Archives for March 2023

A firestorm among the banking sector, including the failures of Silicon Valley Bank and New York’s Signature and infusions of capital into First Republic Bank and Credit Suisse, has real estate investors scrambling to figure out what this all means for accessing debt.

“Our house view is that there is certainly a more constrained credit market, at least temporarily,” says Michael Riccio, senior managing director and co-head of national production at CBRE Capital Markets. “However, it is still fairly early, and every lender is trying to determine how they are going to react to this change in the market,” he says.

Some real estate pros credit the federal government for moving quickly to prevent a bigger systemic crisis and returning some sense of stability, albeit it precariously. A joint statement issued by the Treasury Department, Federal Reserve and FDIC said that it would fully protect depositors of both Silicon Valley Bank and Signature Bank. “Our view is that it may be contained because of what the Federal government has done. So, we’re thinking that there might not be widespread collateral damage,” adds Riccio.

Yet the turmoil is already reducing liquidity in the commercial real estate capital markets. Lenders are expected to err on the side of caution with more conservative underwriting. That pullback is already evident in the past week with spreads that have widened across most lender groups—CMBS, debt funds and banks. And CMBS issuance has ground to a halt due to the volatility in the market.

“After the closures of SVB and Signature Bank, it seems almost inevitable that CRE credit spreads will increase and lending liquidity will decrease over the short run,” says JP Verma, senior product director, banking solutions at Trepp. “However, there are still several questions that don’t have an easy or immediate answer, such as whether lending liquidity is drying up, how lending spreads are reacting, and how long this fallout will last.”

The sector may not have helped its own cause with reports that a run of New York City real estate investors pulling money out of Signature Bank contributed to its failure. The bank also had been one of the largest players in New York City lending with $35 billion in loans to the sector on its balance sheet. Meanwhile, according to CoStar, at least four REITs—Cousins Properties, Alexandria Real Estate Equities, Paramount Group and Hudson Pacific Properties—reported that they face risk because of dealings with Silicon Valley Bank or its parent, SVB Financial Group.

A silver lining to all the doom and gloom is that when risk increases, as it has in recent days, investors often flock to safe investments like Treasury bonds, which pushes down yields and increases their price, notes Verma. This in turn should result in lower losses on bond sales, which is a positive for commercial real estate borrowers, as this means that mortgage rates that had spiked in recent months could now decrease. The industry also is waiting to see how turmoil in the banking sector may influence Fed interest rate policy. The Fed is set to address another possible rate increase at its March 22 FOMC meeting. According to the CME FedWatch Tool, the current probability forecast puts a 25-basis-point increase at 64 percent odds.

Banks conserve capital

Banks are coming off a record year of commercial real estate loan originations in 2022. According to Trepp, banks originated $479.1 billion in loans—nearly 60 percent of the total origination volume among all sources. With the current issues on top of a high interest rate environment, banks are likely to pull back, assess portfolio risk and focus on protecting deposits.

“I think 2023 definitely will be a slower year for banks. Banks are very focused on funding at the moment. Deposit growth is not nearly as strong as it was in 2022. So, that in and of itself will cause banks to be a bit more cautious from a lending perspective,” says Johannes Moller, CFA, FRM, a director and ratings analyst in the financial institutions group at Fitch Ratings.

The capitol spigot is not turned off completely. Banks likely will reserve capital for customers that have existing relationships, especially their depositors, Moller adds. In addition, banks are apt to have different appetites for property types based on current portfolio concentrations, as well as supply and demand dynamics in the markets where they active.

Taking some of the recent bank turmoil out of the equation, the larger money center banks were already more constrained in real estate lending both late last year and the beginning of 2023. In comparison, regional and community banks remained very active. “We did an awful lot of our business with that group of banks last year,” notes Riccio. Anecdotally, Riccio is still hearing that some banks have strong balance sheets and good liquidity. While they may underwrite a little more conservatively because there may be more concern about a possible recession ahead, they are still in the market and have plenty of money to lend, he says.

Strong commercial real estate fundamentals may help counter some of the current turmoil. From a high level, asset and credit quality metrics for commercial real estate are strong for banks, notes Moller. According to the Mortgage Bankers Association, delinquencies on commercial and multifamily mortgages held by banks and thrifts was below 0.5 percent as of the fourth quarter of 2022. When taking a closer look at some of the leading indicators—such as criticized or classified loans—there has been a modest uptick in areas such as office, but levels even overall are still well below long-term averages. “Banks are not starting to wave red flags, but they are mentioning that there is some degree of concern around the ability of their borrowers, specifically these office properties, to be able to perform long term given the dynamic we’re seeing from work from home,” says Moller.

More conservative lending is not good news for borrowers with looming loan maturities. According to Trepp, there are more than $60 billion in fixed-rate loans that will soon require refinancing at higher interest rates. Additionally, there are more than $140 billion in floating-rate CMBS loans that will mature in the next two years, according to Goldman Sachs. “Floating-rate borrowers will have to reset interest rate hedges to extend their mortgage at a higher cost and these hedges have become very expensive,” says Verma. Delinquencies also are expected to rise, especially for the floating-rate loan borrowers. Office properties in particular is expected to be hard hit due to falling values and softening demand related to hybrid and remote work.

Monitoring CRE lending risk

Banks are the largest holders of commercial real estate mortgages in the U.S., holding roughly 40 percent of total commercial and multifamily outstanding debt. Banks also have indirect real estate exposure through their lending to non-bank financial institutions. However, much of that risk is concentrated in smaller banks. The largest banks in the U.S. have very modest exposures to this asset class, at an average of about 5 percent of assets, according to Fitch. “Commercial real estate has always been more the domain of small banks, and it’s why small banks fail,” says Julie Solar, a group credit officer Fitch Ratings’ Credit Policy Group.

Within the Fitch-rated U.S. bank universe, the agency has four banks on Rating Outlook Negative (RON). In addition to Signature Bank, the other three banks are Dime Bank, New York Community Bank and M&T Bank Corp. M&T Bank is the only one with a RON due to real estate exposure. Relative to peers, M&T has high exposure to hospitality loans, which warrants keeping an eye on even though the hotel sector has been recovering since the pandemic, notes Moller.

Another factor that could weigh on bank liquidity is stress testing. Comprehensive Capital Analysis and Review stress testing is a set of forward-looking requirements used by the regulators to oversee banks’ capital adequacy, capital distribution and capital planning processes under various economic scenarios, including a severely adverse macroeconomic stress scenario provided by the regulators themselves. These tests tend to focus on capital adequacy rather than on liquidity and over the last several cycles, all the participants (mostly large banks) have been passing the stress tests, notes Verma. Results from the annual stress tests are typically released in June.

Banks will be applying fairly adverse hypothetical scenarios for their stress testing models, which include a 40 percent reduction in commercial real estate values and a projected loss rate of 9.8 percent. Even under these stress test scenarios, banks are still well capitalized, notes Solar. “Over the last handful of years, the stress tests continue to demonstrate the resiliency of the large U.S. banks that participate,” she says. Banks also have much greater liquidity as compared to levels heading into the Great Financial Crisis.

That said, asset quality is probably unsustainably low, adds Solar. Over the last three years, there have only been 85 basis points in cumulative losses related to commercial real estate loans. Those losses will inevitably increase given the higher interest rates, expectations for lower property values and slowing economy that will make it more difficult for borrowers. “Where you will see the most pain will be smaller banks that are going to be more concentrated,” she says.

Source: “Real Estate Investors Brace for a Liquidity Squeeze Amid Bank Sector Turmoil“

In 1997, Billy Beane, the former general manager of the Oakland A’s, applied Bill James’ sabermetric analytical concepts to the team’s scouting and player evaluation practices. This exercise, while not particularly complex, was innovative, and the outcome changed the game forever.

The need for this change was twofold. Prior to that time, baseball scouting used a criteria of player standards as old as the Major Leagues themselves, with very little variation from team to team. The criteria was heavily subjective, based on scouts’ visual cues such as body type, size, and “look”.

Additionally, there was an utter lack of curiosity around the best way to use the data and this riddled the evaluation with personal biases. Scouts recruited the same high school “phenom” who possessed “five tools”: strong hitting, hitting for power, running, fielding and throwing. For decades, baseball was built on a process passed down from the “good old boys” doctrine of baseball recruiting.

Today, there are still many industries that suffer from blinders put in place by convention. But a new generation of leaders in these established industries, like commercial real estate, are more comfortable abandoning “the way it has always been done” for a different perspective. Bill James, Billy Beane, and Michael Lewis’ bestselling book Moneyball renewed a curiosity with data that extends beyond the Major Leagues.

What does it mean to take the “Moneyball” approach?

Billy Beane’s “Moneyball” concept was extraordinary in its simple innovation. While working with the same data as his predecessors and his contemporaries, his approach to player evaluation through different metrics allowed Beane to value different player characteristics more highly than others. This allowed Oakland, a small market team with an even smaller budget, to allocate resources much more efficiently and productively than their competitors.

This “Moneyball” approach, which has been standardized in baseball for some time, has proliferated in other professional sports leagues, industries, and asset classes. In what we’ve aptly named the “Moneyball” era in commercial real estate, we believe broad digitization and structuring of building data, the adoption of AI/ML, and cloud-based data management will create the unencumbered way forward to better data, analytics, reporting and insights – resulting in better returns, lower costs to operate, and quicker high confidence decision-making.

Three benefits of adopting AI tech in CRE

While experience, market nuance, and industry knowledge will continue to be important, now is the time for commercial real estate professionals to adopt AI-based best practices and navigate the vertical market. Here are three benefits to adopting the “Moneyball” approach.

Increased availability & access to data

There’s a place and time for procedure, but with nearly 90% of organizations’ data classified as unstructured, according to Forbes, it seems many industries need to move away from conventional in-house data governance. As it applies to commercial real estate, today asset allocators and operators manually compile their own portfolio data or turn to expensive and commoditized “scraped” public market data to make critical decisions. This has led to years of siloed access to important assets as well as lopsided data sets with irrelevant and inaccurate information.

With a comprehensive digitized and structured data approach to portfolio management, commercial real estate professionals can easily abstract, share, and cross-reference trusted and sizable data sets. Professionals can then use that comprehensive data to impact the economic value of portfolio assets and make critical asset allocation and operating decisions.

Faster business intelligence

In addition to data access, AI commercial real estate tools can also help users reach insightful conclusions more quickly, leading to faster decision-making. Advanced analytical tools and techniques, such as machine learning and predictive modeling, expedite the process of gathering large amounts of data and effectively extracting valuable insights, and this can ultimately increase the speed of business-crucial decisions, giving firms that adopt this technology a competitive edge.

Competitive pressures

For an increasingly institutional-driven and highly competitive industry undergoing massive changes, the “status quo” means slow death with dramatically lower capital returns. Firms that embrace “Moneyball” concepts position themselves to generate above-market returns, leaving competitors who rely on siloed systems, “scraped” data, gut decisions, and slow, manual data synthesis.

This new “Moneyball” world leverages AI to centralize structured building data to speed up data-informed decision-making, lower costs by reducing manual service dependencies, allow critical systems to share data, and brings data transparency to an opaque operating environment.

Finding faster and better ways to manage asset data will only become more critical as commercial real estate continues to change. However, with the help of AI and a more holistic approach to data, the “Moneyball” method will give players of an ages’ old game an entirely new set of rules.

Source: “The Rise of the “Moneyball Era” of Commercial Real Estate“

The pandemic set off an unusual time in multifamily. The sector became part of the short game. Rents drove upward, responding to increased prices, and things moved very fast. But with the shifts of the market, it’s time for the long game — remembering, or learning, how to maintain the success of multifamily property management under the dual forces of slow rent growth and higher interest rates.

While rents were flat between January and February, that’s one small data point. The bigger issue is the year-over-year fall in many areas. “Asking rent growth remains positive year-over-year in almost every metro, but 23 of Matrix’s top 30 metros recorded negative growth over the last three months and 17 were negative in February,” as the latest edition of the Yardi Matrix National Multifamily Report noted. “Affordability, household growth and deliveries of new stock are key rent drivers.”

The flat move early in the year has been normal, at least in the six years before the pandemic leap in rents and values. Usually, the change between January and February is only $2. “The big question is whether demand and rents pick up as normal in the spring,” the report said. “Many of the high-flyers that recorded outsize increases over the last two years are now negative or barely positive year-over-year. Las Vegas (-1.6%) and Phoenix (-1.2%) saw negative rent growth over the past year, while Austin (2.0%), Atlanta (2.2%) and Sacramento (2.3%) are barely above water.”

At the same time, in the Midwest, Indianapolis saw a year-over-year jump of 9.0% and Kansas City, 7.9%. They haven’t increased multifamily inventory as many other areas have and still remain relatively affordable. There are also some standouts like New York (7.0%) and Chicago (6.3%) that are places “people want to live, if not work.”

Stronger rent performance also split by type of property. Those that were lifestyle frequently took a rent hit. But for rent by necessity (RBN), the metros with monthly gains outpaced those with declines, 19 to 7. In the 30 metros that Yardi featured, only six had a rent-to-income ratio below 30%, meaning that the other 24 were on the average rent burdened.

Where rents are high, renewal rates are low, like Los Angeles at 43.3%, San Francisco at 46.5%, or San Jose with 46.5%. Such dynamics raise the question of whether lowering rent could increase renewals and reduce the need for turnover, which comes with the costs of refreshing units and missing rent for at least some time.

One important point from Yardi is that owners, investors, and developers can no longer hope for lower interest rates as inflation holds in longer than the Federal Reserve has expected. “With rates up, transaction activity will remain low and capitalization rates may continue increasing, which equates to more downside for property values,” the report said.

Source: “Multifamily Plays the Rent Growth Waiting Game“