The Pomp Podcast - #1215 Solo Episode | Will Commercial Real Estate Collapse?!

Episode Date: June 22, 2023

The $20.7 trillion commercial real estate market is in trouble. People from Janet Yellen to Elon Musk have both sounded the alarm. This is a solo episode which breaks down the impending collapse of commercial real estate using data and examples, provides potential solutions, and the impact it could bring on the banking system. ======================= Pomp writes a daily letter to over 235,000+ investors about business, technology, and finance. He breaks down complex topics into easy-to-understand language while sharing opinions on various aspects of each industry. You can subscribe at https://pomp.substack.com/

What's up everyone? This is Anthony Pompliano. Many of you know me as Pomp. You're listening to the Pomp Podcast, which is my effort to find the most interesting people in the world and sit with them for hours while I ask questions in an effort to learn. So it would mean the world to me if you would subscribe to the show on your favorite audio platform, watch episodes on YouTube, and tell your friends and family about the podcast. My goal is to help millions learn from the world's most interesting people. So let's get into today's episode. Anthony Pompliano runs Pomp Investments. All views of him and the guests on his podcast are solely their opinions and do not reflect the opinions of Pomp Investments. You should not treat

any opinion expressed by Pomp or his guests as a specific inducement to make a particular investment or follow a particular strategy, but only as an expression of his personal opinion. This podcast is for informational purposes only. out of sync, everything else follows. Spotify and Accenture are working together to reinvent the rhythm of ad sales using automation, analytics, and smarter workflows to simplify campaign delivery and access better data across the business. The result, less time spent on operations, more time connecting brands with the moments and fandoms that matter most. Learn more at Accenture.com slash Spotify. What's up, guys? Today's podcast episode is a

little bit different. It's a solo episode, just me, and we are going to talk about the impending collapse of the commercial real estate market. This is a $20.7 trillion commercial real estate market, and it is in big, big trouble. A few weeks ago, Treasury Secretary Janet Yellen publicly stated, I do think that there will be issues with respect to commercial real estate. That's not good to hear from the Treasury Secretary. Famed entrepreneur Elon Musk then tweeted, commercial real estate is melting down fast, home values next. He knows a lot. He's got a lot of access to a lot of information. So it is not good to see Elon saying that either. Now, what's interesting to me is that Yellen and Musk don't agree on much when it comes to economics. So it is important to

pay attention when they are both sounding the alarm on the same issue. The first thing to understand about this problem is that demand for large commercial real estate buildings, such as office towers in big cities, has been rapidly declining as work from home trends turn into the market standard. Everyone wants to work from home, and now we have data that backs that up. According to a recent National Bureau of Economic Research working paper, attendance in the 10 largest business districts in the U.S. is still below 50% of its pre-COVID level, as white-collar employees spend an estimated 28% of their workdays at home. The percentage of full days working from home used to be 5% before the pandemic, so only 5% of the days were worked

from home. Now, the recent trend has caused more than a 5x increase in the baseline, and that's where we see that 28% or more of workdays from home, specifically for white-collar employees that go work inside those large office buildings in cities. Now, the national average vacancy rate is another telling data point. That national average vacancy rate is 19%. Los Angeles is at 26%. New York City is at 23%. And even Miami, which has been a winner of the pandemic migration trend, is at a 16% vacancy rate. Cities like Seattle and Dallas are both over 20%. And Boston is really low at 13%. These are staggering numbers. As demand has dropped, equity and debt investors have been trying to identify the current value of these properties. We've seen a

building in San Francisco, which is owned by Mitsubishi that has previously been valued at $300 million was recently put on the market for an 80% discount. You did not hear that wrong. 80% discount off of the previously valued $300 million building. Now that was followed by a report this past week that two office buildings in Midtown Manhattan sold for almost 50% less than asking price. That's like people putting up an office building saying, I want $1 and they're actually selling it for less than 50 cents. That's 50%. I'm not a mathematician, but that is a big, big discount. As you can see in the data that has been provided by the IMF, commercial real estate prices rarely go down. So it can quickly become catastrophic if the market does not correct and

stabilize. The only real drawdown in commercial real estate prices over the last 20 years was during the global financial crisis 2008 to 2010. And those commercial real estate prices were positive again by 2011. Every single time that prices have come down, they rarely go negative. They just kind of return to this baseline that has held for about 20 years. Now, the good news is that the blended delinquency rate on all commercial real estate debt is still relatively low compared to the historical trend. There was a massive uptick in the global financial crisis, but it came down and has pretty much stayed low all the way until modern day. It is true that the overall U.S. CMBS delinquency rate jumped to 3.62%, which is up 53 basis points for the month

of May. But the all-time high was not 3.62%. It was 10.34%, which was in July, 2012. The COVID-19 high was 10.32% in June of 2020. So the way to think about this is that CMBS delinquency rate, both in July of 2012, which was the all-time high, and the COVID-19 high was about the same exact percentage, 10.3%. But right now, we are only at 3.62%, which is an encouraging data point. Now, the problem in the debt market is not what has happened already. It is the tsunami of debt refinancing that will need to happen over the second half of 2023. Megan Henley wrote a recent article in which he stated, quote, about $1.5 trillion in commercial mortgage debt is due by the end of 2025, but steeper borrowing costs coupled with tighter credit conditions and a

decline in property values brought on by remote work have increased the risk of default. Fitch ratings already estimated that 35% or $5.8 billion of pooled securities commercial mortgages coming due between April and December 2023 will not be able to be refinanced, end quote. This is problematic because interest rates have more than doubled in the last two years. Previously, the average U.S. 30-year fixed rate mortgage was sitting about 3% back in May of 2021. Today, that is over 6.5%, which gets us to that doubling in the two-year time period. To make matters more complicated, 67% of commercial real estate loans are issued by small and mid-sized banks. These are the same banks that have felt the brunt of the recent banking crisis, which was induced by

the Fed's 500 basis point hike in interest rates at the fastest pace in history. Now, to put that number in context, if we look at the small and medium-sized banks' share of all outstanding loans, regardless of type, those small and medium-sized banks are responsible for 38% of all outstanding loans. 38% all loans regardless of type. The commercial real estate percentage is 67%. So the entire commercial real estate market, small and medium-sized banks are responsible for 67% of it. Residential real estate, those same exact banks are only 37%. Credit cards, they're only 27%. And auto loans, they're only 15%. So commercial real estate specifically has an outsized percentage held by these small and medium-sized banks, many of them that have come

under immense pressure in recent months. Although most banks did not fall victim to the market in the way that Silicon Valley Bank, Signature Bank, or Silvergate did, there is still immense pressure on these institutions in the current environment. Add in the idea of the Fed conducting further rate hikes later this year, and the doomsday scenario becomes clear. As John Maynard Keynes observed, when you owe your banker a thousand dollars, you are at his mercy. But when you owe him a million dollars, the position is reversed. Now there's a second order effect that will need to be called out here. There's a very real chance that municipal government finances will take a hit as well. Dror Polig wrote an entire article in the Atlantic and in it he said, quote, municipal governments

have even more to worry about. Property taxes underpin city budgets. In New York City, such taxes generate approximately 40% of revenue. Commercial property, mostly office, contributes about 40% of these taxes, or 16% of the city's total tax revenue. NYU professor Arpit Gupta and others estimate a 6.5% fiscal hole in the city's budget due to declining office and retail valuations. Such a hole would need to be plugged by raising tax rates or cutting government spending, end quote. Think about this for a second. collaborations, more time connecting brands with the moments and fandoms that matter most. Learn more at Accenture.com slash Spotify.

Offices, commercial properties, mostly office, contribute 16% of the entire city's total tax revenue in New York City. That is an absurd number. And because the values are dropping so significantly, the NYU professor believes that there's a 6.5% hole in the budget. That is code for the budget is not going to provide enough money for the city to actually run what it needs to do. And so there's only two solutions. If you don't have enough money, just like in personal finance,

you either have to get more money or you have to cut spending. As we see, governments aren't gonna cut spending. They got a spending problem. And so the only path here is if commercial real estate prices continue to come down and it has a negative impact on the tax revenue, then these cities are going to be forced,

whether they like it or not, to increase taxes on other things, recipe for disaster. Now, the potential solutions to this problem are few and far between, unfortunately. One idea is that private equity investors will step in to gobble up commercial real estate assets. This is probably true, but it will only happen at significantly depressed prices.

There is economic pain between where we are today and where prices would have to trade in order to get transaction volume growing again. Buyers and sellers aren't seeing eye to eye right now. And so ultimately, the market is going to be the referee and people are going to have to drop their prices if they want to sell their assets. Now, another idea is that these commercial buildings

could be converted into residential buildings. Theoretically, this makes sense and sounds like an amazing idea. But there are a number of complexities that developers will have to navigate to make it a reality. Zoning and permitting is the obvious one. Cities just may not let them do it. or cities may make it incredibly cost prohibitive or create a really, really long timeline

in order to approve them. But there are other more technical issues like plumbing infrastructure in the building having a low probability of being adapted to the residential use case. So there would be significant construction needed to retrofit these assets. Think about any office building you've ever been in.

Maybe the floor has one or two bathrooms on it. But if you convert it all into residential, you now need a bathroom or two for every single one of the units. How do you take that plumbing infrastructure and actually retrofit it to be able to support so much more need on every single floor? I'm not a general contractor and I am sure not envious of the person who's got to figure that one out. Now, there are also a number of people who believe the commercial real estate crisis could be averted. Marco Santorelli uses three examples of risk mitigators in the market. He writes, first, diversification of commercial real estate. While the office sector is facing

significant challenges, other segments of commercial real estate, such as industrial, retail, and hotels, are performing relatively well. The diversity of assets in the commercial real estate market provides a buffer against potential risks, as the struggles in one segment can be offset by the strength of others. Second, there is manageable refinancing. Despite the refinancing cliff, a considerable portion of commercial real estate debt appears capable of being refinanced without major issues. Banks have maintained strict lending standards and most debt in the market generates sufficient income to meet these standards. This indicates a certain level of stability and preparedness in the industry. And third, Marco points out that there is strong

credit performance so far. Banks have reported excellent credit performance in commercial real estate lending with low delinquency rates and minimal losses. This suggests that lenders have been cautious in their underwriting practices and they have managed risk effectively. The overall health of the commercial real estate market's credit performance indicates a level of resilience in the face of potential challenges. Now, it is unclear how bad the commercial real estate market is going to get. I personally have zero clue how bad this is going to get, how long it is going to go on. Part of that is because there are moving targets, but some of it also is that markets are really complex. Humans, including me, are stupid. And investing tends to be a thing that no matter

how much information you have, you end up being wrong sometimes. There's significant risk ahead, not only for investors, but as I described, local governments as well. So I am anticipating that this topic will gain coverage and become much more popular through the end of the year. We're already seeing a number of people start talking about it, but we haven't seen yet the full-on fear mongering from the mainstream media. And I do anticipate at some point we will see that the federal reserve and the treasury are supposedly watching it very closely and various banks are going to have to navigate the obstacles ahead, or they're going to risk going under. None of the analysis that we've done today has even touched on the knock-on effect of

commercial real estate stress to residential real estate. As we see some of the conditions in commercial real estate spill over things like higher interest rates, higher mortgages, they do not just stop at commercial real estate. What is going to happen in residential real estate? We already are seeing prices come down a little bit, but if we see a complete collapse, which I'm not saying that's going to happen, but it's a potential thing in the commercial space, does residential follow? There's a lot to unpack there. And if we enter a recession in the second half of 2023, it is probably the most telegraphed recession of all time. People have been talking for 18 months about a recession is coming, a recession is coming. And not just the people

who call a recession every year and the broken clock is right every few often. No, these are people who are smart people with money in the market who usually are bulls. They're optimists and they've been calling for a recession as well. That doesn't mean that the economic pain and destruction is going to be avoided though, even though we have seen people calling for a session. So one of the things that you can do is keep paying attention. Make sure that you're educated. The second thing you can do is start to game plan. What would be the exposure in your portfolio if there is more pain in the commercial real estate market? Also ask yourselves, not only if the commercial real estate market finds stress and pain today, given where interest rates are,

but we've seen the Federal Reserve talk about more rate hikes later this year. If that happens, what is the knock-on effect to all that debt, the refinancing of debt, and if the work-from-home trends continue, then that could put even more stress. And so this is a classic situation. Hope for the best, but prepare for the worst. Commercial real estate, we have gone more than a decade without having to worry about it. But we are seeing prices decline significantly. We are seeing the cost of capital explode upwards. And then we have the complexity of the work-from-home where literally people can't get their employees to go back into offices,

which then means that they need less office, which then means they're going to sign smaller and smaller leases, which puts stress on the landlord and the landlord's got to pay their bills. Massive problem. There's an impending collapse of commercial real estate on the horizon.

Hopefully today helped you better understand some of the data, some of the trends, and got you thinking more critically, not only about you as a business owner or you as an investor, but also thinking about your portfolio specifically, where your exposure lies, how you can mitigate it, and maybe even you can help identify some of the trends

or areas of opportunity to capitalize on if the commercial real estate market gets worse. Hope you enjoyed today's podcast episode. Jump on Twitter and let me know what you think. Do you like these individual episodes or do you like the interviews? Do you like both? I'd love to get some feedback

and we'll then continue creating as many episodes as I possibly can to help inform you, educate you, and maybe every once in a while give you a good laugh. Hope you all have a great day and I'll talk to you next episode.