Odd Lots - Lots More on the Big Can Kick in Commercial Real Estate

Episode Date: March 22, 2024

Last year, we spoke with Rich Hill, head of real estate strategy and research at Cohen & Steers, about where stress was building in the $20 trillion market for commercial real estate. Fast forward to today and the doomsday scenario in commercial real estate just hasn't played out like a lot of people thought it would. Defaults have increased, but they aren't disastrous. And some measures of CRE have even been rallying in recent months. So what's driving this surprising resilience? Hill sees it as a 'prisoner's dilemma' where lenders and borrowers have agreed to amend and extend loans in order to both benefit and buy some time. But how long can that continue? And what does the CRE market need to see in order to mount a durable recovery?See omnystudio.com/listener for privacy information.

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slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing Corporation Distributor. Bloomberg 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. Yeah. And instead, it feels like we've seen more stress in the multifamily space.

Yeah, that's a good point. I don't know. Like, 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. I'm not comfortable saying coast is clear yet.

But what do I know? You're caveatting yourself. I feel like that's what you're doing. I did a deadlift. One, two, three. Hedgemi. Okay, go. What two of them?

GEMany. 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. We do have... Cha-ching? 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 a lot smart. 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. So 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. But 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 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. So 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 a level set. The trough in listed REITs, listed real estate, was October 25th of 2023. Since that time, listed rates are 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 great. That's what we love. First and foremost, Listed Reets do really well in the aftermath of the Fed stopping hiking interest rates. Usually on the next 12-month basis, They put up, you know, 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%. Fast 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. It'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 reasons for that.

But I think what I would ultimately say here is listed reeds are a leaning 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 The direction of travel is good. Yeah, the direction of travel is good, better than expectations, all the worst, not being priced.

And 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. And I think it's the very most important question that people can be asking right now. Let 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 what buyers want to buy. There's no transaction activity.

Then as transaction volumes troughed 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. You are right. Transactions, 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. So 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 odd lot's tradition to talk about the looming maturity wall. But the looming maturity wall is not so. looming anymore. It'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. Not 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. Like, you don't just make up $400 billion of loans.

Why did that increase? Well, lo and behold, a lot of loans that were maturing in 2023 were amended and extend it 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, you know, 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 percent instead of like 35 to 40 like we saw during the GFC. And 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 cell side and getting clicks, because I've always had this intuition that journalists in cell side analysts are basically in the same job, and we're sort of compete with each other for people's scarce attention. It's not that different. In fact, I would say as I progress in my journalism career, I felt I learned a lot from reading cell 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 guys. So I feel, uh, no one will know your research is good if they don't

read it. If they don't read it. Yeah. So you got a, in an order and a round of time is spent on titles. Oh yeah. No, they're getting really, they've got, they've gotten so good. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At VanGard. Vanguard, institutional quality isn't a tagline. It's a commitment to your clients.

We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. They say abs are made in the kitchen.

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ready-to-eat meal delivery service. If I own a building, and it's one of these, I don't know, B-tier offices in New York City, and I still have a bunch of empty units and the people who are my tenants aren't bringing their employees back, which do I want?

Do I want them to bring their employees back or do I want rate cuts? You want rate cuts. First and foremost. First and foremost. We had this debate in turn to, 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's 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 a wide. then a no landing scenario whereby rates sort of stay where they are in growth and credit spreads

are just, eh. I 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 market. 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. If you looked at commercial mortgage-backed securities, the loans that were maturing in 2003, 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? Particularly 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 destroy. property into a distress 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. Oh, interesting. 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. I come back to the point I made previously, this is like classic prisoner's dilemma stuff. The borrower's 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 to 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 the 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. But actually, it kind of worked, right? Like we'd had a bunch of home loan modifications after 2008 and, you know, 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. Like this is because real estate investors are allergic to building up equity. The moment they have a little bit of equity, in a building, they want to pull it out and buy the next building. That's not wrong. It's constantly refinancing. Now, some of this is because we've been in a secular decline in 10-year treasury rate 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. I 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 in. 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, 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? It'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 markets dealing with is a return to the old normal and what that does for valuations.

valuations being down 25 to 30 percent, 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. Yeah. And this is where I have to say, like even before the 2020 pandemic, there was talk about underwriting standards slipping in CRE and CNBS 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.

I 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 in private real estate are under indexed to them. Is that a result of like the shopping mall fears of the 2010?

Yeah, they're just red line. 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 shake out coming. So there's been no new supply of shopping centers.

At 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, it was cuspy. 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 that it can do micro-fulfillment to 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. So 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 this story is that there's been this game theory cooperation from lenders and borrowers to avoid paying. 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. And there's still, you know, obviously there are some fancy buildings in New York City, but there's a lot that's just on that 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 click-made piece. But I guess the retail apocalypse of the 2010s has been replaced by the urban death spiral that you have, people aren't coming back to work, that you have dropped the tax base, that the restaurants close down, then people don't want to come back to work, et cetera. And 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. Okay. 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 set and done for a lot of different reasons. So 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-lif 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? And now suddenly it's like vibrant parks. It's restaurants. Pickle ball courts.

That's going to solve the world's problems, apparently. Pickle ball courts. I think New York should let us redesign the city. I'm done. By the way, Tracy, the NYU professor, the rich mentioned, I'm pretty sure Arpid Gupta, who has been to our odd lot trivia event. We really need to have him on the show because he was. talk about the urban doom loop. So there's a message to us basically that we really got to book the Arpit episode. Yeah, let's do it. Lots more is produced by Carmen Rodriguez and Dashel Bennett with help from Moses Ondom and Kail Brooks. Our sound engineer is Blake Maples. Sage Bauman is the head of Bloomberg podcasts. Please rate, review, and subscribe to Odd Lots and Lots more on your favorite podcast platforms.

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