropriate reserves and the borrower has a plan, they're incentivized right now to actually extend that loan.

16:15I come back to the point I made previously. This is like classic prisoner's dilemma stuff. The borrower is not in a good spot. The lender doesn't want the property back. They're actually coming together and finding a solution. And I don't think this is necessarily the kick the can down the road like we've seen in the past. They're getting some pretty decent paydowns. They're actually not increasing their rate too much. It is a prisoner's dilemma. One thing I've come to realize in my own career as a financial journalist is that kicking the can down the road has all these terrible connotations, especially since 2008.

16:45But actually, it kind of worked, right? We had a bunch of home loan modifications after 2008, and real estate recovered. I have come to the conclusion that all of human history is just a big can kick, and we need to destigmatize that concept forever. We're just going to be kicking the can for thousands of years to come, put it off to the next generation, and they'll do the same. Your point about there's something wrong if you don't prepay your loan, this is because real estate investors are allergic to building up equity. The moment they have a little bit of equity in the building, they want to pull it out and buy the next building.

17:20That's not wrong. Yeah. It's constantly refinancing. And now some of this is because we've been in a secular decline in 10-year treasury rates since 1980. You could always refinance into a lower and lower and lower interest rate month after month after month. So someone I was talking to was explaining to me like some of the banking issues that we've seen with some of the community banks. Part of it, I mean, we did an episode on New York Community Bank and the issues that they've had in like the rent regulated multifamily area. But part of it is that a lot of these banks just made a bunch of money on prepayment penalties.

17:53I don't know if they're called penalties, but those prepayment fees. And then the moment rates shot up, shoot up for the first time in 40 years, you just get that big slowdown. Yeah. I mean, well, it's probably fairly nuanced. But when you prepay a fixed rate loan, you have a prepayment penalty, which basically compensates the lender for the interest cost that they otherwise would have received over the life of the loan. So there's a lot of different reasons. I mean, I think the real issue that the market's dealing with is a return to the old normal. I get asked all the time, what do you think about this new normal environment?

18:26It's not a new normal environment. What was weird was the last 10 years where interest rates were historically low, inflation was historically low. That created a lot of weird dynamics for the commercial real estate market. All the market's dealing with is a return to the old normal and what that does for valuations. Valuations being down 25 % to 30%, that's huge on a headline basis. But if you actually think about what it means in terms of how much valuations have increased over the past 10 years, it's really nothing. This is just a deflating of the balloon that should occur from time to time.

18:56Yeah. And this is where I have to say, like, even before the 2020 pandemic, there was talk about underwriting standards slipping in CRE and CMBS specifically. I wanted to ask you one more thing. So one of the themes that comes up on all these CRE episodes is this is not a monolithic asset class. So you obviously have office, multifamily, retail. So you have that segmentation. But then even within those categories, there's additional segmentation. So Joe mentioned the idea of a Class B office. You would also have fancy offices that are Class A. You might have a really nice shopping mall and then a zombie one that's going out of business.

19:37I wanted to ask, in retail, on shopping malls, we heard recently in an episode we did with Tom McGee from the International Council of Shopping Centers, He was talking about there's sort of a revival of demand for shopping centers and that there's a structural lack of supply in certain types of shopping centers. Is that something that you've seen as well? Yeah, look, we really like open air shopping centers. And we like them for a couple different reasons. First of all, we think institutional investors and private real estate are under indexed to them. Is that a result of like the shopping mall fears of the 2010s?

20:10Yeah, they're just redlined. I mean, no one wanted to buy a retail property from 2010 until 2020 because it was going through clickbait, so-called retail apocalypse. That's not a great environment. So you've actually seen institutional ownership of retail go down while institutional ownership of multifamily industrial has risen significantly. But there's actually something really interesting that's happening, two things in particular. No one was really dumb enough to build a new retail property post the great financial crisis because there was this big shakeout coming. So there's been no new supply of shopping centers.

20:46At the same time, you had this great Darwinistic event that happened in COVID where maybe I'm going to use too bold of a term, but it killed all the stuff that wasn't, you know, was cusp-y. So now you actually have an environment that's right-sized from a supply standpoint at a time that retailers, e-commerce companies have actually realized they can do micro-fulfillment through the retail stores. Consumer likes it. So you're actually seeing vacancies for things like neighborhood centers, community centers, power centers actually near historical lows. We haven't seen an environment like this before.

21:19So it's actually a really strong asset class that people aren't paying enough attention to. So I take this key point that, okay, there's been part of the story is that there's been this game theory cooperation from lenders and borrowers to avoid pain. I take this point that there are some in New York City, even that there are prime offices that are doing very well and that not, you know, CRE and even office is not a monolith. On the other hand, it does seem as though in many cities that there is still just a lot of empty square footage within buildings. And I don't think people know what is going to happen with it or whether it's, you know, where that's going.

21:58And there's still, you know, obviously there are some fancy buildings in New York City, but there's a lot that's just on between every block where it's just old and shabby and you just see clearly not a lot of activity. What is happening with that? And of course, in some cities, you know, there's this fear of the urban death spiral, which would be a very good headline for a research piece or for a clickbait piece. But I guess the retail apocalypse of the 2010s has been replaced by the urban death spiral that you have people are coming back to work, that you have dropped the tax base, that the restaurants closed down, and people don't want to come back to work, et cetera.

22:30And then you just have this sort of, you know, like something out of a horror movie or a zombie movie. What are people saying about that these days? Yeah. Well, the first point I would make is the professor, I think he was, I think he was, went to a professor from NYU that coined the death spiral for New York City, actually came back relatively recently and said, I was wrong. That's not playing out like the way I thought it was. So look, the cliche answer is you take all these dead, dead, take all these underutilized office buildings and convert them in multifamily. Guess what, guys? That's easier said than done for a lot of different reasons.

23:05So I think the real answer is people don't know. And that's one of the reasons that people are unwilling to step into the office sector right now, even though valuations have come down a lot. What do I think? I actually think this is a once in a generation opportunity, once in a lifetime opportunity for public and private stakeholders to come together and rethink how these cities should work. So it probably requires a master plan where you actually redevelop all of these into, I hate to say work, live, play, but there's a real opportunity to do that. And so could you imagine like walking down New York City where it used to be all these class B office buildings that no one really wanted to work in.