Commercial Real Estate – Office Rental Woes, Banking Exposure, Systemic Risk (?)
Lights up on my call with a banking insider:
My friend Dan has been an On My Radar reader for a number of years. He has extensive experience in the CRE world—including with all property types and in all market conditions—having worked on over 800 transactions with a total value exceeding $26.3 billion, spanning development, ownership, repositioning, restructuring, and lending. Commercial Observer recognized him as one of “The Most Important Figures of Commercial Real Estate Finance.”
Dan reached out to me after reading one of my recent newsletters. He believes that with the tumultuous state of the commercial real estate market, investors should seek protected risk-adjusted returns, which can be achieved by proper evaluation and structuring of investments at a lower basis in the Capital Stack.
Below are a few slides Dan gave me permission to share with you. I have included notes from our discussion. The first slide sets the stage. It’s information you know, but it’s always good to review:
The key is the last statement: “This environment encouraged borrowers to pay higher prices for assets, including real estate.”
Inflation followed: “The increase in rates has put incredible pressure on both borrowers and lenders.”
Perhaps the most telling slide in Dan’s presentation is this next slide.
Here are the basics:
- Deals were done where the asset buyer put up 35% of the equity, and the bank financed the remaining 65%. That’s 65% debt to 35% equity.
- At the time of the acquisition, the property generated $4.25 million (net operating income).
- But now, since financing costs have increased so much, the net operating income generated from property rents has decreased. In the case of commercial office space where we have high vacancies, it’s even worse.
- So, the value of the building is now worth less.
- The challenges come when the buyers need to refinance the loans.
- The bar on the right in the graph below assumes the cap rate increases to 6%, which reduces the value of the property from $100 million to $70.8 million.
- Under this scenario, the bank will resize the loan to $46 million, down from $65 million.
- As a result, the property owner will lose $29 million, so they need to find some rescue capital in order for a new loan to be written.
- This assumes the property owner is earning enough in rental income to cover expenses, including the higher interest costs.
- Without rescue capital, the owner turns the keys over to the bank.
- Thus, “jingle mail.”
The cost of borrowing has risen sharply. In the chart below, look at the change from pre-pandemic levels to current ones. Ouch!
Dan also sent me a report from Muddy Waters, a short-selling firm that looks for problems and takes short positions to profit in decline. Muddy Waters estimates that one popular REIT (real estate investment trust) fund needs a 180-bps decline in the Fed Funds rate. Otherwise, they’ll have to eliminate their entire dividend payout. I do not have authorization to share the research report.
See the debt maturity calendar below (squared in dotted red). The tipping point is when the loans mature and need to be refunded. I asked Dan about the 2023 debt; he said the 2023 loans have been pushed to 2024, which, surprisingly, the banking regulators are allowing for now. Pretend and extend, apparently. Everyone is hoping the Fed will cut rates by six times or more.
But there is a short timeline for the ability to avoid the issues; there’s $1.9 trillion due to be refinanced.
Many large owners have already started defaulting on their properties. And several more have happened since Dan created this slide.
For his own part, Dan previously owned 36 properties. He sold them all a few years ago and is waiting to reenter the market to buy at distressed prices. According to him, there’s no reason to go over the top and buy these assets right now because every banker he talks to says they “have no problems,” but the loans paint a different picture. He says he’s made offers, and they go to their board of directors or board and waive all the covenants. But you shouldn’t be able to do that if you’re an SEC-reporting bank and you’ve got to issue GAAP-compliant statements. This tells us that the Feds have softened their regulatory position (for now). If Dan were still Vice Chairman of a bank, they would have made him reappraise and take write-downs on every single asset.
I told Dan I’m concerned that the Fed will create a Bank Term Funding Program number two similar to the BTFP they created on March 12, 2023, in response to the banking crisis (SVB, Signature Bank, etc), except that this time, they’d allow banks to push off their bad commercial real estate loans at par. It pains me even to posit that.
Dan suggested that another possible solution, modeled after something utilized in Europe, that doesn’t involve another government bailout. Europe created a market for synthetic securitizations based on Basil III banking standards that allow you to make what is called a substitution. It involves getting a guarantee from another entity that can issue debt. Think of outside investors putting capital into various pools of different levels of risk-and-reward investment structures. This new capital shifts the risk, allowing the banks to free up capital in their books.
The challenge is that no banking regulator is currently willing to give Dan and his team an opinion on this. They will only give their opinion directly to a bank. I’m pulling for Dan.
Concluding thoughts:
Capital will freeze up in another banking crisis. I believe that the Fed is well aware of the problem, and they’ve certainly shown the will to backstop the system with creative new programs. Dan concluded that we were at the top of the first inning with the first batter at the plate—still early in what is likely to be a big problem unless the Fed takes the Fed Funds rate back down to 3% (my guess) or creates something similar to the Bassel III enabled synthetic market in Europe. However, I really have to learn more about that market. A better solution at face value than putting more junk assets, priced at par, but worth significantly less, onto the backs of the US taxpayers.
We’ll go more into the size of the problem next week.
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