March 20, 2023 • 43 mins
Markets are suddenly on edge due to strains in the financial system. But banks aren't the only source of stress. Pockets of the commercial real estate market — which is worth around $20 trillion — are showing cracks as well. Higher interest rates are one factor, but also a lot of commercial office space is still not at pre-Covid capacity levels, putting pressure on income. So where are the trouble spots? And who is holding the bag? On this episode of the podcast, we speak with Rich Hill, head of real estate strategy & research at Cohen & Steers, about the state of the market.
See omnystudio.com/listener for privacy information.
Mark as Played
Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Speaker 1 (00:09):
Hello, and welcome to another episode of the Old Lots podcast.
I'm Tracy Alloway and I'm Joe. Wi isn't all Joe?
People have been asking for this episode for a long time. Yeah,
there's a lot going on right now, definitely a lot
of a lot of balls in the air. But there
is a one topic that one particular topic that's been
brewing for a while as a source of concern is
(00:31):
what's going to happen with commercial real estate, particularly office buildings.
That's right, So we recently had the collapse of Silicon
Valley Bank and that set off, you know, a little
bit of a banking crisis. But a lot of people
are talking about the next shoe to drop really being
on the property or the real estate side. And obviously
(00:53):
there's been a lot of concern about what exactly is
going on with office buildings. But you know, just interest
rates going up in general tends to be bad for
real estate as a broader category. So I think this
is something that we really need to dig into. Yeah,
I mean right, So obviously real estate, my understanding is
that it's a highly leveraged industry in almost any factor,
(01:16):
whether it's malls or office buildings, or apartments or single
family homes. There's a lot of borrowing. Ergo, I think
rates matter, and like every other industry, it's dealing with
this reversal of a long downtrend. And then with office
reads in particular, we all know that working from home
is still a thing. Not everyone goes to the office
every day like they were, and so companies are reducing footprints.
(01:39):
And so if you are the owner of commercial property,
you may be looking at a double whammy in which
a your loan is set to reset or your commercial
mortgage that you plan to roll over is set to reset,
and at the same time, because of vacancies, your business
is not as good as maybe it was in twenty nineteen.
So potentially a major stress point emerging for a lot
(02:02):
of players. And the other thing I would say is
even without the pandemic, and even without the work from
home trend, there was concern about excess in commercial real
estate or CRI, you know, even prior to twenty twenty.
I remember when I was at the Financial Times, I
was writing a lot about the bond market and credit markets,
(02:22):
and I used to write a lot of stories about
you know, subpar underwriting in commercial mortgage backed securities and
investors really reaching for yield in that sector. And there
was one person I spoke to quite a lot when
I was doing those stories, and so I am very
pleased to say that we do have the perfect guest
(02:44):
for this episode. We are going to be speaking to
Rich Hill. I knew him when he was an analyst
at Morgan Stanley, but he is now over at Cohen
and Steers as head of real estate strategy and Research.
So Rich, thank you so much for coming on. All thoughts. Yeah,
thanks so much for having me. So maybe just to
begin with you know, Joe kind of alluded to this
in the intro, but commercial real estate it's not a monolith.
(03:08):
There are a lot of different subsectors within that broad category,
and there are a lot of different actors, so lenders, investors,
things like that. Can you talk to us a little
bit about the ecosystem What is the ecosystem of CRI
actually look like? Yeah, it's it's a great question. And look,
I actually don't disagree with anything you said and your
(03:31):
remarks to start this, but maybe we start off by
talking about the size of the commercial real estate market.
We estimated it's around a twenty trillion dollar market. That's
a pretty big market. And if you think about commercial
real estate, everyone thinks about it a singular asset class,
but it's really fifteen different property types under one umbrella.
(03:51):
And in many cases those fifteen different property types are
sometimes like my kidnergartner, they moved to one side of
the room and then the other side of the room.
The fundamentals don't necessarily all act the same. So you
have office for the fun of it, or is there
a reason why the fundamentals don't move in the same direction,
why people move around so much? Yeah, well, you know
what I would Just the point I'm trying to make
(04:13):
here is that you know, you have office, you have retail,
you have multifamily. What drives multifamily fundamentals might be much
different than what drives retail fundamentals. And we haven't even
really started talking about some of the subsectors like healthcare,
for instance, or data centers or cell towers. There's a
whole host of different property types that are out there
that you know, Yes, commercial real estate is a singular
(04:36):
asset class, but in many respects you as a as
a strategist and a researcher, I'm covering fifteen different parts
of the economy that all have a singular commercial real
estate umbrella, but they have different fundamental drivers. Right, So
this is really important. Some sort of midtown office space
here in New York that maybe in twenty nineteen was
(04:56):
leasing out to being leased out to like tech startups
or something is going to be very different from a
building that's sort of specialized in doctor clinics in which
probably there is not much like work from home activity
happening and there, and so they're just too Yes, they're
both commercial real estate, but they might be very different
fundamental for sure. And frankly, I'll take that one step further.
(05:18):
You know that the office property in Tampa, Florida might
be very different than the office property in New York City.
Are they going to the office in Tampa, Florida, believe
it or not, they are going to be dead? What
are the numbers like? How like you know, I know
there's like trackers of like different cities, and there's a
lot of coverage in the media provis reasons because many
of us are here in New York City. But how
(05:40):
does New York City like, why don't you talk a
little bit about what the numbers look like, yeah, if
you're talking about New York City return to our office,
we're still well below you know, call it fifty percent,
you know utility rates, if you will people actually using office,
call it in the thirty to fifty percent range. But
if you go to the Sun Belt and there's a
lot of reasons why this is the case, if you
go to Sun Belt States, return to office and use
(06:01):
of office space is a lot higher than that. It's
not surprising to see at sixty seventy, maybe even a
little bit higher than that. So there is a big
difference between how people in maybe let's say New England
States are using office versus let's just say Tampa, Florida, Austin,
what have you. So, one of the things I wanted
to ask you is, in addition to there being a
lot of subsectors within the umbrella of commercial real estate,
(06:24):
there are a lot of different ways that people actually
measure what's going on in that market. So, you know,
one CRI specific term that you hear a lot is
cap rates. You obviously have property prices, and then you
have valuations, and you also have what's going on with
the mortgage reets. So publicly listed real estate investors, and
(06:47):
you know, depending on which one of those you look
at at the moment, you kind of get a really
mixed picture of what's actually going on with crin. Can
you explain that, like, why are these different things painting
a different view of the market. Yeah, it's a it's
a really great, great question, and I think it's something
(07:08):
that's maybe sometimes misunderstood. If you were to go back
to three Q twenty two, so not that long ago, Yeah,
the riat market was down more than thirty percent year
to date, but believe it or not, private valuations or
still up more than ten percent on a year to
date basis huge divide forty percent divide between what the
list of market was telling you, what the private market
(07:28):
was telling you. What happens is the list of market.
So that's publicly. Trade at rates are always a leading
indicator for the private market. They go down before the
private market and they go up before the private market.
Why is that the case, Well, list it rates, you
get a mark on them every single day people buy
and sell stocks. On the other hand, valuing a property
(07:48):
can be pretty hard. You have to go get an
appraisal for that, and so there is an inherent lag
on when private markets actually correct to list it markets
do they allow hand in hand? Not always. If you
go back to the late nineteen nineties, post the Russian
debt crisis and everything that was going on with tech,
roots were under pressure and the private market kept chugging along.
(08:10):
I don't think that's going to happen this time around.
Case in point in four Q twenty two, the nucrief
Odyssey Index that's a widely followed index of open ended
mutual funds. This index was down almost five percent in
the quarter. That is the greatest decline since OZ nine,
and it's the second greatest decline since nineteen seventy eight.
So we're talking about almost a twenty percent decline on
(08:32):
an annualized basis, not that much different than what roats
were pricing in. Rots were up five percent during that
quarter as well, So there is a little bit of
a lead lag relationship that's going on here. We'll see
what the year holds for us. For listed roots, they're
about flat on the year after a really good start
to the year. But I think I think private's going
to be down, and I wouldn't be surprised to see
it down ten to twenty. So as you point out,
(08:52):
like even if my conception of what commercial real estate
is as New York office buildings, we can't just like
form a view of all real estate or commercial real
estate based on that. That being said, like, how much
of that do you say? Twenty trillion rough VideA is
how much of that is sort of distressed right now
or in some sort of trouble and how much is
sort of chugging along? Like we're of that twenty trillion,
(09:15):
how much should we be concerned about? Yeah, so it's
the right question to be asking. And there's a lot
of different ways you can think about distress. The first
way we think about distress is distress sales as a
percent of overall transaction volumes. Before I go there, let
me also just be clear. Transaction volumes are down pretty
significantly on a year of year basis, almost seventy percent down.
(09:35):
I can talk about why that's happening. But distress is
sort of like someone having to sell a property when
they don't want to. It's a foreclosure. For instance, Distress
sales are very very low right now. I don't think
they're going to stay low. I think they're going to increase.
But the reason distress sales are really low right now
is banks haven't started foreclosing on their loans and the
bid ask spread between buyers and sellers is pretty wide.
(09:57):
So distress sales are low. We can talk about delink, CMBs, delinquencies,
bank delinquencies, whatever you want to, but the stress sales,
which is the first thing I look at, is low.
It's showing signs of ticking up. I think it's going
to rise. So just going back to the private valuations
(10:29):
for a second. You know, this is something I've been
thinking about and writing about and a lot of other
people have as well. But how long can private valuations
kind of resist the gravity of lower prices and maybe
deteriorating fundamentals, like what is the catalyst or what is
the process for someone to actually take a hit on
(10:53):
that property, Because clearly, you know, if you're a big investor,
you are going to want to resist crystallizing those losses
for as long as possible, it would seem. Yeah, to
answer your question upfront, it can take. It can historically
take twelve to twenty four months for property for private
property valuations to correct to what the list of markets
(11:13):
pricing in. Why is that the case? Well, let's talk
through how private valuations actually correct. The first thing that
happens is transaction volumes bottom out. You have to see
transaction volumes decline precipitously before property valuations begin declining. Why
is that the case. Well, at the early start of
a correction, sellers don't want to sell at the level
(11:35):
buyers want to buy. There's just a huge bid ask
spread between the two. It's sort of like the grieving process.
I'm not trying to be too flippant about it, but
there is a grieving process. It's denial. There's anger than
its acceptance. So we think we're actually starting to get
to this place with transaction volumes down seventy percent year
of ear. That starts to feel okay to me. But
I think this time is going to be different. I
(11:56):
think the correction and private valuations is going to be
much much quicker than seen previously for maybe one of
the reasons that you talked about at the very beginning,
which is the rise in financing costs. So I'm gonna
get not try to not get too wonky here. No,
please get get wonky as you like. Actually are as
wonky as you. I'll stop you if you if we
need something clarified, but always yes, all right. So here's
(12:19):
a great stat for you. Since nineteen eighty prior to
twenty twenty two. That is, there has been less than
five years five months since nineteen eighty. That's a lot
of months where the treasure ten year treasury was not
lower a decade forward. Something Unpack that and explain to
you what that means. That means in January nineteen ninety
the ten year treasury rate was lower than where it
was in January nineteen eighty, and January two thousand it
(12:41):
was lower than where it was in January nineteen ninety.
There has been a secular decline in ten year treasure rates.
Why does that matter? Well, it matters because, as you
correctly said, commercial real estates inherently elaborate asset class. There's
very few owners of commercial real estate that buy a
property without some amount of debt on it. So, as
you've been in a secular decline in ten treasury rates,
and typically commercial real estates finance with tin year debt,
(13:03):
you have always been able to refinance into lower and
lower financing costs over time. So this is the idea
that usually cap rates decline into a rising interest rate environment.
I sort of say, that's not the right thing to
be thinking about cap rates decline into a rising instrate environment,
because historically that rising interest rate environment is symptomatic of
(13:24):
an improving economy, right at a time that your financing
costs are actually rolling down, So of course your level
re turns expand, which allows cap rates to contract. This
time is much different because financing costs are significantly higher,
not just because of the risk free rate and widening
credit spreads, but also because guess what, growth is slowing.
We were in a stag stag stagflationary environment in twenty
(13:47):
twenty two that doesn't really exist since like nineteen seventy.
It's a much different ball game than what we played before.
So just to do a little Devil's advocate question here,
but what does the maturity wall actually look like? And
even though you know, I take the point that financing
costs are going up, but as long as the market
remains open, you can still roll over your loan, presumably
(14:11):
to infinity. And I can't remember the exact saying, but
you know, there's that old joke about a rolling loan
gathers no distress or whatever it is. Can people just
keep rolling these over in theory? Sure, but so let
me maybe answer your question first. So there's about four
and a half trillion dollars of mortgage debt outstanding. That
(14:31):
tells you, on average, the LTV is around twenty five
percent for commercial real estate. That might sound lower than
what people think, but reat LTVs or less than thirty percent.
Then a crief Odyse index which I mentioned previously, which
is high quality core and core plus properties, that's around
twenty two percent. So yes, smaller borrowers that don't have enough,
(14:53):
don't have a lot of capital, will push the LTVs
up to fifty to sixty percent, which you typically see
in a CMBs transaction. But debt's around call it twenty
five percent of that twenty threeion dollars market. What is
actually maturing well on average, it's about you know, call
it five hundred billion dollars over the next five years.
Each year, so you're talking about call it fifteen to
(15:14):
twenty percent of maturing debt coming due each year over
the next five years. You're what you should hold up
five hundred billion per year, five hundred billion per year
and over the next five years, over the next five years,
so two and a half threeion dollars over five that
makes sense. Yeah, cool. So you're talking about, you know,
call it fifteen twenty percent of debt coming due on
a pran on basis over the next five years or so.
(15:38):
And most of the debt that's coming due in two
thousand and twenty three were either loans that were originated
in two thousan thirteen or in two thousand eighteen. Now,
one of the interesting things about this maturity wall that
I don't think a lot of people are really considering
is how much property prices generically have risen since two
thousand and thirteen. Property prices are up a lot. That
(16:00):
doesn't mean they're up for office, that doesn't mean they're
up for malls, and we can talk through that, but
generically they're up a fair amount. So if you happen
to have originated a loan in twenty twenty two when
you bought a property, your effective LTV is actually a
lot lower than fifty to sixty percent right now given
that property and price appreciation, and even if valuations fall
ten twenty thirty percent next year, there's a good chance
(16:22):
these loans are not in the water yet again or
not underwater. Should I say this is not the case
for office. I don't want to give you that impression
that you know, you're talking about effective LTVs that are
you know, probably going to be a little bit higher
than that, And it's certainly not the case from malls.
Malls effective LTVs we think are you know, around ninety
ninety five percent right now, that's probably a pretty good
(16:43):
case study, we think for where the office market's going.
But office, and since this was a focus of this office,
is only about twenty five percent of that fifteen to
twenty percent that's coming due? Okay? And who's holding that?
And like yeah, so who's who's expose to that? So
it's like, okay, Office, maybe if there's maybe one hundred
and twenty five one hundred billion coming due over the
(17:06):
next each year for the next five years, that sound right? Yeah, yeah, yeah,
that sounds about right. So who is who who holds that?
Is that it banks? Is it a private funds? Like
what's the distribution? Yeah? So Tracy mentioned that we we
talked a lot when we were at when she was
at the Financial Times, and everyone likes to talk about
the commercial mortgage backed security market because it's easy to
look at you get spreads. You know, you understand linquencies.
(17:28):
You have a lot of really good reporting. The CMBs
market is at best twenty percent of the lending market.
It's actually not that big a part of the lending market.
Not to bury the lead and get where you're going.
The majority of the debt coming due is held on
bank balance sheets. Okay, we think you know, call it
fifty percent. More than fifty percent of the debt coming
due in two thousand and twenty three is held to
(17:49):
bank balance sheets. Okay, And that does make some logical
sense because twenty thirteen, these are ten year loans. In
the most part, there wasn't a lot of capital markets
activity in twenty just out of the Great Financial Crisis,
So if a bank originated a CMBs loan, there's a
good chance it's still under books. There's a very good
chance it's still on the books. So most of this
(18:10):
is held on bank ballot sheets. What sort of comes
back to your question at the very beginning, like, how
are we thinking about this risk that has been out
there but has come a little bit more to the
forefront over the past couple of days, given some of
the news with bank collapses can you maybe talk a
little bit more about underwriting standards throughout the years, because
(18:30):
this is something that was a big talking point pre pandemic.
You know, CRI slash CMBs. It was a really hot market.
You saw a lot of people pouring money into it,
and so as sometimes happens, you saw some of the
underwriting standards start to slip. Can you maybe like tell
us what you saw and give us some examples of
the kind of deals that you saw coming through that
(18:53):
could in theory be problematic. Now, there's two ways people
think about underwriting standards. The first one is sort of
headline underwriting metrics, things like loan to value, and the
second thing is all the other things that lenders might
require or not require to provide a loan to a borrower.
So let's talk about LTV first and Foremost LTVs are
(19:14):
actually fairly conservative right now, and certainly we're conservative. Heading
into the pandemic, they were approaching call it fifty percent LTVs,
and that's sort of where they stand right now. I
think that might surprise a lot of people that lending
standards were actually tightening from a headline perspective. But let
me explain to you why that's the case in two thousand.
You know, if you would ask me where the upper
(19:35):
center of froth was real technical term for lending standards
post GFC, I would have told you it was around
twenty fourteen. Two fifteen, things were feeling really good. The
banks were giving out a lot of money, so much
so that the regulators and a joint statement came out
and told lenders, hey, guys, you basically have to slow
(19:56):
this down, and if you don't slow it down, we
might have some regulations. And here's that slapping of the rist,
if you will. Actually sort of worked and banks did
start to bring in lending standards. It also occurred at
the same time that risk retention under Dodd Frank was mandated.
So what's risk retention underd Frank? That basically said CMBs
(20:16):
issuers had to have skin in the game and they
or a third party had to retain five percent of
the entire deal for at least five years. And so
when you actually have to eat your own cooking, that
changes things a little bit. So headline LTVs went down,
headlined dscrs went up. These are all good things, but
maybe where the devil devils in the details, and you
(20:38):
were starting to see a lot more io loans, So
interest only loans. These are loans that don't you know,
pay down over term and have a blue maturity payment.
There was you know, certainly reserves for any number of
different things. This is cash that's put on the sidelines,
so that those a lot more prevalent pre financial crisis
interest only loans, Like I feel like you heard about
(20:58):
commercial mortgages that idea, Yeah, I'm gonna be a little
bit flipping here, but but anything sort of went prior
prior to the GFC. But look, ile loans are are
pretty prevalent over the past couple of years. You know,
all those all the additional money on the sidelines reserves,
if you will, those were sort of you know, not
to say they were waived, but but there was less requirements.
(21:19):
So while while I think the hard LTVs and dscrs
were pretty good, maybe the soft underwriting requirements were or
softer than they had been in the past. So a
little bit of give and take care, I would say,
you know, if anything, it's really a question about where
do you think the debt service coverage ratios are going.
(21:39):
So coming out of the GFC, there was this concept
of debt yield that came about. That's how banks underwrite loans.
Debt yield is effectively inoy divided by your loan balance.
Prior to the GFC, and certainly the early two thousands
loans were underwritten on debt service cover ratio. But after
the GFC, no one was concerned about falling interest rates.
They were only concerned about falling NI. So you underwrote
(22:02):
to debt yield. There's a really good scenario that some
loans with really strong debt yields, because NI is pretty
good right now, might have pretty poor dscrs in the future,
given how much interest rates have risen. So I think,
maybe Tracy, to answer your question about like, what's the
what's the biggest risk here, I think it's a debt
service coverag ray shows NI debt yields could still be
(22:24):
above ten percent twelve percent because NI is pretty strong
right now. Fundamentals feel pretty good. But if you have
a big shock to financing costs, your debt service coveragray
show could be a lot lower than two and a
half times, which is going to require recapitalization. Let's set
(22:55):
aside office for a second. Let's set aside some of
the troubled cities. Are there any old pockets that are
weak because again, we hear about certain categories of weakness
that are obvious that we've talked about them office building
in New York. How are some of these other categories
I think you said they are like fifteen in total
or something like that. Are most of the other ones
still looking pretty good or are their weaknesses elsewhere? I mean,
(23:17):
you're talking about a reap market that was down twenty
five percent in two thousand and twenty two, and if
you believe our views that this leading indicator, you know,
all the proper types experienced, you know, some level of
of of weakness to various different degrees. But a lot
of that presumably was like multiply multiples. Right, but but
but yes, but multiple is just a fancy way of
(23:37):
saying valuation terms. You take one, you know, if you
take the inverse of the multiple, that's capriate. But right, So,
what I'm saying, are there any other that are sort
of like clearly seeing poor revenues or poor rental in
the way an office landlord? Yeah, An, the answer is
not not really okay, because if you think about NY
growth overall in twenty twenty two, you at one point
(24:00):
where plus ten percent plus eleven percent in a Y
growth on a year of year basis, that's close to
a historical high. We are obviously seeing deceleration right now.
We're probably around seven percent right now, and we're underwriting
even slower in a Y growth in twenty twenty three,
given recessionary headwinds that we think are real. But a
lot of what's happening here is actually the refinancing risk,
(24:21):
and it's because valuations are lower because financing costs are higher.
I don't want to make two light of this, but
Office in many many respects is the exception to the
fundamental story. YEA, many of the other asset classes are
having quite fine in a Y growth. But I don't
want to be two probably dogs and rainbows over about
(24:42):
this because I truly believe that idiosyncratic risks are real.
You're going to have some multi family properties that were
purchased that really tight cap rates in advance of improving
and are accelerating revenue growth, and that business plan is
not going to come to fruition. So there is there
is some real risks here beyond just financing that that
(25:04):
is going to pressure valuations lower across property types. It's
going to lead to higher distress, lead to higher delinquencies.
Office is the poster child for this. But I don't
want to give you the idea that commercial real estate
fundamentals are uniquely as bad as office because they're not.
We sort of think office is the exception, not the norm.
(25:25):
So you mentioned refinancing risk there, and that's exactly what
I wanted to talk to you about next. And I'm
trying to avoid um sounding like a Judy Bloom novel
here or something. But where does refinancing come from? And like,
is the assumption that I mean, I assume a lot
of it is from banks. Is the assumption that banks
are just going to pull back on it in the
current environment. Yeah, So where does refinancing come from? First
(25:48):
of all, it's banks, it's insurance companies, it's the CMBs market,
it's debt funds and mortgage rate it's the GSS in
the case of multi family and student housing and seniors housing.
So there is a wide variety of financing sources out there.
Banks are a big portion of that. Insurance companies are
are a big portion of that. CMBs is a smaller
(26:10):
portion of that. But but there's a roide variety of
of of financing sources. So in terms of refinancing, look,
I think a lot of people are focusing on the
cost of financing side because that's real. You can see
it every day by looking at just where the risk
free rate has gone. You know it's at call three
and a half three point six percent today. You know
it was two hundred basis points lower a year ago.
(26:32):
That's a big deal. And when you think about where
credit spreads are going, those are wider as well. Tracy,
just maybe just give you some live updates on on
where these things are. The triple A CMBs market is
pricing about one hundred and thirty basis points over the
ten year treasury, and the triple B minus market is
north of nine hundred at this point. So these are
(26:52):
these are those are much wider spreads. The good news is,
you know, the CMBs market, the debt markets are actually
pricing in all these things that we've been talking about. Yeah,
it's not like the CMBs market is you know, naive
about this nine hundred over the ten year treasury when
the ten ye treasures at three fifty you're talking about
it almost a twelve and a half thirteen percent yield.
That's a that's a pretty attractive yield given you know
(27:15):
the risk of loss. So I do think there is
is a lot in the price of where the spreads
are right now. But look, availability of debt capital it's
probably not going to be, you know, as as robust
as it was last year or even twenty nineteen. So
when you think about who's gonna be able to get
debt capital, I think a well qualified a well qualified
(27:37):
sponsor that's well capitalized with a good business plan, they
can probably get debt right now, even on an office property,
believe it or not. The problem with thought with office
just to use maybe an example, is this binary you
can get debt at attractive levels or you can't. It's
it's it's not like an office. A lender is going
to come back and say, hey, guess what, I don't
(27:58):
feel really comfortable with you as a sponsor your business plan.
I'll give that to you at a thirty or forty
percent LTV instead of a fifty percent LTV. That's not
the way it works. It's almost like bit out interesting, Wait,
why is that is that just like a sort of
like norms and cultural thing, or is it does not
make business sense to try to deal with someone in
those marginals. See all of the above. Okay, yeah, it's
(28:21):
if you're going to if you're a lender and you
have to go to your investment committee and you're saying, hey, look,
I'm going to lend on this office property, you gotta
pretty much make sure your eyes are dotted and your
teas are crossed. Now. Now, the other reality is lenders
are really focused on one thing and one thing only
getting their money back, right. And you know, if you
don't get your money back, you take a loss. It
(28:42):
doesn't matter what that spread was, you're not gonna get
paid enough. So just on office I know, we're sort
of saying, there's a lot of other categories besides the one.
The stairs us in the face every day of New
York real estate. But New York office space, the publicly
traded instruments that seem to track your office space. I
mean they look like really dismal. I don't know, I'm
not asking for your like views unnamed, but like, I know,
(29:04):
you know, it's like sl Green is a company that
you see, you owned a lot of buildings in New
York and they're publicly traded, and that was an eighty
dollars stock in March of twenty twenty two, and today
it's a twenty eight dollars stock. Prior to COVID it
was over one hundred dollar stock. Like, what is the
market saying, look about this type of property that's getting
(29:25):
so hard and for not them specifically, but for someone
who owned property like them, what kind of situation are
they facing next time they have to refinance a building
or you know, remortgage your building or whatever. Yeah, well
let me first you know, yeah, yeah, let first be
clear that we're pretty cautious on office in our list
of portfolio. Look, we have very little office exposure. Why
(29:49):
is that the case? Well, maybe to answer your first question,
the public markets are telling you that office valuations are
going to be down substantially. Why is that the case, Well,
it's the it's for three three reasons. First of all,
you don't know where the NY growth is going. Okay,
it's uncertain. Yeah, I just wanted to make sure. Sorry,
(30:09):
sorry about that, which is basically revenue minus expenses for
those playing at home. You don't know where your NEBT
operating income is growing going. You don't know how much
capex you have to spend to generate that NI, and
you don't know what amount of debt you can get
on it. So if you put NY and capex and
financing into it, that's how you get your leveed IRR
(30:30):
and cap rates just a product of that. The market
is telling you that, the list at market is telling
you that cap rates have to go substantially higher. I mean,
maybe just to come back and and and and talk
about this a little bit more. The listed market, on
average across property types is trading at a high five
percent implied cap rate right now. The private market, as
(30:51):
measured by the Newcrief Odyssey Index is still at three nine.
That's a crazy difference between public and private values. Yeah,
the listed market is at a high five percent caprate. Okay,
so last week it was like at five to seven.
It's gonna be wider than that now. And it cap
rates is like a inverse P, so that means that's
that's in stocks, you would call it twenty P. You
(31:12):
call it a five percent capri. So multiples right now
for multiples after taking ato account, cap x in the
reat space around eighteen and a half times, so you're
pretty close. My only point to you is that there's
a two hundred bases point difference between where reats are
pricing cap rates and where the private markets pricing cap rates.
We think, you know, before before we went on, you're
asking me, hey, aren't you a little bit more constructive?
(31:34):
And I was like, well, look, I am constructive on
reets because I think the entry points are pretty attractive here.
But the private market, you know, we still think valuations
are going down. So if you're a legacy holder of
private valuations, you're still gonna have some headwinds and feel
some pain in twenty twenty three. But if you have
new capital to invest in private, that's probably pretty good.
(31:54):
I want to buy low, sell high. I think that's
going to happen in twenty three, and I think the
reat markets pricing in a more pain than private markets
are pricing in right now. Yeah, it does feel like
I mean, in addition to interest rates, it feels like
the wild card here is basically the availability of capital. Sure,
I mean, I'm not pushing back on that at all.
(32:15):
I mean, commercial real estate, Tracy, I think you probably
heard me say this before, it's inherently a level asset class.
So it's financing cost in the availability of capital. I
think you're going to quickly figure out who can swim
really strong against As the tide's going out, why can't
it keep getting worse? And But the reason I ask
that is, you know you're like, oh, I want to
buy low and still high whicheveryone does. And maybe this
(32:36):
is a moment to buy low because there is clearly
a lot of distress out there. But you know, again,
it was the rates move. You know, we had a
forty year down, we had a forty year decline in rates.
We're like one and a half years into the increase
in rates. Why couldn't, Like, do you worry about higher
and higher for longer? Do you worry that that for offices,
(32:58):
that there's not a trend that's going to bounce back soon?
This is like in these distress cities, distress can build
upon distress. The few people not coming into an office
can erode an area's tax base and make people wanted
to stay home too, Like do you worry about acceleration
of headlands? Are you asking me what keeps me out
at night? But beyond my forecast, I guess I think
(33:21):
the single if I was on here a month ago, Yeah,
I would have been telling you the single biggest risk
was a stronger economy that begets higher inflation and the
Fed has to do more and more to temper that.
And so look, I'll be very clear if you know
the terminal rate, so that's basically where the Fed Fed
(33:41):
funds target rates going. If that's closer to six than
six and a half, tenor treasure rates probably before all
of this was happening, probably aren't supposed to be at
three and a half. They're probably supposed to be a
lot higher than that. And so you know, again I'm
gonna get wonky here a little bit, but we think
real rates are really what drive commercial real estate valuations.
Real rates is the different between nominal rates and inflation expectations.
(34:03):
I think if real rates go to around one, that's
probably pretty good for real estate, but if they're going
to be closer to two, that's actually probably not so
good for real estate. So yeah, that's absolutely keeping me
up at night. Our views heading into this year was
that we were transitioning from a stagflationary to a stagnationary market.
What does stagnation mean? Well, let me let me first
(34:25):
of all say what is the stagflationary environment. Stagflation is
where interest rates are rising and growth are slowing. The
FED was in a really awkward position in two twenty
two for reasons that happened in two thousand and twenty one.
They didn't raise rates fast enough, so inflation was at
record high levels. They had to raise interest rates at
a record pace to slow growth in the economy and
the hopes of taming inflation. That's stagflation. We thought, we think,
(34:50):
we still think that we're moving into a stagnationary environment.
That's where interest rates come down and growth slows. That's
actually really good for listed markets. Not so great for
private markets because sort of start catching up, but it's
pretty good for listed markets. You know. Best case scenario
is that all the Fed's medicine starts to work, inflation slows,
and they don't have to they stop raising rates, but
(35:13):
they also don't have to cut interest rates. The other
thing that's keeping me up at night, to be very clear,
is that the market's pricing in six interest rate cuts
over the next eighteen months. I don't want to see
interest rate cuts. I think about when the Fed cuts
interest rates, it's because something bad is actually happening. That's
not a good thing for the market. So you know,
we actually thought we were, you know, sort of in
(35:35):
this not too hot, not too cold environment. You know,
maybe the unintended consequence of these bank failures is this.
It actually a showing that the FEDS interest rate hikes
are finally working and it's starting to break some things.
And that makes me feel, maybe counterintuitively, a little bit
better about where we're going. I hope it doesn't push
us into a really deep recession. I think recession is
(35:56):
our base case, but but you know, it's the two
extremes that me up at night. A much hotter and
stronger economy where interest rates have to go higher than
where they are right now, and a pretty hard recession,
which you know, I would argue that a recession is
the base case. It's just a matter of degree. Yeah,
So there was one thing I wanted to ask you,
and I think Joe and I are gonna try to
(36:18):
do an episode that focuses on, I guess the physical
challenges of converting offices to residential at some point, but
maybe from a financing market perspective, you know, could you
have a situation where a lot of these offices do
get converted to resie and what would that mean first,
(36:39):
CRI investors and lenders in general. Do you know, do
CRI people who have a big portfolio of office properties
do they suddenly become residential lenders? Or I mean, I
guess they would all be classified as multi family. But
how would that work exactly? Yeah, it's sort of a
good tie into some of the other podcasts that you've
done over the past a couple of weeks. Look, let
(37:01):
me say in an outset, we do not have enough
housing in the United States. I think you've covered that
in prior podcasts. We can debate why that's the case.
I think you've already covered it, But we don't have
enough housing in the United States. So the highest and
best use for a lot of these office properties is
not office. And you could make a case in New
York City that we are have a significant shortage of
(37:22):
affordable housing in New York City. So it does make
sense if I could make way my magic Verry Wand
and say convert from office to multifamily. You're probably supposed
to do that for a variety of reasons. It's actually
it's actually much easier said than done. For a whole
host for different reasons, including zoning. It's not like all
(37:44):
of these properties are zoned from multifamily, and so again
you could come back to how do you think about
commercial real estate. It's a single asset class with a
lot of different property types. All these different municipalities have
different zoning laws, and so you have to go through
a rezoning. It's sort of like the same reason why
prior to COVID we were talking. There was talk about, well,
let's just make all of these malls industrial facilities. It's
(38:06):
just not so easy. There is one off examples where
you can get it done, and it makes a lot
of sense, but again it's it's not a cure for
everything yet. All right, Rich, we're going to leave it there.
That was such a good overview of the space, and
you know clearly there's a lot going on, but you
were very good at walking us through the nuance of
the different subsectors and the different way of looking at
(38:28):
prices and valuation at the moment. So thank you so much. Sure,
thanks for having me again. Thanks Rich, that was great.
So Joe, I thought that was a really good walk
(38:50):
through through all of these different parts and for me,
I guess the most salient thing is what rich was
talking about, the discrepancy between the public and private valuations
at the moment, because you have seen a lot of
the mortgage rates just collapse in recent months, you haven't
seen the same pressures on the private side. Although you know,
I guess the clues in the name those particular valuations
(39:13):
aren't quite as transparent right now. I mean, if you
look at like some of them, I mean, you know,
listeners like pull up a chart of like Vornado or
sell Green, like some of these names, I mean they're
real dismal, like below the COVID lows when people were
talking about oh, no one would ever go into an
office ever. Again, so like between the interest rate increases,
(39:33):
between concerns about just like the actual net income and
so forth, the public market is given clearly a very
grim assessment. Yeah. And then also the definition of CRIS
sort of a leveraged bet on interest rates and availability
of capital. I think that's going to be a really
good way to frame it going forward, because even before
(39:55):
recent events and the collapse of Silicon Valley Bank and
worries over the wider banking system, there was obviously concerned
about what was going on in CRE And it's going
to be really interesting to see how this financial crisis
shakes out, because if it leads to the FED cutting
interest rates, well maybe that would be better from a
(40:17):
purer financing cost perspective, but to Rich's point, it would
mean something bad is going on in the economy, and
it would probably mean that there was less brisk appetite
in general out there. Yeah. Right. You know, it's the
same intuition with stocks, which is that if the FED
is cutting rates, it's probably at a time when revenues
are coming down, when net incomes are coming down, Like
(40:39):
it's often the case that it goes hand in hand.
So ostensibly it seems bullish, you know. I guess to
my mind, the question is like, yes, there's going to
be some cyclical shift at some point, but you know,
this is an area if it's so rate sensitive, well
we're coming off like you know, the forty year rate
bull market, and it could be that these sort of
elevated rates not just stay elevated for years. Maybe they're
(41:02):
going to keep getting elevated. I don't think we really
have like any I don't think anyone like knows for sure.
I mean you could see why it's a stressed area.
I did appreciate though, and I do think it is
easy for us in New York to think that all
commercial real estate is like a handful of half empty
buildings and they're like clinics and data center totally. Although
Jim Chano's you know, he's he's short the data centers,
(41:24):
or he at least was, so he has negative aspects
of those. But there's data centers that's its own distinct area.
You know, There's there's a you know, assisted living spaces
that in commercial real estate, so all kinds of categories.
It is crazy to think that with you know, the
pace of interest rate hikes last year, you still saw
commercial property prices go up as a total, and that,
(41:48):
you know, that is because it is not a monolithic
sector and it is not just massive office buildings in Manhattan.
So I'm sure we're gonna end up talking more about
this topic, but for now, shall we leave it there?
Let's leave it there. Hey, this has been another episode
of the Odd Thoughts podcast. I'm Tracy Alloway. You can
follow me on Twitter at Tracy Alloway, and I'm Joe
(42:10):
wisn't Thal. You can follow me on Twitter at the Stalwart.
Follow our producers Carmen Rodriguez at Carmen Arman and Dash
Bennett at Dashbot. Check out all of our podcasts on
Twitter under the handle at podcasts, and for more Odd
Lots content, go to Bloomberg dot com slash odd Lots,
where we post transcripts. We have a blog and a
(42:31):
weekly newsletter comes out every Friday. Thanks for listening. Two
Hello, and welcome to another episode of the Old Lots podcast.
I'm Tracy Alloway and I'm Joe. Wi isn't all Joe?
People have been asking for this episode for a long time. Yeah,
there's a lot going on right now, definitely a lot
of a lot of balls in the air. But there
is a one topic that one particular topic that's been
brewing for a while as a source of concern is
(00:31):
what's going to happen with commercial real estate, particularly office buildings.
That's right, So we recently had the collapse of Silicon
Valley Bank and that set off, you know, a little
bit of a banking crisis. But a lot of people
are talking about the next shoe to drop really being
on the property or the real estate side. And obviously
(00:53):
there's been a lot of concern about what exactly is
going on with office buildings. But you know, just interest
rates going up in general tends to be bad for
real estate as a broader category. So I think this
is something that we really need to dig into. Yeah,
I mean right, So obviously real estate, my understanding is
that it's a highly leveraged industry in almost any factor,
(01:16):
whether it's malls or office buildings, or apartments or single
family homes. There's a lot of borrowing. Ergo, I think
rates matter, and like every other industry, it's dealing with
this reversal of a long downtrend. And then with office
reads in particular, we all know that working from home
is still a thing. Not everyone goes to the office
every day like they were, and so companies are reducing footprints.
(01:39):
And so if you are the owner of commercial property,
you may be looking at a double whammy in which
a your loan is set to reset or your commercial
mortgage that you plan to roll over is set to reset,
and at the same time, because of vacancies, your business
is not as good as maybe it was in twenty nineteen.
So potentially a major stress point emerging for a lot
(02:02):
of players. And the other thing I would say is
even without the pandemic, and even without the work from
home trend, there was concern about excess in commercial real
estate or CRI, you know, even prior to twenty twenty.
I remember when I was at the Financial Times, I
was writing a lot about the bond market and credit markets,
(02:22):
and I used to write a lot of stories about
you know, subpar underwriting in commercial mortgage backed securities and
investors really reaching for yield in that sector. And there
was one person I spoke to quite a lot when
I was doing those stories, and so I am very
pleased to say that we do have the perfect guest
(02:44):
for this episode. We are going to be speaking to
Rich Hill. I knew him when he was an analyst
at Morgan Stanley, but he is now over at Cohen
and Steers as head of real estate strategy and Research.
So Rich, thank you so much for coming on. All thoughts. Yeah,
thanks so much for having me. So maybe just to
begin with you know, Joe kind of alluded to this
in the intro, but commercial real estate it's not a monolith.
(03:08):
There are a lot of different subsectors within that broad category,
and there are a lot of different actors, so lenders, investors,
things like that. Can you talk to us a little
bit about the ecosystem What is the ecosystem of CRI
actually look like? Yeah, it's it's a great question. And look,
I actually don't disagree with anything you said and your
(03:31):
remarks to start this, but maybe we start off by
talking about the size of the commercial real estate market.
We estimated it's around a twenty trillion dollar market. That's
a pretty big market. And if you think about commercial
real estate, everyone thinks about it a singular asset class,
but it's really fifteen different property types under one umbrella.
(03:51):
And in many cases those fifteen different property types are
sometimes like my kidnergartner, they moved to one side of
the room and then the other side of the room.
The fundamentals don't necessarily all act the same. So you
have office for the fun of it, or is there
a reason why the fundamentals don't move in the same direction,
why people move around so much? Yeah, well, you know
what I would Just the point I'm trying to make
(04:13):
here is that you know, you have office, you have retail,
you have multifamily. What drives multifamily fundamentals might be much
different than what drives retail fundamentals. And we haven't even
really started talking about some of the subsectors like healthcare,
for instance, or data centers or cell towers. There's a
whole host of different property types that are out there
that you know, Yes, commercial real estate is a singular
(04:36):
asset class, but in many respects you as a as
a strategist and a researcher, I'm covering fifteen different parts
of the economy that all have a singular commercial real
estate umbrella, but they have different fundamental drivers. Right, So
this is really important. Some sort of midtown office space
here in New York that maybe in twenty nineteen was
(04:56):
leasing out to being leased out to like tech startups
or something is going to be very different from a
building that's sort of specialized in doctor clinics in which
probably there is not much like work from home activity
happening and there, and so they're just too Yes, they're
both commercial real estate, but they might be very different
fundamental for sure. And frankly, I'll take that one step further.
(05:18):
You know that the office property in Tampa, Florida might
be very different than the office property in New York City.
Are they going to the office in Tampa, Florida, believe
it or not, they are going to be dead? What
are the numbers like? How like you know, I know
there's like trackers of like different cities, and there's a
lot of coverage in the media provis reasons because many
of us are here in New York City. But how
(05:40):
does New York City like, why don't you talk a
little bit about what the numbers look like, yeah, if
you're talking about New York City return to our office,
we're still well below you know, call it fifty percent,
you know utility rates, if you will people actually using office,
call it in the thirty to fifty percent range. But
if you go to the Sun Belt and there's a
lot of reasons why this is the case, if you
go to Sun Belt States, return to office and use
(06:01):
of office space is a lot higher than that. It's
not surprising to see at sixty seventy, maybe even a
little bit higher than that. So there is a big
difference between how people in maybe let's say New England
States are using office versus let's just say Tampa, Florida, Austin,
what have you. So, one of the things I wanted
to ask you is, in addition to there being a
lot of subsectors within the umbrella of commercial real estate,
(06:24):
there are a lot of different ways that people actually
measure what's going on in that market. So, you know,
one CRI specific term that you hear a lot is
cap rates. You obviously have property prices, and then you
have valuations, and you also have what's going on with
the mortgage reets. So publicly listed real estate investors, and
(06:47):
you know, depending on which one of those you look
at at the moment, you kind of get a really
mixed picture of what's actually going on with crin. Can
you explain that, like, why are these different things painting
a different view of the market. Yeah, it's a it's
a really great, great question, and I think it's something
(07:08):
that's maybe sometimes misunderstood. If you were to go back
to three Q twenty two, so not that long ago, Yeah,
the riat market was down more than thirty percent year
to date, but believe it or not, private valuations or
still up more than ten percent on a year to
date basis huge divide forty percent divide between what the
list of market was telling you, what the private market
(07:28):
was telling you. What happens is the list of market.
So that's publicly. Trade at rates are always a leading
indicator for the private market. They go down before the
private market and they go up before the private market.
Why is that the case, Well, list it rates, you
get a mark on them every single day people buy
and sell stocks. On the other hand, valuing a property
(07:48):
can be pretty hard. You have to go get an
appraisal for that, and so there is an inherent lag
on when private markets actually correct to list it markets
do they allow hand in hand? Not always. If you
go back to the late nineteen nineties, post the Russian
debt crisis and everything that was going on with tech,
roots were under pressure and the private market kept chugging along.
(08:10):
I don't think that's going to happen this time around.
Case in point in four Q twenty two, the nucrief
Odyssey Index that's a widely followed index of open ended
mutual funds. This index was down almost five percent in
the quarter. That is the greatest decline since OZ nine,
and it's the second greatest decline since nineteen seventy eight.
So we're talking about almost a twenty percent decline on
(08:32):
an annualized basis, not that much different than what roats
were pricing in. Rots were up five percent during that
quarter as well, So there is a little bit of
a lead lag relationship that's going on here. We'll see
what the year holds for us. For listed roots, they're
about flat on the year after a really good start
to the year. But I think I think private's going
to be down, and I wouldn't be surprised to see
it down ten to twenty. So as you point out,
(08:52):
like even if my conception of what commercial real estate
is as New York office buildings, we can't just like
form a view of all real estate or commercial real
estate based on that. That being said, like, how much
of that do you say? Twenty trillion rough VideA is
how much of that is sort of distressed right now
or in some sort of trouble and how much is
sort of chugging along? Like we're of that twenty trillion,
(09:15):
how much should we be concerned about? Yeah, so it's
the right question to be asking. And there's a lot
of different ways you can think about distress. The first
way we think about distress is distress sales as a
percent of overall transaction volumes. Before I go there, let
me also just be clear. Transaction volumes are down pretty
significantly on a year of year basis, almost seventy percent down.
(09:35):
I can talk about why that's happening. But distress is
sort of like someone having to sell a property when
they don't want to. It's a foreclosure. For instance, Distress
sales are very very low right now. I don't think
they're going to stay low. I think they're going to increase.
But the reason distress sales are really low right now
is banks haven't started foreclosing on their loans and the
bid ask spread between buyers and sellers is pretty wide.
(09:57):
So distress sales are low. We can talk about delink, CMBs, delinquencies,
bank delinquencies, whatever you want to, but the stress sales,
which is the first thing I look at, is low.
It's showing signs of ticking up. I think it's going
to rise. So just going back to the private valuations
(10:29):
for a second. You know, this is something I've been
thinking about and writing about and a lot of other
people have as well. But how long can private valuations
kind of resist the gravity of lower prices and maybe
deteriorating fundamentals, like what is the catalyst or what is
the process for someone to actually take a hit on
(10:53):
that property, Because clearly, you know, if you're a big investor,
you are going to want to resist crystallizing those losses
for as long as possible, it would seem. Yeah, to
answer your question upfront, it can take. It can historically
take twelve to twenty four months for property for private
property valuations to correct to what the list of markets
(11:13):
pricing in. Why is that the case? Well, let's talk
through how private valuations actually correct. The first thing that
happens is transaction volumes bottom out. You have to see
transaction volumes decline precipitously before property valuations begin declining. Why
is that the case. Well, at the early start of
a correction, sellers don't want to sell at the level
(11:35):
buyers want to buy. There's just a huge bid ask
spread between the two. It's sort of like the grieving process.
I'm not trying to be too flippant about it, but
there is a grieving process. It's denial. There's anger than
its acceptance. So we think we're actually starting to get
to this place with transaction volumes down seventy percent year
of ear. That starts to feel okay to me. But
I think this time is going to be different. I
(11:56):
think the correction and private valuations is going to be
much much quicker than seen previously for maybe one of
the reasons that you talked about at the very beginning,
which is the rise in financing costs. So I'm gonna
get not try to not get too wonky here. No,
please get get wonky as you like. Actually are as
wonky as you. I'll stop you if you if we
need something clarified, but always yes, all right. So here's
(12:19):
a great stat for you. Since nineteen eighty prior to
twenty twenty two. That is, there has been less than
five years five months since nineteen eighty. That's a lot
of months where the treasure ten year treasury was not
lower a decade forward. Something Unpack that and explain to
you what that means. That means in January nineteen ninety
the ten year treasury rate was lower than where it
was in January nineteen eighty, and January two thousand it
(12:41):
was lower than where it was in January nineteen ninety.
There has been a secular decline in ten year treasure rates.
Why does that matter? Well, it matters because, as you
correctly said, commercial real estates inherently elaborate asset class. There's
very few owners of commercial real estate that buy a
property without some amount of debt on it. So, as
you've been in a secular decline in ten treasury rates,
and typically commercial real estates finance with tin year debt,
(13:03):
you have always been able to refinance into lower and
lower financing costs over time. So this is the idea
that usually cap rates decline into a rising interest rate environment.
I sort of say, that's not the right thing to
be thinking about cap rates decline into a rising instrate environment,
because historically that rising interest rate environment is symptomatic of
(13:24):
an improving economy, right at a time that your financing
costs are actually rolling down, So of course your level
re turns expand, which allows cap rates to contract. This
time is much different because financing costs are significantly higher,
not just because of the risk free rate and widening
credit spreads, but also because guess what, growth is slowing.
We were in a stag stag stagflationary environment in twenty
(13:47):
twenty two that doesn't really exist since like nineteen seventy.
It's a much different ball game than what we played before.
So just to do a little Devil's advocate question here,
but what does the maturity wall actually look like? And
even though you know, I take the point that financing
costs are going up, but as long as the market
remains open, you can still roll over your loan, presumably
(14:11):
to infinity. And I can't remember the exact saying, but
you know, there's that old joke about a rolling loan
gathers no distress or whatever it is. Can people just
keep rolling these over in theory? Sure, but so let
me maybe answer your question first. So there's about four
and a half trillion dollars of mortgage debt outstanding. That
(14:31):
tells you, on average, the LTV is around twenty five
percent for commercial real estate. That might sound lower than
what people think, but reat LTVs or less than thirty percent.
Then a crief Odyse index which I mentioned previously, which
is high quality core and core plus properties, that's around
twenty two percent. So yes, smaller borrowers that don't have enough,
(14:53):
don't have a lot of capital, will push the LTVs
up to fifty to sixty percent, which you typically see
in a CMBs transaction. But debt's around call it twenty
five percent of that twenty threeion dollars market. What is
actually maturing well on average, it's about you know, call
it five hundred billion dollars over the next five years.
Each year, so you're talking about call it fifteen to
(15:14):
twenty percent of maturing debt coming due each year over
the next five years. You're what you should hold up
five hundred billion per year, five hundred billion per year
and over the next five years, over the next five years,
so two and a half threeion dollars over five that
makes sense. Yeah, cool. So you're talking about, you know,
call it fifteen twenty percent of debt coming due on
a pran on basis over the next five years or so.
(15:38):
And most of the debt that's coming due in two
thousand and twenty three were either loans that were originated
in two thousan thirteen or in two thousand eighteen. Now,
one of the interesting things about this maturity wall that
I don't think a lot of people are really considering
is how much property prices generically have risen since two
thousand and thirteen. Property prices are up a lot. That
(16:00):
doesn't mean they're up for office, that doesn't mean they're
up for malls, and we can talk through that, but
generically they're up a fair amount. So if you happen
to have originated a loan in twenty twenty two when
you bought a property, your effective LTV is actually a
lot lower than fifty to sixty percent right now given
that property and price appreciation, and even if valuations fall
ten twenty thirty percent next year, there's a good chance
(16:22):
these loans are not in the water yet again or
not underwater. Should I say this is not the case
for office. I don't want to give you that impression
that you know, you're talking about effective LTVs that are
you know, probably going to be a little bit higher
than that, And it's certainly not the case from malls.
Malls effective LTVs we think are you know, around ninety
ninety five percent right now, that's probably a pretty good
(16:43):
case study, we think for where the office market's going.
But office, and since this was a focus of this office,
is only about twenty five percent of that fifteen to
twenty percent that's coming due? Okay? And who's holding that?
And like yeah, so who's who's expose to that? So
it's like, okay, Office, maybe if there's maybe one hundred
and twenty five one hundred billion coming due over the
(17:06):
next each year for the next five years, that sound right? Yeah, yeah, yeah,
that sounds about right. So who is who who holds that?
Is that it banks? Is it a private funds? Like
what's the distribution? Yeah? So Tracy mentioned that we we
talked a lot when we were at when she was
at the Financial Times, and everyone likes to talk about
the commercial mortgage backed security market because it's easy to
look at you get spreads. You know, you understand linquencies.
(17:28):
You have a lot of really good reporting. The CMBs
market is at best twenty percent of the lending market.
It's actually not that big a part of the lending market.
Not to bury the lead and get where you're going.
The majority of the debt coming due is held on
bank balance sheets. Okay, we think you know, call it
fifty percent. More than fifty percent of the debt coming
due in two thousand and twenty three is held to
(17:49):
bank balance sheets. Okay, And that does make some logical
sense because twenty thirteen, these are ten year loans. In
the most part, there wasn't a lot of capital markets
activity in twenty just out of the Great Financial Crisis,
So if a bank originated a CMBs loan, there's a
good chance it's still under books. There's a very good
chance it's still on the books. So most of this
(18:10):
is held on bank ballot sheets. What sort of comes
back to your question at the very beginning, like, how
are we thinking about this risk that has been out
there but has come a little bit more to the
forefront over the past couple of days, given some of
the news with bank collapses can you maybe talk a
little bit more about underwriting standards throughout the years, because
(18:30):
this is something that was a big talking point pre pandemic.
You know, CRI slash CMBs. It was a really hot market.
You saw a lot of people pouring money into it,
and so as sometimes happens, you saw some of the
underwriting standards start to slip. Can you maybe like tell
us what you saw and give us some examples of
the kind of deals that you saw coming through that
(18:53):
could in theory be problematic. Now, there's two ways people
think about underwriting standards. The first one is sort of
headline underwriting metrics, things like loan to value, and the
second thing is all the other things that lenders might
require or not require to provide a loan to a borrower.
So let's talk about LTV first and Foremost LTVs are
(19:14):
actually fairly conservative right now, and certainly we're conservative. Heading
into the pandemic, they were approaching call it fifty percent LTVs,
and that's sort of where they stand right now. I
think that might surprise a lot of people that lending
standards were actually tightening from a headline perspective. But let
me explain to you why that's the case in two thousand.
You know, if you would ask me where the upper
(19:35):
center of froth was real technical term for lending standards
post GFC, I would have told you it was around
twenty fourteen. Two fifteen, things were feeling really good. The
banks were giving out a lot of money, so much
so that the regulators and a joint statement came out
and told lenders, hey, guys, you basically have to slow
(19:56):
this down, and if you don't slow it down, we
might have some regulations. And here's that slapping of the rist,
if you will. Actually sort of worked and banks did
start to bring in lending standards. It also occurred at
the same time that risk retention under Dodd Frank was mandated.
So what's risk retention underd Frank? That basically said CMBs
(20:16):
issuers had to have skin in the game and they
or a third party had to retain five percent of
the entire deal for at least five years. And so
when you actually have to eat your own cooking, that
changes things a little bit. So headline LTVs went down,
headlined dscrs went up. These are all good things, but
maybe where the devil devils in the details, and you
(20:38):
were starting to see a lot more io loans, So
interest only loans. These are loans that don't you know,
pay down over term and have a blue maturity payment.
There was you know, certainly reserves for any number of
different things. This is cash that's put on the sidelines,
so that those a lot more prevalent pre financial crisis
interest only loans, Like I feel like you heard about
(20:58):
commercial mortgages that idea, Yeah, I'm gonna be a little
bit flipping here, but but anything sort of went prior
prior to the GFC. But look, ile loans are are
pretty prevalent over the past couple of years. You know,
all those all the additional money on the sidelines reserves,
if you will, those were sort of you know, not
to say they were waived, but but there was less requirements.
(21:19):
So while while I think the hard LTVs and dscrs
were pretty good, maybe the soft underwriting requirements were or
softer than they had been in the past. So a
little bit of give and take care, I would say,
you know, if anything, it's really a question about where
do you think the debt service coverage ratios are going.
(21:39):
So coming out of the GFC, there was this concept
of debt yield that came about. That's how banks underwrite loans.
Debt yield is effectively inoy divided by your loan balance.
Prior to the GFC, and certainly the early two thousands
loans were underwritten on debt service cover ratio. But after
the GFC, no one was concerned about falling interest rates.
They were only concerned about falling NI. So you underwrote
(22:02):
to debt yield. There's a really good scenario that some
loans with really strong debt yields, because NI is pretty
good right now, might have pretty poor dscrs in the future,
given how much interest rates have risen. So I think,
maybe Tracy, to answer your question about like, what's the
what's the biggest risk here, I think it's a debt
service coverag ray shows NI debt yields could still be
(22:24):
above ten percent twelve percent because NI is pretty strong
right now. Fundamentals feel pretty good. But if you have
a big shock to financing costs, your debt service coveragray
show could be a lot lower than two and a
half times, which is going to require recapitalization. Let's set
(22:55):
aside office for a second. Let's set aside some of
the troubled cities. Are there any old pockets that are
weak because again, we hear about certain categories of weakness
that are obvious that we've talked about them office building
in New York. How are some of these other categories
I think you said they are like fifteen in total
or something like that. Are most of the other ones
still looking pretty good or are their weaknesses elsewhere? I mean,
(23:17):
you're talking about a reap market that was down twenty
five percent in two thousand and twenty two, and if
you believe our views that this leading indicator, you know,
all the proper types experienced, you know, some level of
of of weakness to various different degrees. But a lot
of that presumably was like multiply multiples. Right, but but
but yes, but multiple is just a fancy way of
(23:37):
saying valuation terms. You take one, you know, if you
take the inverse of the multiple, that's capriate. But right, So,
what I'm saying, are there any other that are sort
of like clearly seeing poor revenues or poor rental in
the way an office landlord? Yeah, An, the answer is
not not really okay, because if you think about NY
growth overall in twenty twenty two, you at one point
(24:00):
where plus ten percent plus eleven percent in a Y
growth on a year of year basis, that's close to
a historical high. We are obviously seeing deceleration right now.
We're probably around seven percent right now, and we're underwriting
even slower in a Y growth in twenty twenty three,
given recessionary headwinds that we think are real. But a
lot of what's happening here is actually the refinancing risk,
(24:21):
and it's because valuations are lower because financing costs are higher.
I don't want to make two light of this, but
Office in many many respects is the exception to the
fundamental story. YEA, many of the other asset classes are
having quite fine in a Y growth. But I don't
want to be two probably dogs and rainbows over about
(24:42):
this because I truly believe that idiosyncratic risks are real.
You're going to have some multi family properties that were
purchased that really tight cap rates in advance of improving
and are accelerating revenue growth, and that business plan is
not going to come to fruition. So there is there
is some real risks here beyond just financing that that
(25:04):
is going to pressure valuations lower across property types. It's
going to lead to higher distress, lead to higher delinquencies.
Office is the poster child for this. But I don't
want to give you the idea that commercial real estate
fundamentals are uniquely as bad as office because they're not.
We sort of think office is the exception, not the norm.
(25:25):
So you mentioned refinancing risk there, and that's exactly what
I wanted to talk to you about next. And I'm
trying to avoid um sounding like a Judy Bloom novel
here or something. But where does refinancing come from? And like,
is the assumption that I mean, I assume a lot
of it is from banks. Is the assumption that banks
are just going to pull back on it in the
current environment. Yeah, So where does refinancing come from? First
(25:48):
of all, it's banks, it's insurance companies, it's the CMBs market,
it's debt funds and mortgage rate it's the GSS in
the case of multi family and student housing and seniors housing.
So there is a wide variety of financing sources out there.
Banks are a big portion of that. Insurance companies are
are a big portion of that. CMBs is a smaller
(26:10):
portion of that. But but there's a roide variety of
of of financing sources. So in terms of refinancing, look,
I think a lot of people are focusing on the
cost of financing side because that's real. You can see
it every day by looking at just where the risk
free rate has gone. You know it's at call three
and a half three point six percent today. You know
it was two hundred basis points lower a year ago.
(26:32):
That's a big deal. And when you think about where
credit spreads are going, those are wider as well. Tracy,
just maybe just give you some live updates on on
where these things are. The triple A CMBs market is
pricing about one hundred and thirty basis points over the
ten year treasury, and the triple B minus market is
north of nine hundred at this point. So these are
(26:52):
these are those are much wider spreads. The good news is,
you know, the CMBs market, the debt markets are actually
pricing in all these things that we've been talking about. Yeah,
it's not like the CMBs market is you know, naive
about this nine hundred over the ten year treasury when
the ten ye treasures at three fifty you're talking about
it almost a twelve and a half thirteen percent yield.
That's a that's a pretty attractive yield given you know
(27:15):
the risk of loss. So I do think there is
is a lot in the price of where the spreads
are right now. But look, availability of debt capital it's
probably not going to be, you know, as as robust
as it was last year or even twenty nineteen. So
when you think about who's gonna be able to get
debt capital, I think a well qualified a well qualified
(27:37):
sponsor that's well capitalized with a good business plan, they
can probably get debt right now, even on an office property,
believe it or not. The problem with thought with office
just to use maybe an example, is this binary you
can get debt at attractive levels or you can't. It's
it's it's not like an office. A lender is going
to come back and say, hey, guess what, I don't
(27:58):
feel really comfortable with you as a sponsor your business plan.
I'll give that to you at a thirty or forty
percent LTV instead of a fifty percent LTV. That's not
the way it works. It's almost like bit out interesting, Wait,
why is that is that just like a sort of
like norms and cultural thing, or is it does not
make business sense to try to deal with someone in
those marginals. See all of the above. Okay, yeah, it's
(28:21):
if you're going to if you're a lender and you
have to go to your investment committee and you're saying, hey, look,
I'm going to lend on this office property, you gotta
pretty much make sure your eyes are dotted and your
teas are crossed. Now. Now, the other reality is lenders
are really focused on one thing and one thing only
getting their money back, right. And you know, if you
don't get your money back, you take a loss. It
(28:42):
doesn't matter what that spread was, you're not gonna get
paid enough. So just on office I know, we're sort
of saying, there's a lot of other categories besides the one.
The stairs us in the face every day of New
York real estate. But New York office space, the publicly
traded instruments that seem to track your office space. I
mean they look like really dismal. I don't know, I'm
not asking for your like views unnamed, but like, I know,
(29:04):
you know, it's like sl Green is a company that
you see, you owned a lot of buildings in New
York and they're publicly traded, and that was an eighty
dollars stock in March of twenty twenty two, and today
it's a twenty eight dollars stock. Prior to COVID it
was over one hundred dollar stock. Like, what is the
market saying, look about this type of property that's getting
(29:25):
so hard and for not them specifically, but for someone
who owned property like them, what kind of situation are
they facing next time they have to refinance a building
or you know, remortgage your building or whatever. Yeah, well
let me first you know, yeah, yeah, let first be
clear that we're pretty cautious on office in our list
of portfolio. Look, we have very little office exposure. Why
(29:49):
is that the case? Well, maybe to answer your first question,
the public markets are telling you that office valuations are
going to be down substantially. Why is that the case, Well,
it's the it's for three three reasons. First of all,
you don't know where the NY growth is going. Okay,
it's uncertain. Yeah, I just wanted to make sure. Sorry,
(30:09):
sorry about that, which is basically revenue minus expenses for
those playing at home. You don't know where your NEBT
operating income is growing going. You don't know how much
capex you have to spend to generate that NI, and
you don't know what amount of debt you can get
on it. So if you put NY and capex and
financing into it, that's how you get your leveed IRR
(30:30):
and cap rates just a product of that. The market
is telling you that, the list at market is telling
you that cap rates have to go substantially higher. I mean,
maybe just to come back and and and and talk
about this a little bit more. The listed market, on
average across property types is trading at a high five
percent implied cap rate right now. The private market, as
(30:51):
measured by the Newcrief Odyssey Index is still at three nine.
That's a crazy difference between public and private values. Yeah,
the listed market is at a high five percent caprate. Okay,
so last week it was like at five to seven.
It's gonna be wider than that now. And it cap
rates is like a inverse P, so that means that's
that's in stocks, you would call it twenty P. You
(31:12):
call it a five percent capri. So multiples right now
for multiples after taking ato account, cap x in the
reat space around eighteen and a half times, so you're
pretty close. My only point to you is that there's
a two hundred bases point difference between where reats are
pricing cap rates and where the private markets pricing cap rates.
We think, you know, before before we went on, you're
asking me, hey, aren't you a little bit more constructive?
(31:34):
And I was like, well, look, I am constructive on
reets because I think the entry points are pretty attractive here.
But the private market, you know, we still think valuations
are going down. So if you're a legacy holder of
private valuations, you're still gonna have some headwinds and feel
some pain in twenty twenty three. But if you have
new capital to invest in private, that's probably pretty good.
(31:54):
I want to buy low, sell high. I think that's
going to happen in twenty three, and I think the
reat markets pricing in a more pain than private markets
are pricing in right now. Yeah, it does feel like
I mean, in addition to interest rates, it feels like
the wild card here is basically the availability of capital. Sure,
I mean, I'm not pushing back on that at all.
(32:15):
I mean, commercial real estate, Tracy, I think you probably
heard me say this before, it's inherently a level asset class.
So it's financing cost in the availability of capital. I
think you're going to quickly figure out who can swim
really strong against As the tide's going out, why can't
it keep getting worse? And But the reason I ask
that is, you know you're like, oh, I want to
buy low and still high whicheveryone does. And maybe this
(32:36):
is a moment to buy low because there is clearly
a lot of distress out there. But you know, again,
it was the rates move. You know, we had a
forty year down, we had a forty year decline in rates.
We're like one and a half years into the increase
in rates. Why couldn't, Like, do you worry about higher
and higher for longer? Do you worry that that for offices,
(32:58):
that there's not a trend that's going to bounce back soon?
This is like in these distress cities, distress can build
upon distress. The few people not coming into an office
can erode an area's tax base and make people wanted
to stay home too, Like do you worry about acceleration
of headlands? Are you asking me what keeps me out
at night? But beyond my forecast, I guess I think
(33:21):
the single if I was on here a month ago, Yeah,
I would have been telling you the single biggest risk
was a stronger economy that begets higher inflation and the
Fed has to do more and more to temper that.
And so look, I'll be very clear if you know
the terminal rate, so that's basically where the Fed Fed
(33:41):
funds target rates going. If that's closer to six than
six and a half, tenor treasure rates probably before all
of this was happening, probably aren't supposed to be at
three and a half. They're probably supposed to be a
lot higher than that. And so you know, again I'm
gonna get wonky here a little bit, but we think
real rates are really what drive commercial real estate valuations.
Real rates is the different between nominal rates and inflation expectations.
(34:03):
I think if real rates go to around one, that's
probably pretty good for real estate, but if they're going
to be closer to two, that's actually probably not so
good for real estate. So yeah, that's absolutely keeping me
up at night. Our views heading into this year was
that we were transitioning from a stagflationary to a stagnationary market.
What does stagnation mean? Well, let me let me first
(34:25):
of all say what is the stagflationary environment. Stagflation is
where interest rates are rising and growth are slowing. The
FED was in a really awkward position in two twenty
two for reasons that happened in two thousand and twenty one.
They didn't raise rates fast enough, so inflation was at
record high levels. They had to raise interest rates at
a record pace to slow growth in the economy and
the hopes of taming inflation. That's stagflation. We thought, we think,
(34:50):
we still think that we're moving into a stagnationary environment.
That's where interest rates come down and growth slows. That's
actually really good for listed markets. Not so great for
private markets because sort of start catching up, but it's
pretty good for listed markets. You know. Best case scenario
is that all the Fed's medicine starts to work, inflation slows,
and they don't have to they stop raising rates, but
(35:13):
they also don't have to cut interest rates. The other
thing that's keeping me up at night, to be very clear,
is that the market's pricing in six interest rate cuts
over the next eighteen months. I don't want to see
interest rate cuts. I think about when the Fed cuts
interest rates, it's because something bad is actually happening. That's
not a good thing for the market. So you know,
we actually thought we were, you know, sort of in
(35:35):
this not too hot, not too cold environment. You know,
maybe the unintended consequence of these bank failures is this.
It actually a showing that the FEDS interest rate hikes
are finally working and it's starting to break some things.
And that makes me feel, maybe counterintuitively, a little bit
better about where we're going. I hope it doesn't push
us into a really deep recession. I think recession is
(35:56):
our base case, but but you know, it's the two
extremes that me up at night. A much hotter and
stronger economy where interest rates have to go higher than
where they are right now, and a pretty hard recession,
which you know, I would argue that a recession is
the base case. It's just a matter of degree. Yeah,
So there was one thing I wanted to ask you,
and I think Joe and I are gonna try to
(36:18):
do an episode that focuses on, I guess the physical
challenges of converting offices to residential at some point, but
maybe from a financing market perspective, you know, could you
have a situation where a lot of these offices do
get converted to resie and what would that mean first,
(36:39):
CRI investors and lenders in general. Do you know, do
CRI people who have a big portfolio of office properties
do they suddenly become residential lenders? Or I mean, I
guess they would all be classified as multi family. But
how would that work exactly? Yeah, it's sort of a
good tie into some of the other podcasts that you've
done over the past a couple of weeks. Look, let
(37:01):
me say in an outset, we do not have enough
housing in the United States. I think you've covered that
in prior podcasts. We can debate why that's the case.
I think you've already covered it, But we don't have
enough housing in the United States. So the highest and
best use for a lot of these office properties is
not office. And you could make a case in New
York City that we are have a significant shortage of
(37:22):
affordable housing in New York City. So it does make
sense if I could make way my magic Verry Wand
and say convert from office to multifamily. You're probably supposed
to do that for a variety of reasons. It's actually
it's actually much easier said than done. For a whole
host for different reasons, including zoning. It's not like all
(37:44):
of these properties are zoned from multifamily, and so again
you could come back to how do you think about
commercial real estate. It's a single asset class with a
lot of different property types. All these different municipalities have
different zoning laws, and so you have to go through
a rezoning. It's sort of like the same reason why
prior to COVID we were talking. There was talk about, well,
let's just make all of these malls industrial facilities. It's
(38:06):
just not so easy. There is one off examples where
you can get it done, and it makes a lot
of sense, but again it's it's not a cure for
everything yet. All right, Rich, we're going to leave it there.
That was such a good overview of the space, and
you know clearly there's a lot going on, but you
were very good at walking us through the nuance of
the different subsectors and the different way of looking at
(38:28):
prices and valuation at the moment. So thank you so much. Sure,
thanks for having me again. Thanks Rich, that was great.
So Joe, I thought that was a really good walk
(38:50):
through through all of these different parts and for me,
I guess the most salient thing is what rich was
talking about, the discrepancy between the public and private valuations
at the moment, because you have seen a lot of
the mortgage rates just collapse in recent months, you haven't
seen the same pressures on the private side. Although you know,
I guess the clues in the name those particular valuations
(39:13):
aren't quite as transparent right now. I mean, if you
look at like some of them, I mean, you know,
listeners like pull up a chart of like Vornado or
sell Green, like some of these names, I mean they're
real dismal, like below the COVID lows when people were
talking about oh, no one would ever go into an
office ever. Again, so like between the interest rate increases,
(39:33):
between concerns about just like the actual net income and
so forth, the public market is given clearly a very
grim assessment. Yeah. And then also the definition of CRIS
sort of a leveraged bet on interest rates and availability
of capital. I think that's going to be a really
good way to frame it going forward, because even before
(39:55):
recent events and the collapse of Silicon Valley Bank and
worries over the wider banking system, there was obviously concerned
about what was going on in CRE And it's going
to be really interesting to see how this financial crisis
shakes out, because if it leads to the FED cutting
interest rates, well maybe that would be better from a
(40:17):
purer financing cost perspective, but to Rich's point, it would
mean something bad is going on in the economy, and
it would probably mean that there was less brisk appetite
in general out there. Yeah. Right. You know, it's the
same intuition with stocks, which is that if the FED
is cutting rates, it's probably at a time when revenues
are coming down, when net incomes are coming down, Like
(40:39):
it's often the case that it goes hand in hand.
So ostensibly it seems bullish, you know. I guess to
my mind, the question is like, yes, there's going to
be some cyclical shift at some point, but you know,
this is an area if it's so rate sensitive, well
we're coming off like you know, the forty year rate
bull market, and it could be that these sort of
elevated rates not just stay elevated for years. Maybe they're
(41:02):
going to keep getting elevated. I don't think we really
have like any I don't think anyone like knows for sure.
I mean you could see why it's a stressed area.
I did appreciate though, and I do think it is
easy for us in New York to think that all
commercial real estate is like a handful of half empty
buildings and they're like clinics and data center totally. Although
Jim Chano's you know, he's he's short the data centers,
(41:24):
or he at least was, so he has negative aspects
of those. But there's data centers that's its own distinct area.
You know, There's there's a you know, assisted living spaces
that in commercial real estate, so all kinds of categories.
It is crazy to think that with you know, the
pace of interest rate hikes last year, you still saw
commercial property prices go up as a total, and that,
(41:48):
you know, that is because it is not a monolithic
sector and it is not just massive office buildings in Manhattan.
So I'm sure we're gonna end up talking more about
this topic, but for now, shall we leave it there?
Let's leave it there. Hey, this has been another episode
of the Odd Thoughts podcast. I'm Tracy Alloway. You can
follow me on Twitter at Tracy Alloway, and I'm Joe
(42:10):
wisn't Thal. You can follow me on Twitter at the Stalwart.
Follow our producers Carmen Rodriguez at Carmen Arman and Dash
Bennett at Dashbot. Check out all of our podcasts on
Twitter under the handle at podcasts, and for more Odd
Lots content, go to Bloomberg dot com slash odd Lots,
where we post transcripts. We have a blog and a
(42:31):
weekly newsletter comes out every Friday. Thanks for listening. Two
Hosts And Creators
Joe Weisenthal
Tracy Alloway
Popular Podcasts
24/7 News: The Latest
The latest news in 4 minutes updated every hour, every day.
Therapy Gecko
An unlicensed lizard psychologist travels the universe talking to strangers about absolutely nothing. TO CALL THE GECKO: follow me on https://www.twitch.tv/lyleforever to get a notification for when I am taking calls. I am usually live Mondays, Wednesdays, and Fridays but lately a lot of other times too. I am a gecko.
The Joe Rogan Experience
The official podcast of comedian Joe Rogan.