Archives for March 2024

After decades of growth bolstered by low interest rates and easy credit, commercial real estate has hit a wall.

Office and retail property valuations have been falling since the pandemic changed where people live and work, and how they shop. The Fed’s efforts to fight inflation by raising interest rates have also hurt the credit-dependent industry.

The effects have been felt around the world, with banks from the US to Japan, Switzerland and Germany forced to write off billions in bad debts. Shares of New York Community Bancorp — battered by real estate losses — are down 66% so far this year.

But some analysts are beginning to see light at the end of the tunnel.

Tracy Chen, a senior analyst at Brandywine Global, says that she’s starting to see some upside in commercial mortgage-backed securities (CMBS). Those are bonds backed by a pool of commercial real estate loans and secured by properties like office buildings, retail shops and apartments.

In fact CMBS with a BBB rating — as measured by indexes compiled by the Intercontinental Exchange and Bank of America — have done better than Treasuries, corporate bonds and other types of loans so far this year. Chen says that’s a good leading indicator for the rest of the commercial real estate market.

Before the Bell spoke with her about finding pockets of optimism in CRE.

This story has been edited for length and clarity.

Before the Bell: We often hear about how bad things are for the commercial real estate market and how it could really hurt the US economy. Is that doom and gloom overstated?

Tracy Chen: I definitely think so. The CRE market is very rate sensitive. If we are at the peak of interest rates, and if the Fed pivot (to cutting rates) happens, that will be tremendously beneficial for the CRE market. Even a marginal reduction of interest rates should be a tremendous help in lifting sentiment. I think that the gloomy sentiment around the CRE market is a little overdone.

It looks like the Fed may be holding interest rates steady for the time being. Does that present problems for CRE?

That could mean it takes longer for the CRE market to recover. It is extremely sensitive to interest rates. It’s so levered, and there is not enough transparency or transactions right now. So you definitely need some price adjustment (drops) going forward.

What’s the significance of commercial mortgage-backed securities outperforming Treasuries or corporate bonds? 

There are many factors that are set up for outperformance in the CMBS market. First of all, most of the bad news is already priced in. Banks aren’t totally marked down, but the CMBS market is more transparent. When people invest in the CMBS market, they have all kinds of assumptions. I think those assumptions are quite draconian right now. So the pessimistic market sentiment is reflected in the CMBS market more than in the banking sector or the private credit sector.

The CMBS market also has a smaller share in CRE lending, just a bit over 10%, whereas regional banks have the biggest share. So even though CMBS has a smaller share it’s the most transparent in terms of pricing in bad news. And right after the Fed paused interest rate hikes, it had a strong recovery and rally year-to-date.

I take that as a signal of a potential turn in the CMBS market in terms of the market sentiment. I would say this probably is a forerunner to the CRE market recovery.

But do you expect regional banks like New York Community Bank to continue to struggle?

New York Community Bank has an idiosyncratic problem. I don’t think that’s prevalent in the rest of the CRE market. They were very concentrated in New York City multi-family homes, which have rent control issues. I don’t think that’s representative of the CRE market.

In general, do you believe that these regional or smaller banks will continue to see CRE-related losses?

I believe some of the regional banks are very under-reserved in terms of potential losses, so they probably will have some pain going forward. But I don’t think they can trigger systemic risk. And it will take time to recover from the pain associated with the CRE market. It will take years for those loans to work out. It will be a very prolonged reckoning.

What should Before the Bell readers take away from this information?

It’s not just all gloom and doom in the CRE market. You see a silver lining in the CMBS market. And commercial real estate isn’t all about office space, there’s a broad spectrum of property types, and some are doing really well. Suburban offices are doing well, so are Class A buildings, which are in short supply. And buildings built after 2010 have been in demand. I don’t think people should paint a broad brush and stay away from anything related to the CRE market, you can definitely get good investment returns if you do your work.

So there’s room for some optimism? 

We have been seasoned CMBS investors for quite a long time, for more than a decade. We’ve been through the retail story where you had 5,000 to 6,000 store closures each year. But now look what’s happened, they’ve rationalized the supply and at the same time people are still going to stores. Any retail that survived Covid is good retail and so people are feeling confident about investing in retail property. Why shouldn’t the same thing happen to offices in the future? There is lots of hope for the future.

The US economy is so strong that there might not be any rate cuts in 2024

2024 was supposed to be the year consumers could start breathing again.

After more than 20 months of inflation and higher borrowing costs, investors, economists and — eventually — Federal Reserve officials said they expected the economy to soften this year, allowing the central bank to finally start cutting rates.

But those expectations of a Fed pivot keep getting pushed back. While the market initially expected six rate cuts this year, starting in March, that’s now off the table.

“I don’t think it’s likely that the committee will reach a level of confidence by the time of the March meeting to identify March as the time to do that,” Fed Chair Jerome Powell said of possible cuts at the Fed’s January meeting.

Now, some economists think the Fed won’t cut interest rates at all this year.

The economy is not slowing down and some underlying measures of inflation are growing, said Torsten Slok, chief economist at Apollo Global Management, in a note to investors Friday.

“The Fed will not cut rates this year and rates are going to stay higher for longer,” he added.

Richmond Federal Reserve President Tom Barkin echoed the idea that the central bank may not cut interest rates this year.

“We’ll see,” Barkin said in an interview with CNBC on Friday morning. “I’m still hopeful inflation is going to come down, and if inflation normalizes then it makes the case for why you want to normalize rates, but to me it starts with inflation.”

Source: “Why it’s not all doom and gloom for commercial real estate“

At MBA’s recent CREF conference, the prevalent outlook seemed to be optimism tempered with uncertainty. Many in the commercial real estate lending space believe that things will improve over 2024 to varying degrees depending on the market and sector. The anticipation of future rate reductions and increased transaction volume is somewhat tempered by concern about risks that are still very present in the market, including distressed assets, insurance rates, and construction challenges. Below is a recap of the discussions around these risks along with mitigation strategies for lenders.

Property Condition as a Marker of Distress

Property condition was a key discussion point in several CREF panels – Michelle Evans, EVP and Head of Multifamily for Fannie Mae, commented that it is one of the first indicators that something is wrong. The condition of a property often serves as a potent warning sign of borrower distress. Deferred maintenance, neglect, and even poor housekeeping can point to underlying financial or operational challenges. When such conditions are apparent, there may be more serious problems under the surface: poorly maintained building systems, compromised building envelope, or structural issues, or other deficiencies that require costly repairs or upgrades and may impact the property’s value and marketability. By monitoring property condition as an early indicator of distress, lenders can address potential problems proactively. A good first step is ordering a Property Condition Assessment (PCA).

Even if a PCA was performed upon loan origination, changing building conditions warrant an updated assessment. If a collateral asset is showing signs of distress, an equity-level PCA may be the best way to mitigate risk. While equity-level PCAs cost more than standard ASTM PCAs, the additional depth and scrutiny provided by equity-level assessment is worth the investment, particularly if foreclosure is a possibility.

At MBA CREF, Kevin Palmer, Senior Vice President and Head of Multifamily for Freddie Mac, pointed out that property condition issues are a major focus for 2024. According to Palmer, Freddie Mac received a great deal of feedback in 2023 on how to address property condition issues. This has led to some adjustments of policies. “In general, it’s kind of heightened due diligence and surveillance,” Palmer said. “Key there is if issues are identified—if life safety issues are identified—that we’re notified immediately, that we’re working collectively to be able to address these issues very, very timely.”

Insurability Through Property Resilience

The landscape of the property insurance industry is shifting dramatically. Over recent years, frequent catastrophic natural disasters have led to skyrocketing insurance premiums and/or loss of coverage. As lenders continue to grapple with the impact of insurance rates and insurability, they are beginning to consider property resilience assessments and improvements as a way to get deals done. Resilience assessments consider regional, historic climate data and building-specific characteristics to evaluate the building’s exposure to climate-related risk and identify measures to increase its ability to withstand severe weather events. When scoped to align with an insurer’s underwriting criteria, resilience assessments provide data that insurers require to assess risk. Borrowers can use this data to lower premiums, or in some cases, secure insurance for difficult-to-insure properties.

Construction Challenges Warrant Increased Contingencies

Construction projects are facing unprecedented challenges as material prices surge, labor costs rise, and supply chain disruptions persist. In response, many project owners are increasing contingencies to buffer against unforeseen expenses and mitigate potential financial setbacks. However, increased contingencies may not suffice to protect construction lenders in the event of project distress or failure. To effectively manage risks, construction lenders must adopt proactive measures.

Good construction risk management (CRM) is comprehensive and programmatic, designed to minimize the risk of construction financing throughout the lifecycle of the project.

Pre-Construction: Inadequate plans, overly optimistic schedules and budgets, under-qualified contractors, and even an incomplete understanding of the end product can significantly impact the probability of success. Pre-construction risk management measures include Document & Cost Review (DCR), Contractor Evaluation (CE), and Project & Budget Review (PBR). Construction Phase: Construction Progress Monitoring (CPM) provides regular reporting to the lender regarding the progress of construction. Funds Control / Funds Disbursement (FC/FD) encompasses all of the activities necessary to manage the pay application and disbursement process to ensure quality accounting and valid, appropriate draw requests. Construction Completion Commitment: Owner’s Representative (OR) Services: typically engaged by project owners, Owner’s Representative services are an option for lenders on distressed projects as an alternative to foreclosure. An OR can determine the cause of project distress, restore communication between owner, contractor, and lender, troubleshoot issues and act on behalf of the owner (or lender) to see the project through to completion.

While the above are traditional, solid approaches to construction risk management, 2023 saw an increase in lenders using Project Completion Insurance, a policy that benefits the lender in the event of default. Easier and less costly than a bond, Project Completion Insurance allows lenders to finance projects for borrowers who require credit enhancement but do not qualify for bonds. Policies are issued in conjunction with traditional CRM services which reduce the likelihood of default.

Despite the shifts and adjustments in the CRE finance markets, the conversations and presentations from MBA CREF Conference were marked with a sense of anticipation for a positive trajectory for the year. While challenges persist, savvy lenders can use strategic risk management practices to continue transacting regardless of headwinds.

Source: “Property Risks to Watch in 2024“

It’s not quite “Don’t Worry, Be Happy,” but a new note from CBRE emphasizes that multifamily problems will eventually end. “Markets are never static and strong rent increases are likely to resume in traditionally higher growth cities as excess supply is absorbed,” they wrote.

Negative results in commercial real estate are nothing new. As with any market, it happens periodically and then improves. As pre-Socratic and misanthropic philosopher Heraclitus wrote, change is the only constant in life. When things are good, the saying rankles, but when they’re bad, it is a comfort.

The worry of multifamily negatives has been on the increase. In the minutes of the January Federal Open Markets Committee meeting, the Federal Reserve paired only this category with office as major causes of concern among bankers. Freddie Mac has seen a relative sharp escalation in serious multifamily delinquencies, although an at least decade-long high is still only 0.44%.

New York Community Bancorp, which set off concerns with recent losses, reported even higher-than-expected future losses on its commercial real estate loans last week.

JPMorgan Chase recently took a “deep dive” into its $120 billion multifamily loan portfolio and said that it didn’t have “any particularly large concerns about the multifamily portfolio,” which is different from saying no concerns. That concerns have been high, especially as the internal operations of banks can be opaque to many is probably why JPMorgan Chief Financial Officer Jeremy Barnum noted that even with multifamily representing $120 billion of JPMorgan’s $200 billion in commercial real estate loans, things were different from stressed apartments. “We underwrite to current rents, not future rents,” he said. “We don’t underwrite based on the hope or the expectation of market-rate conversions on the rent-controlled space.”

“The bounce back will likely be sharpest in Phoenix, Charlotte and Nashville,” CBRE wrote.

“Interestingly, higher rent expectations, paired with increased going-in yields, will likely bolster investment performance in these markets. But a market like Austin, where supply grew 6% in 2023 – three times the national average – will take longer to recover. Meanwhile, Cleveland, Milwaukee and similarly situated markets will see slightly slower rent growth but will continue to benefit from stable fundamentals and higher-than-normal barriers to homeownership.”

Source: “Multifamily’s Bounce Back Will Be Sharpest in These Markets“

The COVID-19 pandemic has reshaped the commercial real estate market, creating a divide between winners and losers. A variety of factors that include retailers and brands over-expanding, changing consumer behavior and macroeconomic forces such as inflation have set the stage for these conditions to continue for some time.

Here, Dan O’Brien, executive vice president and partner at Hilco Real Estate, shares insights into the current state of the market while also exploring how the market has changed, which sectors are thriving, and what challenges remain for struggling businesses.

Dan O’Brien: Generally, I think the CRE market is being broken into the haves and have-nots amongst tenants and landlords, where there are some that are thriving and some that are struggling. For example, luxury retail is still doing well. Other approachable-luxury or mainline brands have found their path in different areas of retail. In contrast, many over-expanded pre- and post-COVID[-19] operators are struggling to meet obligations and keep pace in the ever-challenging brick-and-mortar world, namely in the restaurant sector or service industry (see health care). And then you always have certain retailers that simply succumb to the fads of time, as we are ever-increasingly fickle consumers.

Similarly, the industrial/data center/logistics world is a relatively hot marketplace. Still, some operators’ business models have proven untenable, and we’ve seen struggles and restructurings.

In the office sector, you have concept companies trying to stabilize a relatively new way of doing business in that traditional arena as we all collectively seek a balance in light of the more recent work-from-home trends. For office landlords, you have A/A+ assets that have been reinforced (and amplified) compared to non-A assets’ struggles. Similar with retail real estate landlords, certain asset classes, markets and properties are stronger now when compared to other non-performing competitors, and the difference between the viable real estate and the non-viable properties is becoming more apparent.