Archives for February 2023

A new analysis by Trepp and CompStak raises the question of whether the office segment of CRE is facing a now-cliched perfect storm metaphor. The three dangers that could unite are office loan maturities, large lease expirations, and low space demand.

Said another way, it comes down to inflation and the end of easy money, worry about corporate financial performance, and the desire of working people to control more of their lives.

The report says that by the end of 2424, $40.47 billion in loans — that’s 353 loans backed by 583 office properties — and 56% are floating rate with an average remaining term of over 10 months and all with extension options of 29 months.

These are spread across 11 metros: New York-Newark-Jersey City; San Francisco-Oakland-Hayward; Los Angeles-Long Beach-Anaheim; Chicago-Naperville-Elgin; Boston-Cambridge-Newton; Washington, D.C-Arlington-Alexandria; Houston-The Woodlands-Sugarland; Dallas-Fort Worth-Arlington; San Diego-Carlsbad; Atlanta-Sandy Springs-Roswell; and Phoenix-Mesa-Scottsdale.

The list is by current outstanding balance, from $15.72 billion to $420 million. Refinancing means stepping in at much higher rates than a few years ago, which means higher interest and probably lenders who have tightened up on leverage. The process will not only cost more over time, but likely require injections of equity.

Some additional complications are the state of major tenants. The average number of the top five tenants in these buildings with leases that expire within two years ranges from 0.73 in greater Boston to 1.93 in Dallas-Fort Worth. The average square footage expiring among those top five at the low end is 19,182 in Boston. The high end is 49,670 in and around Chicago.

This is already an uncomfortable position. Now add changes in office leasing. Average new lease terms are pretty close to where they were before the pandemic. Renewals in 2022 through Q3 were at 53.5 months, but that’s down almost 12% from 2019 and average renewal transactions are down 28.7% from 2019. The renewal figures have continued to fall since pre-pandemic. For Class B or older space, the situation is even worse, as many are on the way to becoming obsolete.

Put more succinctly, higher refinancing rates hurt debt service coverage ratios and, at a time when hiking rents is pretty difficult, that means tighter finances. Concern over the economy continues to mean companies want shorter renewals and may be looking at cutting space. The last part also means getting replacement tenants isn’t something to count on.

But, against all this is the point that Moody’s Analytics recently made, that utilization rates are improving because even with hybrid, the trend is for people to choose the middle of the week as when to be in the office. And when everyone comes in at the same time, cutting office space may not be viable, because companies must have capacity for peak appearance.

Source: “The Cliched Perfect Storm May Be Headed to the Office Market“

Debt funds are enjoying a “lender’s market” in a landscape where many large banks have retreated, which is creating more opportunities to do deals with higher-quality borrowers and lower risk, while still capturing enhanced returns.

AllianceBernstein is one firm that has experienced tremendous growth across its U.S. commercial real estate debt platform over the past three years. The team originated $5 billion in loans between 2020-2022—half of which occurred in 2022. “Looking ahead to 2023, we expect to remain active and capture increased deal volume from banks and other less capitalized alternative lenders,” says Peter Gordon, chief investment officer and head of U.S. Commercial Real Estate Debt at AllianceBernstein.

Debt funds have ample liquidity thanks to steady fundraising from investors that are continuing to gravitate to debt strategies. Investors like the risk-adjusted returns debt funds are delivering. Yields can run from low single-digits to mid-teens depending on the strategy. For example, Alliance Bernstein’s debt portfolios have consistently generated unlevered mid-to-high-single digit yields along with a strong emphasis on principal protection. “In today’s market environment, we believe returns for debt funds are expected to be higher when compared to 2019-2022,” says Gordon.

Across all risk profiles, debt investors are achieving wider margins, driven by capital markets headwinds, while base rates are higher due to the Fed’s focus on inflation reduction, adds Dean Dulchinos, head of debt portfolio management at AEW Private Equity. This environment affords investors the opportunity to achieve outsized returns while lending on collateral that has been repriced due to cap rate expansion and capital markets impacts. At the same time, leverage levels for new loan transactions are significantly below historical averages, often by as much as five to ten percent.

“As a result, lenders are enjoying better positioning power in the capital stack that could be compared with the capital markets following the GFC,” he says. “All of this taken together means that the risk-return tradeoff in the current market may be more favorable than at most other times in a typical cycle.”

Fundraising momentum

The market has seen a flurry of new announcements in recent weeks. For example, Greystar Real Estate Partners LLC announced the final close of its $600 million Greystar Credit Partners III in December. And Dwight Capital and its affiliated real estate investment trust, Dwight Mortgage Trust, announced in January that it was launching a commercial real estate rescue capital fund to aid sponsors with equity shortfalls. The company said that it expects to deploy roughly $2 billion throughout 2023.

Although there seems to be a surge in interest in debt and credit investments lately, the reality is that capital has been flowing into private equity debt fund strategies for the past several years. In fact, fundraising among North American-focused debt funds slowed to $18.5 billion last year compared to the $26.3 billion raised in 2021, according to Preqin.

Yet some sponsors see the current constrained capital market as an opportunity to take advantage of fundraising tailwinds. “We’ve definitely seen a shift over the last nine to 12 months, especially as interest rates have increased, with both institutional and non-institutional investors that are looking for those higher returns,” says Gary Bechtel, CEO of Red Oak Capital Holdings. The company recently announced the launch of its latest Fund VI, which is a $75 million hybrid fund for CRE debt featuring two distinct products: a bond offering and a preferred units offering. The fund will focus on U.S. senior-secured, small-balance sheet real estate debt investments in primary and secondary markets.

Debt funds also are taking advantage of the contraction in the lending market with opportunities to deploy capital. “Our pipeline has done nothing but grow as interest rates have ticked up, especially as a lot of the floating rate lenders, debt funds and non-debt lenders, have seen their business curtailed pretty dramatically,” says Bechtel. The market has seen some shake-out among bridge lenders that were reliant on demand from floating rate product and business models that required bank warehouse lines or securitization in the CRE-CLO market—all of which are weaker in the current market. Red Oak also has added new products, including core and core-plus financing options, to satisfy demand from both borrowers and investors that are looking for lower risk profiles. “Even in a higher interest rate environment, we see an opportunity for growth,” says Bechtel.

Fund managers follow different strategies

Investors are finding plenty of choices with debt funds that are pursuing a variety of different strategies in terms of the types of loans and the property sectors they are targeting. Funds also are deploying capital across different risk strategies, including core, core-plus, value-add and opportunistic. Funds operating with higher return strategies tend to originate more subordinate or mezzanine debt, while funds with more conservative strategies are focusing on lower-leverage senior loans that have a senior position in the capital stack.

“In the U.S., we primarily focus on core-plus, construction-to-permanent, and value-add whole and subordinate loans,” says Dipak Patel, managing director of commercial real estate for AB Private Alternatives Business Development at AllianceBernstein. Its U.S. debt funds originate both fixed and floating rate loans across each strategy and offer investors the option of unlevered or levered investment vehicles. “The diversity of capital across our platform is what allowed our team to remain active during 2022,” adds Patel. Among the $2.5 billion in debt Alliance Bernstein originated across its US platform last year, 60  percent of that volume occurred in the second half of the year.

According to Dulchinos, debt strategies that can offer “clean” balance sheets free of legacy investments are focusing largely on providing capital to fill the gap being created from the estimated $500 billion of non-bank loan maturities coming due over the next two years. Meanwhile, lenders providing both acquisition and construction financing in senior and subordinate debt positions are finding opportunities in sectors that benefit from durable demand growth, particularly residential, logistics, and healthcare.

“While the lending market remains competitive in certain favored sectors, such as multifamily and logistics, the number of bidders across all transactions is significantly lower than it was a year ago,” notes Dulchinos. Regulatory pressures on bank lenders and capital markets pressures on debt funds, coupled with the burden of managing legacy loan portfolios, have reduced the number of active market participants and consequently the amount of available capital chasing deals, he adds.

Looking ahead to the coming year, debt funds may have to work harder to capture investor capital. Investors recognize that they do have many choices, and they also are more selective given the macro-economic challenges ahead. Debt fund managers will be looking to differentiate themselves through their strategies, track record and underwriting expertise, as well as a proven ability to select and manage assets successfully.

Source: “Seeing an Opportunity, CRE Debt Funds Raise Massive War Chests“

As head of financial and economic research at Buckingham Wealth Partners, I’ve been getting lots of queries from investors concerned about the risk of the U.S. defaulting on its debt. In this article, I’ll explain the situation, point out the risks and provide strategies investors can consider to address them.

The Current Situation

The U.S. government has a self-imposed borrowing limit known as the debt ceiling. When that ceiling is reached, the Treasury Department cannot issue any more debt—it can only pay bills as it receives tax revenues. We reached the debt ceiling on January 19, 2023, when the national debt crept up to above $31.4 trillion. The current ceiling was set in December 2021—when it was raised by $2.5 trillion. Until Congress increases it again, the Treasury Department is relying on extraordinary measures to meet the government’s obligations. These measures cannot go on indefinitely, and the government will be at risk of default sometime later this year. If the ceiling isn’t raised or suspended, the Treasury Department would not be able to issue more Treasury bonds. The government would be forced to choose between paying federal employees’ salaries, Social Security benefits or the interest on the national debt. If it doesn’t pay that interest, the country would default.

History

When considering what could happen if the country were to default, it’s helpful to examine our trusted videotapes. Here is a quick review of the last episode when default was at risk.

In January 2013, Congress threatened to not raise the debt ceiling. It wanted the federal government to cut spending in the fiscal year 2013 budget. Better-than-expected revenues meant the debt ceiling debate was postponed until that fall. On September 25, 2013, the Treasury Secretary warned that the nation would reach the debt ceiling on October 17. On the first day of fiscal year 2014 (Oct. 1, 2013), the government shut down because Congress hadn’t approved the funding bill. On October 17, 2013, Congress finally agreed to a deal that would let the Treasury issue debt until Feb. 7, 2014. The Council of Economic Advisers estimated that the combination of the government shutdown and debt limit brinksmanship may have resulted in 120,000 fewer private-sector jobs created during the first two weeks of October and slowed economic growth by as much as 0.6%. Yields on Treasury bonds remained virtually unchanged over those 17 days, and the S&P 500 Index actually rose about 1.5%. Thus, investors who took action to avoid risk incurred expenses in doing so and missed out on positive equity returns.

Although it was not the result of a debt ceiling crisis, the last government shutdown, running from December 22, 2018 until January 25, 2019 (35 days), was the longest in history. It occurred when the 116th Congress and President Trump could not agree on an appropriations bill to fund the operations of the federal government for the 2019 fiscal year or a temporary continuing resolution that would extend the deadline. Over this 35-day period, the S&P 500 rose about 2.7% (indexes are unmanaged baskets of securities and cannot be directly invested in nor are they indicative of trading in an actual portfolio). Treasury bond yields were virtually unchanged. Once again, investors who acted on their fears of default incurred expenses and missed out on positive equity returns.

These two episodes  provide important lessons about having a well-thought-out plan that already incorporates the risks of such inevitable negative events, so you don’t have to consider taking actions that can turn out to be expensive. Unfortunately, most investors have selective memories when it comes to the actions they contemplated based on their fears and tend to forget the losing trades and remember the ones that worked out well.

Having reviewed the historical evidence, we can now consider the risks to markets a prolonged default represents. We begin by noting that financial markets dislike uncertainty. When uncertainty increases, risk premiums demanded by investors increase, driving up the price of risk assets related to economic activity and driving credit risk down.

Economic Effects of a Default

The macroeconomic effects of a federal debt default are extremely uncertain, ranging from a temporary blip down in real activity if the default is short-lived to a major crisis that pushes the economy into recession—and potentially deflation if the crisis is prolonged.

For investors, uncertainty increases the potential dispersion of possible outcomes. And in the case of a U.S default, there are no precedents to rely on to help forecast what could happen. Although other countries have defaulted on their sovereign debt, those defaults occurred in situations when countries could not feasibly continue to service their debt. Failure to raise the U.S. federal debt ceiling would be a voluntary decision to stop meeting the government’s obligations. In addition, other nations that defaulted did not have  the world’s leading reserve currency. As such, it acts as the benchmark against which all risk assets are measured. With that in mind, we’ll consider some possible, if not likely, economic scenarios.

Economic Risks of Default  

Yields on Treasury securities could rise noticeably if the debt limit impasse dragged on for weeks. As one example, it could conceivably lead investors to demand a premium similar to that paid on AAA corporate bonds. As of this writing, the spread difference between long-term Treasuries and AAA corporate debt was about 55 basis points. On $31 trillion in debt, that’s an incremental interest cost of about $165 billion.

Not only could Treasury yields rise significantly, but because a prolonged standoff would increase economic uncertainty, private interest rates could rise sharply. Rising interest rates and rising risk premiums would in turn push stock prices down significantly.

In the case of a prolonged default, liquidity in financial markets could be severely impaired. It might increase the reluctance of investors to hold Treasury securities and dollar-denominated assets in general, leading to a higher risk premium on all U.S. assets and a decline in the dollar, with negative impacts on inflation.

Given a default and assuming the Treasury prioritizes its payments to cover all scheduled net interest payments, federal spending on such important programs as Social Security, Medicare/Medicaid, Veterans Benefits and other transfer programs would have to be temporarily reduced. While shortfalls in disbursements would probably be made up later, consumer spending would fall in the meantime. The multiplier effects could lead to a sharp fall in the economy.

FOMC Weighs In

During the debt crisis of 2013, the Federal Open Market Committee (FOMC) issued a report that showed the results of a simulation of its economic model in which the economy is hit with a variety of shocks to financial markets, income flows, government operations and household and business confidence. They assumed an impasse would be short-lived (about six weeks). Their main findings were that:

1. A one-month furlough of workers would result in a loss of real federal spending (and hence real GDP) that would not be made up. This effect would shave 0.75 percentage point from the annual rate of real GDP growth in that quarter but add the same to GDP growth in the following quarter;
2. Ten-year Treasury yields would rise about 80 basis points and BBB corporate bond yields would increase about 220 basis points;
3. Stock prices would fall by about 30%;
4. The dollar would drop by about 10%;
5. The deterioration in financial conditions would be accompanied by a tightening in credit availability as well as a reduction in household and business confidence;
6. Private spending would fall sharply, about one-third to one-half as large as the fall during the Great Recession (late 2008 and early 2009);
7. The economy would fall into a mild recession for two quarters, with the unemployment rate rising to almost 8%;
8. The slowdown in economic activity would allow inflation to fall; and
9. Monetary policy would remain accommodative.

The FOMC report noted that they expected the various shocks to fade away over the course of the following two years. Thus, they concluded there likely would be no permanent rise in term/risk premiums on Treasury debt, nor any sustained rise in the country risk premium applied to holding dollar-denominated assets.

Summarizing, the risks to the economy and financial markets of a prolonged default are almost unthinkable, especially given the simple solution. That is why we have never had a default. Unfortunately, given the current situation, with a narrowly divided Congress and a small number of Republicans (five) who have vowed to get concessions before agreeing to an increase in the debt ceiling, treating even the highly unlikely as impossible is a mistake that investors should not make. The question is: What if any actions should one consider taking given the risks?

As always, economic theory provides the way to think about the problem. First, diversification of risk is always the prudent strategy. With U.S. equities currently making up about 50% of the world’s market capitalization, investors should consider having 50% of their assets diversified into international equities, with about three-fourths of the remainder allocated to developed markets and one-fourth to emerging markets. And while one’s labor capital is not on any financial balance sheet, it is an important asset for those employed (and the younger one is, the more important that labor capital is as a percent of all assets). Thus, younger U.S. workers might consider an even somewhat higher allocation to international assets. Offsetting the diversification benefits, investing in the U.S. is typically a bit cheaper to implement and is also more tax efficient in tax-advantaged accounts. Those facts argue for a slight tilt toward U.S. assets. At any rate, investors concerned about the risk of default can increase their allocation to international assets.

While we don’t recommend engaging in market timing based on valuations, they are the best predictor we have of future real expected returns, with the E/P ratio (the inverse of the P/E ratio) providing important information. U.S. stocks dramatically outperforming international stocks over the past decade has resulted in U.S. valuations being dramatically higher—future expected returns are now much lower than for those of international stocks. For example, Morningstar shows that Vanguard’s Total U.S. Stock Market Index Fund (VTSMX) has a P/E of 16.4 (E/P of 6.1%). In contrast, its Developed Markets Index Fund (VTMGX) has a P/E of just 11.6 (E/P of 8.6%), and its Emerging Markets Index Fund (VEIEX) has a P/E of just 11.2 (E/P of 8.9%). Thus, the real expected returns to VTMGX and VEIEX are currently 2.5% and 2.8% higher, respectively, than for VTSMX. Investors concerned about the risks of a U.S. default can diversify that risk while potentially increasing their expected (not guaranteed) return.

Another approach is to diversify a portfolio by increasing exposure to risk assets that do not have exposure to U.S. economic cycle risks. Strategies investors can consider include reinsurance (funds such as Stone Ridge’s SHRIX and SRRIX and Pioneer Amundi’s XILSX). These funds can benefit from rising interest rates, as the collateral they hold is invested in short-term Treasuries and long-short multi-asset factor funds, such as AQR’s QSPRX and QRPRX. While useful in diversifying a portfolio, reinsurance and other alternative strategies involve a high level of risk, including liquidity risk.

Investors also can consider adding or increasing their exposure to trend-following strategies such as AQR’s AQMRX. My Wealth Management article on January 24, 2023 examined the empirical evidence on two tail-hedging strategies, buying puts and trend following, which found that, while puts are effective when the tail risks are very short-lived but disastrous when they are long-lived (e.g., during the GFC), trend following provides strong hedging benefits when the tail risk is long-lived, and diversification benefits over the long term.

One final point before closing: For the fixed income portion of your portfolio that is designed to be the anchor that keeps the ship safe in port during a storm, an intermediate maturity (typically four to five years) investment that balances the risks of inflation and reinvestment (such as government bonds, FDIC insured CDs, and AAA/AA municipal bonds) is the prudent strategy.

It’s critical that investors not make the mistake of “resulting”—judging the quality of a decision based on the outcome, rather than on the quality, of the process. Engaging in resulting can lead investors to abandon even well-thought-out plans. Robert Rubin, former co-chairman of Goldman Sachs, advised investors: “Any individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.”

Source: “The Potential Economic Consequences of a U.S. Default“

Apartment developers are getting creative in order to keep the construction pipeline flowing amid construction and capital challenges.

Four of the developers leading those efforts described their approach to continue building new housing in a session at the 2023 NMHC Apartment Strategies Conference in Las Vegas Tuesday. Each of the panelists has seen delays in their construction projects as the macroeconomic environment has shifted.

Jair Lynch Real Estate Partners had planned to have three market-rate projects start construction in 2023, but those projects are now delayed, said Ruth Hoang, the Washington, D.C.–based company’s senior vice president, development. “We’re still hoping one of them moves forward, but that’s 1,500 units and hopefully 600 move forward this year.”

Hoang said the developer is pivoting to ramp up its attainable housing strategy, investing $1.6 billion in acquisitions in that portfolio such as The Barcroft, a 1,300-unit affordable community in Arlington, Virginia. The strategy of pivoting to mixed-income or affordable housing development was echoed by the other panelists.

“We are going to focus on workforce housing,” said Kimberly Grimm, chief development officer for Menomonee Falls, Wisconsin–based Continental Properties. Grimm said that focus allows the company to go into more secondary or tertiary markets where the municipalities are “a little more reasonable” when it comes to scope, permitting and reducing fees.

“We are trying to build a pipeline to have a significant number of groundbreakings in 2024,” she said.

Teaming up with municipalities and other partners is one creative way to move projects forward. On The Barcroft project, Jair Lynch partnered with Arlington County and the Amazon Housing Equity Fund to secure $310 million in low-interest financing to win a competitive acquisition process and preserve the community’s affordable housing.

Is pricing relief here?

The potential upside of the shifting economic environment and declining starts is an easing of labor supply constraints, and the panelists predicted the trend will have an impact on construction costs as the year goes on.

“The most common question I get is when is construction pricing going to come under control to save my deal?” said Dan Hull, president of construction for Cleveland-based NRP Group. Looking back at the period from late 2020 to mid-2022, the industry saw permits skyrocket 50% while completions only slightly ticked up as demand outstripped the industry’s ability to build and complete projects. The COVID-19 supply chain shortages amplified the problem.

“As I look at the next 9 to 12 months, I look at our ability to complete to start ticking up and permits to come back down to parity, and when that happens I see our buying power increase with subs,” Hull said.

NRP has also had success in recent years by expanding direct purchasing to improve buying power. The developer executed a large lumber purchase for 13 properties, for example, as a way to squeeze out some additional savings.

Value by design

Value engineering is an inevitable step in making projects pencil out as capital costs rise, and the panelists said they’re looking for creative ways to reduce costs without negatively affecting the resident experience.

Rather than having those value-engineering conversations at the end of a project, where decisions will impact finishes that residents can see and touch, the process should start earlier during building design, said Chip Bay, chief construction officer for Boca Raton, Florida–based Mill Creek Residential. At the design stage, developers can look at making their floor plans more efficient and more easily repeatable for subcontractors.

That strategy is especially important for affordable housing. Whereas in market-rate housing the pressure is to go bigger and better, Hull said NRP Group is working with municipalities and housing authorities to reestablish a more reasonable scope of work that’s closer to projects the firm was completing four years ago.

On the labor front, the panelists predicted that capacity will start to trickle in this year from the single-family for-sale market as starts decrease. But the developers are also working hard to develop their own pipelines for talent.

Bay said Mill Creek is hitting colleges with construction programs and beefing up its internship program.

“We’re trying to get out there early, get ahead of it with the younger construction folks that want to get in our industry and that’s worked out very well for us,” he said.

Source: “How developers are keeping the construction pipeline flowing“