Speaker 1: Hello, and welcome to another episode of the Old Lots podcast.
Speaker 1: I'm Tracy Alloway and I'm Joe. Wi isn't all Joe?
Speaker 1: People have been asking for this episode for a long time. Yeah,
Speaker 1: there's a lot going on right now, definitely a lot
Speaker 1: of a lot of balls in the air. But there
Speaker 1: is a one topic that one particular topic that's been
Speaker 1: brewing for a while as a source of concern is
Speaker 1: what's going to happen with commercial real estate, particularly office buildings.
Speaker 1: That's right, So we recently had the collapse of Silicon
Speaker 1: Valley Bank and that set off, you know, a little
Speaker 1: bit of a banking crisis. But a lot of people
Speaker 1: are talking about the next shoe to drop really being
Speaker 1: on the property or the real estate side. And obviously
Speaker 1: there's been a lot of concern about what exactly is
Speaker 1: going on with office buildings. But you know, just interest
Speaker 1: rates going up in general tends to be bad for
Speaker 1: real estate as a broader category. So I think this
Speaker 1: is something that we really need to dig into. Yeah,
Speaker 1: I mean right, So obviously real estate, my understanding is
Speaker 1: that it's a highly leveraged industry in almost any factor,
Speaker 1: whether it's malls or office buildings, or apartments or single
Speaker 1: family homes. There's a lot of borrowing. Ergo, I think
Speaker 1: rates matter, and like every other industry, it's dealing with
Speaker 1: this reversal of a long downtrend. And then with office
Speaker 1: reads in particular, we all know that working from home
Speaker 1: is still a thing. Not everyone goes to the office
Speaker 1: every day like they were, and so companies are reducing footprints.
Speaker 1: And so if you are the owner of commercial property,
Speaker 1: you may be looking at a double whammy in which
Speaker 1: a your loan is set to reset or your commercial
Speaker 1: mortgage that you plan to roll over is set to reset,
Speaker 1: and at the same time, because of vacancies, your business
Speaker 1: is not as good as maybe it was in twenty nineteen.
Speaker 1: So potentially a major stress point emerging for a lot
Speaker 1: of players. And the other thing I would say is
Speaker 1: even without the pandemic, and even without the work from
Speaker 1: home trend, there was concern about excess in commercial real
Speaker 1: estate or CRI, you know, even prior to twenty twenty.
Speaker 1: I remember when I was at the Financial Times, I
Speaker 1: was writing a lot about the bond market and credit markets,
Speaker 1: and I used to write a lot of stories about
Speaker 1: you know, subpar underwriting in commercial mortgage backed securities and
Speaker 1: investors really reaching for yield in that sector. And there
Speaker 1: was one person I spoke to quite a lot when
Speaker 1: I was doing those stories, and so I am very
Speaker 1: pleased to say that we do have the perfect guest
Speaker 1: for this episode. We are going to be speaking to
Speaker 1: Rich Hill. I knew him when he was an analyst
Speaker 1: at Morgan Stanley, but he is now over at Cohen
Speaker 1: and Steers as head of real estate strategy and Research.
Speaker 1: So Rich, thank you so much for coming on. All thoughts. Yeah,
Speaker 1: thanks so much for having me. So maybe just to
Speaker 1: begin with you know, Joe kind of alluded to this
Speaker 1: in the intro, but commercial real estate it's not a monolith.
Speaker 1: There are a lot of different subsectors within that broad category,
Speaker 1: and there are a lot of different actors, so lenders, investors,
Speaker 1: things like that. Can you talk to us a little
Speaker 1: bit about the ecosystem What is the ecosystem of CRI
Speaker 1: actually look like? Yeah, it's it's a great question. And look,
Speaker 1: I actually don't disagree with anything you said and your
Speaker 1: remarks to start this, but maybe we start off by
Speaker 1: talking about the size of the commercial real estate market.
Speaker 1: We estimated it's around a twenty trillion dollar market. That's
Speaker 1: a pretty big market. And if you think about commercial
Speaker 1: real estate, everyone thinks about it a singular asset class,
Speaker 1: but it's really fifteen different property types under one umbrella.
Speaker 1: And in many cases those fifteen different property types are
Speaker 1: sometimes like my kidnergartner, they moved to one side of
Speaker 1: the room and then the other side of the room.
Speaker 1: The fundamentals don't necessarily all act the same. So you
Speaker 1: have office for the fun of it, or is there
Speaker 1: a reason why the fundamentals don't move in the same direction,
Speaker 1: why people move around so much? Yeah, well, you know
Speaker 1: what I would Just the point I'm trying to make
Speaker 1: here is that you know, you have office, you have retail,
Speaker 1: you have multifamily. What drives multifamily fundamentals might be much
Speaker 1: different than what drives retail fundamentals. And we haven't even
Speaker 1: really started talking about some of the subsectors like healthcare,
Speaker 1: for instance, or data centers or cell towers. There's a
Speaker 1: whole host of different property types that are out there
Speaker 1: that you know, Yes, commercial real estate is a singular
Speaker 1: asset class, but in many respects you as a as
Speaker 1: a strategist and a researcher, I'm covering fifteen different parts
Speaker 1: of the economy that all have a singular commercial real
Speaker 1: estate umbrella, but they have different fundamental drivers. Right, So
Speaker 1: this is really important. Some sort of midtown office space
Speaker 1: here in New York that maybe in twenty nineteen was
Speaker 1: leasing out to being leased out to like tech startups
Speaker 1: or something is going to be very different from a
Speaker 1: building that's sort of specialized in doctor clinics in which
Speaker 1: probably there is not much like work from home activity
Speaker 1: happening and there, and so they're just too Yes, they're
Speaker 1: both commercial real estate, but they might be very different
Speaker 1: fundamental for sure. And frankly, I'll take that one step further.
Speaker 1: You know that the office property in Tampa, Florida might
Speaker 1: be very different than the office property in New York City.
Speaker 1: Are they going to the office in Tampa, Florida, believe
Speaker 1: it or not, they are going to be dead? What
Speaker 1: are the numbers like? How like you know, I know
Speaker 1: there's like trackers of like different cities, and there's a
Speaker 1: lot of coverage in the media provis reasons because many
Speaker 1: of us are here in New York City. But how
Speaker 1: does New York City like, why don't you talk a
Speaker 1: little bit about what the numbers look like, yeah, if
Speaker 1: you're talking about New York City return to our office,
Speaker 1: we're still well below you know, call it fifty percent,
Speaker 1: you know utility rates, if you will people actually using office,
Speaker 1: call it in the thirty to fifty percent range. But
Speaker 1: if you go to the Sun Belt and there's a
Speaker 1: lot of reasons why this is the case, if you
Speaker 1: go to Sun Belt States, return to office and use
Speaker 1: of office space is a lot higher than that. It's
Speaker 1: not surprising to see at sixty seventy, maybe even a
Speaker 1: little bit higher than that. So there is a big
Speaker 1: difference between how people in maybe let's say New England
Speaker 1: States are using office versus let's just say Tampa, Florida, Austin,
Speaker 1: what have you. So, one of the things I wanted
Speaker 1: to ask you is, in addition to there being a
Speaker 1: lot of subsectors within the umbrella of commercial real estate,
Speaker 1: there are a lot of different ways that people actually
Speaker 1: measure what's going on in that market. So, you know,
Speaker 1: one CRI specific term that you hear a lot is
Speaker 1: cap rates. You obviously have property prices, and then you
Speaker 1: have valuations, and you also have what's going on with
Speaker 1: the mortgage reets. So publicly listed real estate investors, and
Speaker 1: you know, depending on which one of those you look
Speaker 1: at at the moment, you kind of get a really
Speaker 1: mixed picture of what's actually going on with crin. Can
Speaker 1: you explain that, like, why are these different things painting
Speaker 1: a different view of the market. Yeah, it's a it's
Speaker 1: a really great, great question, and I think it's something
Speaker 1: that's maybe sometimes misunderstood. If you were to go back
Speaker 1: to three Q twenty two, so not that long ago, Yeah,
Speaker 1: the riat market was down more than thirty percent year
Speaker 1: to date, but believe it or not, private valuations or
Speaker 1: still up more than ten percent on a year to
Speaker 1: date basis huge divide forty percent divide between what the
Speaker 1: list of market was telling you, what the private market
Speaker 1: was telling you. What happens is the list of market.
Speaker 1: So that's publicly. Trade at rates are always a leading
Speaker 1: indicator for the private market. They go down before the
Speaker 1: private market and they go up before the private market.
Speaker 1: Why is that the case, Well, list it rates, you
Speaker 1: get a mark on them every single day people buy
Speaker 1: and sell stocks. On the other hand, valuing a property
Speaker 1: can be pretty hard. You have to go get an
Speaker 1: appraisal for that, and so there is an inherent lag
Speaker 1: on when private markets actually correct to list it markets
Speaker 1: do they allow hand in hand? Not always. If you
Speaker 1: go back to the late nineteen nineties, post the Russian
Speaker 1: debt crisis and everything that was going on with tech,
Speaker 1: roots were under pressure and the private market kept chugging along.
Speaker 1: I don't think that's going to happen this time around.
Speaker 1: Case in point in four Q twenty two, the nucrief
Speaker 1: Odyssey Index that's a widely followed index of open ended
Speaker 1: mutual funds. This index was down almost five percent in
Speaker 1: the quarter. That is the greatest decline since OZ nine,
Speaker 1: and it's the second greatest decline since nineteen seventy eight.
Speaker 1: So we're talking about almost a twenty percent decline on
Speaker 1: an annualized basis, not that much different than what roats
Speaker 1: were pricing in. Rots were up five percent during that
Speaker 1: quarter as well, So there is a little bit of
Speaker 1: a lead lag relationship that's going on here. We'll see
Speaker 1: what the year holds for us. For listed roots, they're
Speaker 1: about flat on the year after a really good start
Speaker 1: to the year. But I think I think private's going
Speaker 1: to be down, and I wouldn't be surprised to see
Speaker 1: it down ten to twenty. So as you point out,
Speaker 1: like even if my conception of what commercial real estate
Speaker 1: is as New York office buildings, we can't just like
Speaker 1: form a view of all real estate or commercial real
Speaker 1: estate based on that. That being said, like, how much
Speaker 1: of that do you say? Twenty trillion rough VideA is
Speaker 1: how much of that is sort of distressed right now
Speaker 1: or in some sort of trouble and how much is
Speaker 1: sort of chugging along? Like we're of that twenty trillion,
Speaker 1: how much should we be concerned about? Yeah, so it's
Speaker 1: the right question to be asking. And there's a lot
Speaker 1: of different ways you can think about distress. The first
Speaker 1: way we think about distress is distress sales as a
Speaker 1: percent of overall transaction volumes. Before I go there, let
Speaker 1: me also just be clear. Transaction volumes are down pretty
Speaker 1: significantly on a year of year basis, almost seventy percent down.
Speaker 1: I can talk about why that's happening. But distress is
Speaker 1: sort of like someone having to sell a property when
Speaker 1: they don't want to. It's a foreclosure. For instance, Distress
Speaker 1: sales are very very low right now. I don't think
Speaker 1: they're going to stay low. I think they're going to increase.
Speaker 1: But the reason distress sales are really low right now
Speaker 1: is banks haven't started foreclosing on their loans and the
Speaker 1: bid ask spread between buyers and sellers is pretty wide.
Speaker 1: So distress sales are low. We can talk about delink, CMBs, delinquencies,
Speaker 1: bank delinquencies, whatever you want to, but the stress sales,
Speaker 1: which is the first thing I look at, is low.
Speaker 1: It's showing signs of ticking up. I think it's going
Speaker 1: to rise. So just going back to the private valuations
Speaker 1: for a second. You know, this is something I've been
Speaker 1: thinking about and writing about and a lot of other
Speaker 1: people have as well. But how long can private valuations
Speaker 1: kind of resist the gravity of lower prices and maybe
Speaker 1: deteriorating fundamentals, like what is the catalyst or what is
Speaker 1: the process for someone to actually take a hit on
Speaker 1: that property, Because clearly, you know, if you're a big investor,
Speaker 1: you are going to want to resist crystallizing those losses
Speaker 1: for as long as possible, it would seem. Yeah, to
Speaker 1: answer your question upfront, it can take. It can historically
Speaker 1: take twelve to twenty four months for property for private
Speaker 1: property valuations to correct to what the list of markets
Speaker 1: pricing in. Why is that the case? Well, let's talk
Speaker 1: through how private valuations actually correct. The first thing that
Speaker 1: happens is transaction volumes bottom out. You have to see
Speaker 1: transaction volumes decline precipitously before property valuations begin declining. Why
Speaker 1: is that the case. Well, at the early start of
Speaker 1: a correction, sellers don't want to sell at the level
Speaker 1: buyers want to buy. There's just a huge bid ask
Speaker 1: spread between the two. It's sort of like the grieving process.
Speaker 1: I'm not trying to be too flippant about it, but
Speaker 1: there is a grieving process. It's denial. There's anger than
Speaker 1: its acceptance. So we think we're actually starting to get
Speaker 1: to this place with transaction volumes down seventy percent year
Speaker 1: of ear. That starts to feel okay to me. But
Speaker 1: I think this time is going to be different. I
Speaker 1: think the correction and private valuations is going to be
Speaker 1: much much quicker than seen previously for maybe one of
Speaker 1: the reasons that you talked about at the very beginning,
Speaker 1: which is the rise in financing costs. So I'm gonna
Speaker 1: get not try to not get too wonky here. No,
Speaker 1: please get get wonky as you like. Actually are as
Speaker 1: wonky as you. I'll stop you if you if we
Speaker 1: need something clarified, but always yes, all right. So here's
Speaker 1: a great stat for you. Since nineteen eighty prior to
Speaker 1: twenty twenty two. That is, there has been less than
Speaker 1: five years five months since nineteen eighty. That's a lot
Speaker 1: of months where the treasure ten year treasury was not
Speaker 1: lower a decade forward. Something Unpack that and explain to
Speaker 1: you what that means. That means in January nineteen ninety
Speaker 1: the ten year treasury rate was lower than where it
Speaker 1: was in January nineteen eighty, and January two thousand it
Speaker 1: was lower than where it was in January nineteen ninety.
Speaker 1: There has been a secular decline in ten year treasure rates.
Speaker 1: Why does that matter? Well, it matters because, as you
Speaker 1: correctly said, commercial real estates inherently elaborate asset class. There's
Speaker 1: very few owners of commercial real estate that buy a
Speaker 1: property without some amount of debt on it. So, as
Speaker 1: you've been in a secular decline in ten treasury rates,
Speaker 1: and typically commercial real estates finance with tin year debt,
Speaker 1: you have always been able to refinance into lower and
Speaker 1: lower financing costs over time. So this is the idea
Speaker 1: that usually cap rates decline into a rising interest rate environment.
Speaker 1: I sort of say, that's not the right thing to
Speaker 1: be thinking about cap rates decline into a rising instrate environment,
Speaker 1: because historically that rising interest rate environment is symptomatic of
Speaker 1: an improving economy, right at a time that your financing
Speaker 1: costs are actually rolling down, So of course your level
Speaker 1: re turns expand, which allows cap rates to contract. This
Speaker 1: time is much different because financing costs are significantly higher,
Speaker 1: not just because of the risk free rate and widening
Speaker 1: credit spreads, but also because guess what, growth is slowing.
Speaker 1: We were in a stag stag stagflationary environment in twenty
Speaker 1: twenty two that doesn't really exist since like nineteen seventy.
Speaker 1: It's a much different ball game than what we played before.
Speaker 1: So just to do a little Devil's advocate question here,
Speaker 1: but what does the maturity wall actually look like? And
Speaker 1: even though you know, I take the point that financing
Speaker 1: costs are going up, but as long as the market
Speaker 1: remains open, you can still roll over your loan, presumably
Speaker 1: to infinity. And I can't remember the exact saying, but
Speaker 1: you know, there's that old joke about a rolling loan
Speaker 1: gathers no distress or whatever it is. Can people just
Speaker 1: keep rolling these over in theory? Sure, but so let
Speaker 1: me maybe answer your question first. So there's about four
Speaker 1: and a half trillion dollars of mortgage debt outstanding. That
Speaker 1: tells you, on average, the LTV is around twenty five
Speaker 1: percent for commercial real estate. That might sound lower than
Speaker 1: what people think, but reat LTVs or less than thirty percent.
Speaker 1: Then a crief Odyse index which I mentioned previously, which
Speaker 1: is high quality core and core plus properties, that's around
Speaker 1: twenty two percent. So yes, smaller borrowers that don't have enough,
Speaker 1: don't have a lot of capital, will push the LTVs
Speaker 1: up to fifty to sixty percent, which you typically see
Speaker 1: in a CMBs transaction. But debt's around call it twenty
Speaker 1: five percent of that twenty threeion dollars market. What is
Speaker 1: actually maturing well on average, it's about you know, call
Speaker 1: it five hundred billion dollars over the next five years.
Speaker 1: Each year, so you're talking about call it fifteen to
Speaker 1: twenty percent of maturing debt coming due each year over
Speaker 1: the next five years. You're what you should hold up
Speaker 1: five hundred billion per year, five hundred billion per year
Speaker 1: and over the next five years, over the next five years,
Speaker 1: so two and a half threeion dollars over five that
Speaker 1: makes sense. Yeah, cool. So you're talking about, you know,
Speaker 1: call it fifteen twenty percent of debt coming due on
Speaker 1: a pran on basis over the next five years or so.
Speaker 1: And most of the debt that's coming due in two
Speaker 1: thousand and twenty three were either loans that were originated
Speaker 1: in two thousan thirteen or in two thousand eighteen. Now,
Speaker 1: one of the interesting things about this maturity wall that
Speaker 1: I don't think a lot of people are really considering
Speaker 1: is how much property prices generically have risen since two
Speaker 1: thousand and thirteen. Property prices are up a lot. That
Speaker 1: doesn't mean they're up for office, that doesn't mean they're
Speaker 1: up for malls, and we can talk through that, but
Speaker 1: generically they're up a fair amount. So if you happen
Speaker 1: to have originated a loan in twenty twenty two when
Speaker 1: you bought a property, your effective LTV is actually a
Speaker 1: lot lower than fifty to sixty percent right now given
Speaker 1: that property and price appreciation, and even if valuations fall
Speaker 1: ten twenty thirty percent next year, there's a good chance
Speaker 1: these loans are not in the water yet again or
Speaker 1: not underwater. Should I say this is not the case
Speaker 1: for office. I don't want to give you that impression
Speaker 1: that you know, you're talking about effective LTVs that are
Speaker 1: you know, probably going to be a little bit higher
Speaker 1: than that, And it's certainly not the case from malls.
Speaker 1: Malls effective LTVs we think are you know, around ninety
Speaker 1: ninety five percent right now, that's probably a pretty good
Speaker 1: case study, we think for where the office market's going.
Speaker 1: But office, and since this was a focus of this office,
Speaker 1: is only about twenty five percent of that fifteen to
Speaker 1: twenty percent that's coming due? Okay? And who's holding that?
Speaker 1: And like yeah, so who's who's expose to that? So
Speaker 1: it's like, okay, Office, maybe if there's maybe one hundred
Speaker 1: and twenty five one hundred billion coming due over the
Speaker 1: next each year for the next five years, that sound right? Yeah, yeah, yeah,
Speaker 1: that sounds about right. So who is who who holds that?
Speaker 1: Is that it banks? Is it a private funds? Like
Speaker 1: what's the distribution? Yeah? So Tracy mentioned that we we
Speaker 1: talked a lot when we were at when she was
Speaker 1: at the Financial Times, and everyone likes to talk about
Speaker 1: the commercial mortgage backed security market because it's easy to
Speaker 1: look at you get spreads. You know, you understand linquencies.
Speaker 1: You have a lot of really good reporting. The CMBs
Speaker 1: market is at best twenty percent of the lending market.
Speaker 1: It's actually not that big a part of the lending market.
Speaker 1: Not to bury the lead and get where you're going.
Speaker 1: The majority of the debt coming due is held on
Speaker 1: bank balance sheets. Okay, we think you know, call it
Speaker 1: fifty percent. More than fifty percent of the debt coming
Speaker 1: due in two thousand and twenty three is held to
Speaker 1: bank balance sheets. Okay, And that does make some logical
Speaker 1: sense because twenty thirteen, these are ten year loans. In
Speaker 1: the most part, there wasn't a lot of capital markets
Speaker 1: activity in twenty just out of the Great Financial Crisis,
Speaker 1: So if a bank originated a CMBs loan, there's a
Speaker 1: good chance it's still under books. There's a very good
Speaker 1: chance it's still on the books. So most of this
Speaker 1: is held on bank ballot sheets. What sort of comes
Speaker 1: back to your question at the very beginning, like, how
Speaker 1: are we thinking about this risk that has been out
Speaker 1: there but has come a little bit more to the
Speaker 1: forefront over the past couple of days, given some of
Speaker 1: the news with bank collapses can you maybe talk a
Speaker 1: little bit more about underwriting standards throughout the years, because
Speaker 1: this is something that was a big talking point pre pandemic.
Speaker 1: You know, CRI slash CMBs. It was a really hot market.
Speaker 1: You saw a lot of people pouring money into it,
Speaker 1: and so as sometimes happens, you saw some of the
Speaker 1: underwriting standards start to slip. Can you maybe like tell
Speaker 1: us what you saw and give us some examples of
Speaker 1: the kind of deals that you saw coming through that
Speaker 1: could in theory be problematic. Now, there's two ways people
Speaker 1: think about underwriting standards. The first one is sort of
Speaker 1: headline underwriting metrics, things like loan to value, and the
Speaker 1: second thing is all the other things that lenders might
Speaker 1: require or not require to provide a loan to a borrower.
Speaker 1: So let's talk about LTV first and Foremost LTVs are
Speaker 1: actually fairly conservative right now, and certainly we're conservative. Heading
Speaker 1: into the pandemic, they were approaching call it fifty percent LTVs,
Speaker 1: and that's sort of where they stand right now. I
Speaker 1: think that might surprise a lot of people that lending
Speaker 1: standards were actually tightening from a headline perspective. But let
Speaker 1: me explain to you why that's the case in two thousand.
Speaker 1: You know, if you would ask me where the upper
Speaker 1: center of froth was real technical term for lending standards
Speaker 1: post GFC, I would have told you it was around
Speaker 1: twenty fourteen. Two fifteen, things were feeling really good. The
Speaker 1: banks were giving out a lot of money, so much
Speaker 1: so that the regulators and a joint statement came out
Speaker 1: and told lenders, hey, guys, you basically have to slow
Speaker 1: this down, and if you don't slow it down, we
Speaker 1: might have some regulations. And here's that slapping of the rist,
Speaker 1: if you will. Actually sort of worked and banks did
Speaker 1: start to bring in lending standards. It also occurred at
Speaker 1: the same time that risk retention under Dodd Frank was mandated.
Speaker 1: So what's risk retention underd Frank? That basically said CMBs
Speaker 1: issuers had to have skin in the game and they
Speaker 1: or a third party had to retain five percent of
Speaker 1: the entire deal for at least five years. And so
Speaker 1: when you actually have to eat your own cooking, that
Speaker 1: changes things a little bit. So headline LTVs went down,
Speaker 1: headlined dscrs went up. These are all good things, but
Speaker 1: maybe where the devil devils in the details, and you
Speaker 1: were starting to see a lot more io loans, So
Speaker 1: interest only loans. These are loans that don't you know,
Speaker 1: pay down over term and have a blue maturity payment.
Speaker 1: There was you know, certainly reserves for any number of
Speaker 1: different things. This is cash that's put on the sidelines,
Speaker 1: so that those a lot more prevalent pre financial crisis
Speaker 1: interest only loans, Like I feel like you heard about
Speaker 1: commercial mortgages that idea, Yeah, I'm gonna be a little
Speaker 1: bit flipping here, but but anything sort of went prior
Speaker 1: prior to the GFC. But look, ile loans are are
Speaker 1: pretty prevalent over the past couple of years. You know,
Speaker 1: all those all the additional money on the sidelines reserves,
Speaker 1: if you will, those were sort of you know, not
Speaker 1: to say they were waived, but but there was less requirements.
Speaker 1: So while while I think the hard LTVs and dscrs
Speaker 1: were pretty good, maybe the soft underwriting requirements were or
Speaker 1: softer than they had been in the past. So a
Speaker 1: little bit of give and take care, I would say,
Speaker 1: you know, if anything, it's really a question about where
Speaker 1: do you think the debt service coverage ratios are going.
Speaker 1: So coming out of the GFC, there was this concept
Speaker 1: of debt yield that came about. That's how banks underwrite loans.
Speaker 1: Debt yield is effectively inoy divided by your loan balance.
Speaker 1: Prior to the GFC, and certainly the early two thousands
Speaker 1: loans were underwritten on debt service cover ratio. But after
Speaker 1: the GFC, no one was concerned about falling interest rates.
Speaker 1: They were only concerned about falling NI. So you underwrote
Speaker 1: to debt yield. There's a really good scenario that some
Speaker 1: loans with really strong debt yields, because NI is pretty
Speaker 1: good right now, might have pretty poor dscrs in the future,
Speaker 1: given how much interest rates have risen. So I think,
Speaker 1: maybe Tracy, to answer your question about like, what's the
Speaker 1: what's the biggest risk here, I think it's a debt
Speaker 1: service coverag ray shows NI debt yields could still be
Speaker 1: above ten percent twelve percent because NI is pretty strong
Speaker 1: right now. Fundamentals feel pretty good. But if you have
Speaker 1: a big shock to financing costs, your debt service coveragray
Speaker 1: show could be a lot lower than two and a
Speaker 1: half times, which is going to require recapitalization. Let's set
Speaker 1: aside office for a second. Let's set aside some of
Speaker 1: the troubled cities. Are there any old pockets that are
Speaker 1: weak because again, we hear about certain categories of weakness
Speaker 1: that are obvious that we've talked about them office building
Speaker 1: in New York. How are some of these other categories
Speaker 1: I think you said they are like fifteen in total
Speaker 1: or something like that. Are most of the other ones
Speaker 1: still looking pretty good or are their weaknesses elsewhere? I mean,
Speaker 1: you're talking about a reap market that was down twenty
Speaker 1: five percent in two thousand and twenty two, and if
Speaker 1: you believe our views that this leading indicator, you know,
Speaker 1: all the proper types experienced, you know, some level of
Speaker 1: of of weakness to various different degrees. But a lot
Speaker 1: of that presumably was like multiply multiples. Right, but but
Speaker 1: but yes, but multiple is just a fancy way of
Speaker 1: saying valuation terms. You take one, you know, if you
Speaker 1: take the inverse of the multiple, that's capriate. But right, So,
Speaker 1: what I'm saying, are there any other that are sort
Speaker 1: of like clearly seeing poor revenues or poor rental in
Speaker 1: the way an office landlord? Yeah, An, the answer is
Speaker 1: not not really okay, because if you think about NY
Speaker 1: growth overall in twenty twenty two, you at one point
Speaker 1: where plus ten percent plus eleven percent in a Y
Speaker 1: growth on a year of year basis, that's close to
Speaker 1: a historical high. We are obviously seeing deceleration right now.
Speaker 1: We're probably around seven percent right now, and we're underwriting
Speaker 1: even slower in a Y growth in twenty twenty three,
Speaker 1: given recessionary headwinds that we think are real. But a
Speaker 1: lot of what's happening here is actually the refinancing risk,
Speaker 1: and it's because valuations are lower because financing costs are higher.
Speaker 1: I don't want to make two light of this, but
Speaker 1: Office in many many respects is the exception to the
Speaker 1: fundamental story. YEA, many of the other asset classes are
Speaker 1: having quite fine in a Y growth. But I don't
Speaker 1: want to be two probably dogs and rainbows over about
Speaker 1: this because I truly believe that idiosyncratic risks are real.
Speaker 1: You're going to have some multi family properties that were
Speaker 1: purchased that really tight cap rates in advance of improving
Speaker 1: and are accelerating revenue growth, and that business plan is
Speaker 1: not going to come to fruition. So there is there
Speaker 1: is some real risks here beyond just financing that that
Speaker 1: is going to pressure valuations lower across property types. It's
Speaker 1: going to lead to higher distress, lead to higher delinquencies.
Speaker 1: Office is the poster child for this. But I don't
Speaker 1: want to give you the idea that commercial real estate
Speaker 1: fundamentals are uniquely as bad as office because they're not.
Speaker 1: We sort of think office is the exception, not the norm.
Speaker 1: So you mentioned refinancing risk there, and that's exactly what
Speaker 1: I wanted to talk to you about next. And I'm
Speaker 1: trying to avoid um sounding like a Judy Bloom novel
Speaker 1: here or something. But where does refinancing come from? And like,
Speaker 1: is the assumption that I mean, I assume a lot
Speaker 1: of it is from banks. Is the assumption that banks
Speaker 1: are just going to pull back on it in the
Speaker 1: current environment. Yeah, So where does refinancing come from? First
Speaker 1: of all, it's banks, it's insurance companies, it's the CMBs market,
Speaker 1: it's debt funds and mortgage rate it's the GSS in
Speaker 1: the case of multi family and student housing and seniors housing.
Speaker 1: So there is a wide variety of financing sources out there.
Speaker 1: Banks are a big portion of that. Insurance companies are
Speaker 1: are a big portion of that. CMBs is a smaller
Speaker 1: portion of that. But but there's a roide variety of
Speaker 1: of of financing sources. So in terms of refinancing, look,
Speaker 1: I think a lot of people are focusing on the
Speaker 1: cost of financing side because that's real. You can see
Speaker 1: it every day by looking at just where the risk
Speaker 1: free rate has gone. You know it's at call three
Speaker 1: and a half three point six percent today. You know
Speaker 1: it was two hundred basis points lower a year ago.
Speaker 1: That's a big deal. And when you think about where
Speaker 1: credit spreads are going, those are wider as well. Tracy,
Speaker 1: just maybe just give you some live updates on on
Speaker 1: where these things are. The triple A CMBs market is
Speaker 1: pricing about one hundred and thirty basis points over the
Speaker 1: ten year treasury, and the triple B minus market is
Speaker 1: north of nine hundred at this point. So these are
Speaker 1: these are those are much wider spreads. The good news is,
Speaker 1: you know, the CMBs market, the debt markets are actually
Speaker 1: pricing in all these things that we've been talking about. Yeah,
Speaker 1: it's not like the CMBs market is you know, naive
Speaker 1: about this nine hundred over the ten year treasury when
Speaker 1: the ten ye treasures at three fifty you're talking about
Speaker 1: it almost a twelve and a half thirteen percent yield.
Speaker 1: That's a that's a pretty attractive yield given you know
Speaker 1: the risk of loss. So I do think there is
Speaker 1: is a lot in the price of where the spreads
Speaker 1: are right now. But look, availability of debt capital it's
Speaker 1: probably not going to be, you know, as as robust
Speaker 1: as it was last year or even twenty nineteen. So
Speaker 1: when you think about who's gonna be able to get
Speaker 1: debt capital, I think a well qualified a well qualified
Speaker 1: sponsor that's well capitalized with a good business plan, they
Speaker 1: can probably get debt right now, even on an office property,
Speaker 1: believe it or not. The problem with thought with office
Speaker 1: just to use maybe an example, is this binary you
Speaker 1: can get debt at attractive levels or you can't. It's
Speaker 1: it's it's not like an office. A lender is going
Speaker 1: to come back and say, hey, guess what, I don't
Speaker 1: feel really comfortable with you as a sponsor your business plan.
Speaker 1: I'll give that to you at a thirty or forty
Speaker 1: percent LTV instead of a fifty percent LTV. That's not
Speaker 1: the way it works. It's almost like bit out interesting, Wait,
Speaker 1: why is that is that just like a sort of
Speaker 1: like norms and cultural thing, or is it does not
Speaker 1: make business sense to try to deal with someone in
Speaker 1: those marginals. See all of the above. Okay, yeah, it's
Speaker 1: if you're going to if you're a lender and you
Speaker 1: have to go to your investment committee and you're saying, hey, look,
Speaker 1: I'm going to lend on this office property, you gotta
Speaker 1: pretty much make sure your eyes are dotted and your
Speaker 1: teas are crossed. Now. Now, the other reality is lenders
Speaker 1: are really focused on one thing and one thing only
Speaker 1: getting their money back, right. And you know, if you
Speaker 1: don't get your money back, you take a loss. It
Speaker 1: doesn't matter what that spread was, you're not gonna get
Speaker 1: paid enough. So just on office I know, we're sort
Speaker 1: of saying, there's a lot of other categories besides the one.
Speaker 1: The stairs us in the face every day of New
Speaker 1: York real estate. But New York office space, the publicly
Speaker 1: traded instruments that seem to track your office space. I
Speaker 1: mean they look like really dismal. I don't know, I'm
Speaker 1: not asking for your like views unnamed, but like, I know,
Speaker 1: you know, it's like sl Green is a company that
Speaker 1: you see, you owned a lot of buildings in New
Speaker 1: York and they're publicly traded, and that was an eighty
Speaker 1: dollars stock in March of twenty twenty two, and today
Speaker 1: it's a twenty eight dollars stock. Prior to COVID it
Speaker 1: was over one hundred dollar stock. Like, what is the
Speaker 1: market saying, look about this type of property that's getting
Speaker 1: so hard and for not them specifically, but for someone
Speaker 1: who owned property like them, what kind of situation are
Speaker 1: they facing next time they have to refinance a building
Speaker 1: or you know, remortgage your building or whatever. Yeah, well
Speaker 1: let me first you know, yeah, yeah, let first be
Speaker 1: clear that we're pretty cautious on office in our list
Speaker 1: of portfolio. Look, we have very little office exposure. Why
Speaker 1: is that the case? Well, maybe to answer your first question,
Speaker 1: the public markets are telling you that office valuations are
Speaker 1: going to be down substantially. Why is that the case, Well,
Speaker 1: it's the it's for three three reasons. First of all,
Speaker 1: you don't know where the NY growth is going. Okay,
Speaker 1: it's uncertain. Yeah, I just wanted to make sure. Sorry,
Speaker 1: sorry about that, which is basically revenue minus expenses for
Speaker 1: those playing at home. You don't know where your NEBT
Speaker 1: operating income is growing going. You don't know how much
Speaker 1: capex you have to spend to generate that NI, and
Speaker 1: you don't know what amount of debt you can get
Speaker 1: on it. So if you put NY and capex and
Speaker 1: financing into it, that's how you get your leveed IRR
Speaker 1: and cap rates just a product of that. The market
Speaker 1: is telling you that, the list at market is telling
Speaker 1: you that cap rates have to go substantially higher. I mean,
Speaker 1: maybe just to come back and and and and talk
Speaker 1: about this a little bit more. The listed market, on
Speaker 1: average across property types is trading at a high five
Speaker 1: percent implied cap rate right now. The private market, as
Speaker 1: measured by the Newcrief Odyssey Index is still at three nine.
Speaker 1: That's a crazy difference between public and private values. Yeah,
Speaker 1: the listed market is at a high five percent caprate. Okay,
Speaker 1: so last week it was like at five to seven.
Speaker 1: It's gonna be wider than that now. And it cap
Speaker 1: rates is like a inverse P, so that means that's
Speaker 1: that's in stocks, you would call it twenty P. You
Speaker 1: call it a five percent capri. So multiples right now
Speaker 1: for multiples after taking ato account, cap x in the
Speaker 1: reat space around eighteen and a half times, so you're
Speaker 1: pretty close. My only point to you is that there's
Speaker 1: a two hundred bases point difference between where reats are
Speaker 1: pricing cap rates and where the private markets pricing cap rates.
Speaker 1: We think, you know, before before we went on, you're
Speaker 1: asking me, hey, aren't you a little bit more constructive?
Speaker 1: And I was like, well, look, I am constructive on
Speaker 1: reets because I think the entry points are pretty attractive here.
Speaker 1: But the private market, you know, we still think valuations
Speaker 1: are going down. So if you're a legacy holder of
Speaker 1: private valuations, you're still gonna have some headwinds and feel
Speaker 1: some pain in twenty twenty three. But if you have
Speaker 1: new capital to invest in private, that's probably pretty good.
Speaker 1: I want to buy low, sell high. I think that's
Speaker 1: going to happen in twenty three, and I think the
Speaker 1: reat markets pricing in a more pain than private markets
Speaker 1: are pricing in right now. Yeah, it does feel like
Speaker 1: I mean, in addition to interest rates, it feels like
Speaker 1: the wild card here is basically the availability of capital. Sure,
Speaker 1: I mean, I'm not pushing back on that at all.
Speaker 1: I mean, commercial real estate, Tracy, I think you probably
Speaker 1: heard me say this before, it's inherently a level asset class.
Speaker 1: So it's financing cost in the availability of capital. I
Speaker 1: think you're going to quickly figure out who can swim
Speaker 1: really strong against As the tide's going out, why can't
Speaker 1: it keep getting worse? And But the reason I ask
Speaker 1: that is, you know you're like, oh, I want to
Speaker 1: buy low and still high whicheveryone does. And maybe this
Speaker 1: is a moment to buy low because there is clearly
Speaker 1: a lot of distress out there. But you know, again,
Speaker 1: it was the rates move. You know, we had a
Speaker 1: forty year down, we had a forty year decline in rates.
Speaker 1: We're like one and a half years into the increase
Speaker 1: in rates. Why couldn't, Like, do you worry about higher
Speaker 1: and higher for longer? Do you worry that that for offices,
Speaker 1: that there's not a trend that's going to bounce back soon?
Speaker 1: This is like in these distress cities, distress can build
Speaker 1: upon distress. The few people not coming into an office
Speaker 1: can erode an area's tax base and make people wanted
Speaker 1: to stay home too, Like do you worry about acceleration
Speaker 1: of headlands? Are you asking me what keeps me out
Speaker 1: at night? But beyond my forecast, I guess I think
Speaker 1: the single if I was on here a month ago, Yeah,
Speaker 1: I would have been telling you the single biggest risk
Speaker 1: was a stronger economy that begets higher inflation and the
Speaker 1: Fed has to do more and more to temper that.
Speaker 1: And so look, I'll be very clear if you know
Speaker 1: the terminal rate, so that's basically where the Fed Fed
Speaker 1: funds target rates going. If that's closer to six than
Speaker 1: six and a half, tenor treasure rates probably before all
Speaker 1: of this was happening, probably aren't supposed to be at
Speaker 1: three and a half. They're probably supposed to be a
Speaker 1: lot higher than that. And so you know, again I'm
Speaker 1: gonna get wonky here a little bit, but we think
Speaker 1: real rates are really what drive commercial real estate valuations.
Speaker 1: Real rates is the different between nominal rates and inflation expectations.
Speaker 1: I think if real rates go to around one, that's
Speaker 1: probably pretty good for real estate, but if they're going
Speaker 1: to be closer to two, that's actually probably not so
Speaker 1: good for real estate. So yeah, that's absolutely keeping me
Speaker 1: up at night. Our views heading into this year was
Speaker 1: that we were transitioning from a stagflationary to a stagnationary market.
Speaker 1: What does stagnation mean? Well, let me let me first
Speaker 1: of all say what is the stagflationary environment. Stagflation is
Speaker 1: where interest rates are rising and growth are slowing. The
Speaker 1: FED was in a really awkward position in two twenty
Speaker 1: two for reasons that happened in two thousand and twenty one.
Speaker 1: They didn't raise rates fast enough, so inflation was at
Speaker 1: record high levels. They had to raise interest rates at
Speaker 1: a record pace to slow growth in the economy and
Speaker 1: the hopes of taming inflation. That's stagflation. We thought, we think,
Speaker 1: we still think that we're moving into a stagnationary environment.
Speaker 1: That's where interest rates come down and growth slows. That's
Speaker 1: actually really good for listed markets. Not so great for
Speaker 1: private markets because sort of start catching up, but it's
Speaker 1: pretty good for listed markets. You know. Best case scenario
Speaker 1: is that all the Fed's medicine starts to work, inflation slows,
Speaker 1: and they don't have to they stop raising rates, but
Speaker 1: they also don't have to cut interest rates. The other
Speaker 1: thing that's keeping me up at night, to be very clear,
Speaker 1: is that the market's pricing in six interest rate cuts
Speaker 1: over the next eighteen months. I don't want to see
Speaker 1: interest rate cuts. I think about when the Fed cuts
Speaker 1: interest rates, it's because something bad is actually happening. That's
Speaker 1: not a good thing for the market. So you know,
Speaker 1: we actually thought we were, you know, sort of in
Speaker 1: this not too hot, not too cold environment. You know,
Speaker 1: maybe the unintended consequence of these bank failures is this.
Speaker 1: It actually a showing that the FEDS interest rate hikes
Speaker 1: are finally working and it's starting to break some things.
Speaker 1: And that makes me feel, maybe counterintuitively, a little bit
Speaker 1: better about where we're going. I hope it doesn't push
Speaker 1: us into a really deep recession. I think recession is
Speaker 1: our base case, but but you know, it's the two
Speaker 1: extremes that me up at night. A much hotter and
Speaker 1: stronger economy where interest rates have to go higher than
Speaker 1: where they are right now, and a pretty hard recession,
Speaker 1: which you know, I would argue that a recession is
Speaker 1: the base case. It's just a matter of degree. Yeah,
Speaker 1: So there was one thing I wanted to ask you,
Speaker 1: and I think Joe and I are gonna try to
Speaker 1: do an episode that focuses on, I guess the physical
Speaker 1: challenges of converting offices to residential at some point, but
Speaker 1: maybe from a financing market perspective, you know, could you
Speaker 1: have a situation where a lot of these offices do
Speaker 1: get converted to resie and what would that mean first,
Speaker 1: CRI investors and lenders in general. Do you know, do
Speaker 1: CRI people who have a big portfolio of office properties
Speaker 1: do they suddenly become residential lenders? Or I mean, I
Speaker 1: guess they would all be classified as multi family. But
Speaker 1: how would that work exactly? Yeah, it's sort of a
Speaker 1: good tie into some of the other podcasts that you've
Speaker 1: done over the past a couple of weeks. Look, let
Speaker 1: me say in an outset, we do not have enough
Speaker 1: housing in the United States. I think you've covered that
Speaker 1: in prior podcasts. We can debate why that's the case.
Speaker 1: I think you've already covered it, But we don't have
Speaker 1: enough housing in the United States. So the highest and
Speaker 1: best use for a lot of these office properties is
Speaker 1: not office. And you could make a case in New
Speaker 1: York City that we are have a significant shortage of
Speaker 1: affordable housing in New York City. So it does make
Speaker 1: sense if I could make way my magic Verry Wand
Speaker 1: and say convert from office to multifamily. You're probably supposed
Speaker 1: to do that for a variety of reasons. It's actually
Speaker 1: it's actually much easier said than done. For a whole
Speaker 1: host for different reasons, including zoning. It's not like all
Speaker 1: of these properties are zoned from multifamily, and so again
Speaker 1: you could come back to how do you think about
Speaker 1: commercial real estate. It's a single asset class with a
Speaker 1: lot of different property types. All these different municipalities have
Speaker 1: different zoning laws, and so you have to go through
Speaker 1: a rezoning. It's sort of like the same reason why
Speaker 1: prior to COVID we were talking. There was talk about, well,
Speaker 1: let's just make all of these malls industrial facilities. It's
Speaker 1: just not so easy. There is one off examples where
Speaker 1: you can get it done, and it makes a lot
Speaker 1: of sense, but again it's it's not a cure for
Speaker 1: everything yet. All right, Rich, we're going to leave it there.
Speaker 1: That was such a good overview of the space, and
Speaker 1: you know clearly there's a lot going on, but you
Speaker 1: were very good at walking us through the nuance of
Speaker 1: the different subsectors and the different way of looking at
Speaker 1: prices and valuation at the moment. So thank you so much. Sure,
Speaker 1: thanks for having me again. Thanks Rich, that was great.
Speaker 1: So Joe, I thought that was a really good walk
Speaker 1: through through all of these different parts and for me,
Speaker 1: I guess the most salient thing is what rich was
Speaker 1: talking about, the discrepancy between the public and private valuations
Speaker 1: at the moment, because you have seen a lot of
Speaker 1: the mortgage rates just collapse in recent months, you haven't
Speaker 1: seen the same pressures on the private side. Although you know,
Speaker 1: I guess the clues in the name those particular valuations
Speaker 1: aren't quite as transparent right now. I mean, if you
Speaker 1: look at like some of them, I mean, you know,
Speaker 1: listeners like pull up a chart of like Vornado or
Speaker 1: sell Green, like some of these names, I mean they're
Speaker 1: real dismal, like below the COVID lows when people were
Speaker 1: talking about oh, no one would ever go into an
Speaker 1: office ever. Again, so like between the interest rate increases,
Speaker 1: between concerns about just like the actual net income and
Speaker 1: so forth, the public market is given clearly a very
Speaker 1: grim assessment. Yeah. And then also the definition of CRIS
Speaker 1: sort of a leveraged bet on interest rates and availability
Speaker 1: of capital. I think that's going to be a really
Speaker 1: good way to frame it going forward, because even before
Speaker 1: recent events and the collapse of Silicon Valley Bank and
Speaker 1: worries over the wider banking system, there was obviously concerned
Speaker 1: about what was going on in CRE And it's going
Speaker 1: to be really interesting to see how this financial crisis
Speaker 1: shakes out, because if it leads to the FED cutting
Speaker 1: interest rates, well maybe that would be better from a
Speaker 1: purer financing cost perspective, but to Rich's point, it would
Speaker 1: mean something bad is going on in the economy, and
Speaker 1: it would probably mean that there was less brisk appetite
Speaker 1: in general out there. Yeah. Right. You know, it's the
Speaker 1: same intuition with stocks, which is that if the FED
Speaker 1: is cutting rates, it's probably at a time when revenues
Speaker 1: are coming down, when net incomes are coming down, Like
Speaker 1: it's often the case that it goes hand in hand.
Speaker 1: So ostensibly it seems bullish, you know. I guess to
Speaker 1: my mind, the question is like, yes, there's going to
Speaker 1: be some cyclical shift at some point, but you know,
Speaker 1: this is an area if it's so rate sensitive, well
Speaker 1: we're coming off like you know, the forty year rate
Speaker 1: bull market, and it could be that these sort of
Speaker 1: elevated rates not just stay elevated for years. Maybe they're
Speaker 1: going to keep getting elevated. I don't think we really
Speaker 1: have like any I don't think anyone like knows for sure.
Speaker 1: I mean you could see why it's a stressed area.
Speaker 1: I did appreciate though, and I do think it is
Speaker 1: easy for us in New York to think that all
Speaker 1: commercial real estate is like a handful of half empty
Speaker 1: buildings and they're like clinics and data center totally. Although
Speaker 1: Jim Chano's you know, he's he's short the data centers,
Speaker 1: or he at least was, so he has negative aspects
Speaker 1: of those. But there's data centers that's its own distinct area.
Speaker 1: You know, There's there's a you know, assisted living spaces
Speaker 1: that in commercial real estate, so all kinds of categories.
Speaker 1: It is crazy to think that with you know, the
Speaker 1: pace of interest rate hikes last year, you still saw
Speaker 1: commercial property prices go up as a total, and that,
Speaker 1: you know, that is because it is not a monolithic
Speaker 1: sector and it is not just massive office buildings in Manhattan.
Speaker 1: So I'm sure we're gonna end up talking more about
Speaker 1: this topic, but for now, shall we leave it there?
Speaker 1: Let's leave it there. Hey, this has been another episode
Speaker 1: of the Odd Thoughts podcast. I'm Tracy Alloway. You can
Speaker 1: follow me on Twitter at Tracy Alloway, and I'm Joe
Speaker 1: wisn't Thal. You can follow me on Twitter at the Stalwart.
Speaker 1: Follow our producers Carmen Rodriguez at Carmen Arman and Dash
Speaker 1: Bennett at Dashbot. Check out all of our podcasts on
Speaker 1: Twitter under the handle at podcasts, and for more Odd
Speaker 1: Lots content, go to Bloomberg dot com slash odd Lots,
Speaker 1: where we post transcripts. We have a blog and a
Speaker 1: weekly newsletter comes out every Friday. Thanks for listening. Two