What Commercial Real Estate Stress Means for Banks and Bond Funds | Odd Lots

Introduction

In this episode of the Odd Lots podcast, Joe Eisenthal and Tracy Alloway discuss the impact of regional banks on commercial real estate. They introduce Jim Costello, Chief Economist at MSCI's Real Assets Team, as their guest to provide insights into the topic.

The Impact of Regional Banks on Commercial Real Estate

• There are concerns about commercial real estate loans that some smaller regional banks might hold.

• Deposits pulled from smaller banks may affect their ability to pour money into the sector.

• These two factors are impacting each other and compounding each other at the same time.

Understanding Commercial Real Estate

In this section, Joe and Tracy discuss how commercial real estate is not a monolithic market. They talk about different categories such as office space, medical facilities, and residential development.

Different Categories in Commercial Real Estate

• Multi-family residential development is different from an office building in Downtown New York that might be empty now.

• A big bank has a different risk profile than a smaller regional bank.

• It's important to dive into the details and get some real numbers rather than just generalizations.

Interview with Jim Costello

In this section, Joe and Tracy interview Jim Costello, Chief Economist at MSCI's Real Assets Team. He provides insights into how regional banks impact commercial real estate.

How Regional Banks Impact Commercial Real Estate

• Smaller regional banks have quite substantial exposure to commercial real estate.

• The collapse of Silicon Valley Bank was not really about credit quality but deposit concentration.

• There is concern about whether these smaller banks will be able to refinance their loans in the current environment.

• Medical facilities have been doing well during the pandemic while office spaces have been struggling.

Commercial Real Estate Lending

The speaker discusses the challenges of analyzing commercial real estate lending and how to avoid looking at the wrong figures.

Share of Bank Lending to Commercial Real Estate

• Banks are not everything in the commercial real estate lending world.

• 48% of all commercial real estate loans from 2015 to 2019 were in the banking realm, with about 60% being local and regional banks.

• The institutional universe is not tracked for properties under $2.5 million, which can skew data.

Concerns About Commercial Real Estate Loans

• There are concerns that commercial real estate loans may default or be unable to refinance.

• Banks invested in CMBS may be affected by recent turmoil in deposits.

• Lenders are becoming more restrictive when originating loans, leading to lower deal activity and volume.

Differences from Previous Downturns

• Every downturn has unique characteristics, and it's important not to just look at past events but also seek out new opportunities.

• Many people try to use the playbook of those who made money during previous downturns, but every situation is different.

Commercial Real Estate Financing

In this section, the speaker discusses the financing of commercial real estate and how small/regional banks are more natural sources of financing for these projects than larger banks due to regulatory shopping in the financial world.

Small/Regional Banks vs. Large Banks

• Small/regional banks have fewer restrictions placed on them compared to large national banks.

• Administrative costs rise exponentially once a bank reaches a certain threshold level for regulatory burdens.

• Banks must hire more risk management people and do more work on scenario planning around different Fed scenarios that could affect the economy and asset prices.

• Regulators may be situated on-site in larger banks to monitor their operations.

Regulation of Commercial Real Estate Financing

• High volatility commercial real estate regulations (HVCRE) came into effect in 2015, requiring lenders to hold more capital and reserves for loans with shorter terms.

• Construction lending was affected by HVCRE as it typically involves short-term loans that pay out quickly. The decline in construction financing led to an increase in debt funds' activity.

Understanding the Behavior of Lenders

In this section, the speaker discusses how lenders behave differently when originating loans. Banks underwrite loans to avoid foreclosure situations and put covenants in place to ensure they are whole. Debt funds, on the other hand, view it as an opportunity to take over a property at a lower basis than before and raise capital to stabilize it.

Differences in Underwriting

• Some lenders complain about their competitors being more aggressive by originating loans at higher LTVs, lower interest rates, and with fewer covenants.

• Banks underwrite loans wanting to avoid foreclosure situations and use covenants to ensure they are whole.

• Debt funds view loan origination as an opportunity to take over a property at a lower basis than before and raise capital to stabilize it.

The Maturity Wall

In this section, the speaker talks about the maturity wall that is coming due in 2023 through 2025. They discuss how banks and private investors will be able to refinance those loans.

Refinancing Challenges

• A wall of maturities is coming due in 2023 through 2025.

• If someone had a loan originated in 2021 with high LTV and low-interest rates, refinancing may be challenging because lenders will offer money at a much lower LTV comparative before with mortgage rates closer to seven percent than three and a half percent.

• Three options for borrowers include cash-in refinancing where they bring more equity themselves or get some outside investor to bring that cash or default situation if there's no expectation of price growth ahead or income growth.

Income Stress in Commercial Real Estate

In this section, the speaker discusses income stress within the commercial real estate world and how it affects different types of properties.

Manhattan Offices

• There is a reduction in demand for office space in Manhattan due to lower subway ridership and less foot traffic on certain days.

• However, there is still some good occupancy in Manhattan offices, and tenants are still paying rent.

• The weighted average lease term is an important factor to consider when assessing the income potential of a property. Properties with long lease terms and high-quality tenants are seen as safer investments.

Non-Manhattan Offices

• Most of the US office market is located in suburban areas, which have been bigger than CBD locations in terms of deal volume since 2015.

• While there has been a reduction in demand for office space overall, suburban markets have not been hit as hard as CBD locations.

The Impact of Deal Volume on Commercial Real Estate

In this section, the speaker discusses how deal volume has changed over time and its impact on commercial real estate.

Deal Volume Trends

• Since 2015, deal volume has fallen off for CBD locations due to Chinese investors pulling back from investing in the US.

• Suburban markets have seen more deal volume recently compared to CBD locations.

Introduction to the Current State of Real Estate

The speaker discusses the decline in real estate investment since 2015 and how it has affected suburban locations.

Decline in Real Estate Investment

• Real estate investment has declined since 2015.

• Income deterioration and weighted average lease terms have made it difficult to refinance properties.

• The "extend and pretend" strategy used during the financial crisis won't work this time around due to uncertainty around income moving forward.

Distressed Asset Sales

The speaker talks about distressed asset sales and how they differ from those seen after the financial crisis.

Types of Buyers for Distressed Assets

• There haven't been many distressed asset sales yet, but they are expected.

• Local developer owner-operator types have been buying these properties so far, rather than private equity firms as seen after the financial crisis.

• The distress is more fundamental this time around, with properties that have uncertainty around income moving forward.

Repositioning Properties

• Repositioning distressed assets takes a lot of elbow grease both physically and figuratively.

• It involves identifying opportunities to make something other than what it was before, such as turning a mall into residential or logistics space.

• However, local zoning issues can be a challenge when trying to change land use regulations.

Buyers of Distressed Properties

The buyers of distressed properties are not just those who know how to flip a spreadsheet, but rather those with concrete connections.

• Buyers of distressed properties have concrete connections.

• They are not just people who know how to flip a spreadsheet.

CBD Office and Income Stressed Areas

This section discusses the solidity of numbers in terms of bank and private credit funds for income-stressed areas like CBD office.

Originations and Maturities

• There is no good measure of the stock.

• Estimates are available for maturities.

• Some loans may default, which makes measuring the stock tricky.

• Debt funds were around 13% of originations during the boom period.

• Short-term loans associated with debt funds will be a significant component of near-term maturities.

Hedging Commercial Real Estate Exposure

This section discusses whether private investors are hedging their commercial real estate exposure at this moment in time.

Synthetic Instruments

• CMBX is a derivatives index tied to not that many CMBS properties.

• It is sometimes an imperfect hedge for this kind of exposure.

• Hedging commercial real estate has been difficult due to lack of buyers and sellers on opposite sides of transactions.

Comparison with Residential Market

• There are fundamental differences between residential and commercial markets.

• The residential market is much larger than the commercial market, making information availability an issue.

• More academic literature exists on residential real estate because there is more data available.

Shorting Commercial Real Estate Market

This section compares shorting the residential real estate market pre-2008 using ABX with shorting the commercial real estate market.

Differences from Residential Market

• There are fundamental differences between residential and commercial markets.

• The residential market has more subsidized finance.

• The residential market is much larger than the commercial market, making information availability an issue.

Difficulty in Shorting Commercial Real Estate

• It is difficult to put on a big commercial real estate short due to lack of information availability.

• The academic literature on commercial real estate is limited compared to that on residential real estate.

Commercial Real Estate and the Banking System

The speaker discusses the significance of commercial real estate (CRE) in a theoretical bank's balance sheet, how to assess the exposure of banks to CRE, and the seriousness of CRE weakness to banks.

Significance of CRE in a Bank's Balance Sheet

• A theoretical bank could have treasuries, agency MBS, or other assets on its balance sheet.

• FDIC call sheets provide information about some entities' exposure to CRE.

• A study estimated that around 200 banks face challenges related to CRE.

Assessing Banks' Exposure to CRE

• It is challenging to determine how seriously banks are affected by their exposure to CRE.

• Loan loss provisions for CRE are unknown.

• The sector is opaque and requires conversations with people for insights.

Seriousness of Weakness in CRE

• The seriousness of weakness in CRE depends on whether banks have taken write-downs and replaced capital before bank runs occur.

• Securities marketed to market may not be worth what they were when interest rates were low.

• It is difficult to determine capitulation points.

Understanding the Dynamics of Commercial Real Estate

In this section, Jim Costello discusses the current state of commercial real estate and how it has been impacted by COVID-19. He talks about the changes in economic justification for different types of properties and how income stress is affecting them.

Income Pressure vs Rate Pressure

• The income stress has mostly been a story of properties where the previous economic justification from is evaporating.

• Malls have been dealing with this issue for a long time, but now offices are facing similar challenges.

• The other property types are not as extreme on income uncertainty.

Changes in Economic Justification

• The change in economic justification is causing issues for many assets.

• There has been a change in the patterns of daily room rates because there are many more tourists than business travelers.

Conclusion

• Commercial real estate is going through significant changes due to COVID-19, and it will take some time to see how things play out.

Why is Commercial Real Estate Difficult to Short or Hedge?

In this section, the hosts discuss why commercial real estate seems to be difficult to short or hedge.

Challenges in Shorting Commercial Real Estate

• People have come up with creative ways of going short on commercial real estate, but there hasn't been an obvious industry standard other than cmbx.

• It's not as simple as buying a stock or a CD. There isn't always a hedge out there that someone could have bought.

• The idea that everyone has an ISDA agreement up their sleeve is a naive fantasy about how these markets work.

Conclusion

• Follow Jim Costello at JimCostelloCRE and the producers Carmen Rodriguez at CarmenArmin and Dash Bennett at Dashbot.

• For more Odd Lots content, go to bloomberg.com/OddLots. They have transcripts, a blog, and a newsletter. You can also hang out with other listeners on the Odd Lots Discord.

• Thanks for listening!