by Ming Zhao
26/03/2023
Soon you will hear a lot more on Commercial Real Estate.
Why? Because US banks & PE firms are headed for real estate doomsday.
4 collapses in 11 days
$270B in Commercial Real Estate loans due end of year.
$3B+ defaulted in March 2023 alone
What is Commercial Real Estate & Why Does it Matter?
“Commercial real estate” = Property for Business
The US Commercial Real Estate industry is a $20.7 trillion market.
Core segments include:
– office
– industrial
– multifamily
– retail
– hotels
– land
Investors specialize into 3 major investment strategies:
– Core
– Value add
– Opportunistic
Core:
– low risk, “steady income” play
– safe geos (NYC, SF)
– high starting occupancy
– target IRR: 6-9%
Value add:
– medium risk, “asset appreciation” play
– investor must put in work (e.g. make repairs, grow occupancy rate)
– target IRR: 12-18%
Opportunistic:
– high risk
– original asset fucked, this is basically distressed equity/ activist investing
– target IRR: 18+%
Ways to Invest in Commercial Real Estate
1. Directly buy property & manage (or outsource to mgmt corp) — a CRE equity investor
2. Originate or buy CRE loans — a CRE debt investor
3. Invest in a property REIT (which does #1) or a mortgage REIT (which does #2)
What’s going on in 2023 — Banks’ Current Exposure
Here’s the problem:
Commercial Real Estate debt investors today are HIGHLY CONCENTRATED.
Small banks hold *80%* of CRE loans worth $2.3T.
Once defaults start piling in, the US banking sector and all its stakeholders will be F*CKED…
How We Got Here
In 2022, US banks went on a frenzied buying spree for CRE. Loan exposure increased $4.8T to $5.3T, 4x the rate of years prior!
Why?
Back in ’21 rates were 0% & hikes imminent. Many CRE loans promise floating rate returns.
Result: banks unanimously said BUY!
This frenzied buying was much worse at SMALL banks than big.
Borrowing as a % of reserves shot from 25% to 95% YoY (Feb 2023)
…versus, this same metric only increased to 35% for big banks.
Key Operating Metrics — When & How to tell if Commercial Real Estate is in trouble
1. Discount/premium to NAV:
– for a $20T industry, if current asset values fall 10% across the board, that’s $2T in loss!
– who’s gonna pay? –> govt bailout
2. NOI:
– “net operating income”
– calculated by subtracting operating expenses from gross income
– deterioration here suggests problems with occupancy rates and/or rent collection and/or tenant quality
3. DSCR
– “debt service coverage ratio”
– a property’s ability to pay debts
– decline in DSCR means cash flow problems & is often the next symptom after decline in NOI
– problems here –> default
4. Occupancy rate
– duh, no tenants = no cash flow coming in
– in general a good occupancy ratio is ~90%
– in SF & NYC: current office space sector has 44% occupancy ????
5. Cap rate
– equal to NOI/ Property Value
– essentially: the rate of return for equity investors
Chart below contains a comprehensive list of all key operating metrics & who cares to measure each of them.
Current Market Forces Impacting CRE Market
a. Rate hikes:
– EFFR is now 4.8%. In mid-2021, this was 0%.
– Let me break down the effect of a rate hike explicitly: CRE loans come in 2 flavors only: either fixed rate or floating rate.
– Hike kills fixed rate NAV b/c bondholders still getting low coupons while the market is +480bps.
– Hike kills floating rate NAV b/c tenants can’t afford the new interest & default risk skyrockets.
b. WFH / COVID:
– this obviously destroyed occupancy rates across the country
– 2023 occupancy rates at a glance:
Austin: 66% of pre-pandemic levels
NYC: 47%
SF: 44%
In major cities, CRE sales transactions plummeted almost 50% from 2019 to 2020 & they haven’t picked up since.
What’s Ahead: Defaults… Cascading Defaults
So far in 2023:
– Feb: Brookfield, #1 largest office owner in LA defaulted on $784M
– March: Pacific Investment Mgmt Co. defaulted on $1.7B of mortgage notes on 7 assets
– also March: Blackstone defaulted on $562M in Nordic CMBS
This is just the tip of the iceberg.
Breaking:
– Current value of loans & securities held by banks is $2.2T lower than the book value recorded on their balance sheets
– 10% of banks have larger unrecognized losses than those at SVB
– even if only half of uninsured depositors decide to withdraw, 190+ banks are at risk of $300B of insured deposits at risk.
Top CRE Lenders at Risk
Note: the watchlist below only ranks banks by absolute value exposure to the $2.2T of unrealized losses…
Small regional banks have less absolute exposure but may carry much higher exposure relative to their equity value.
Summary:
– While a single $1.7B commercial mortgage default in March 2023 may have spooked markets, this is a bellwether for many more to come.
– Investors & policymakers need to understand the contagion risk of the CRE loan crisis for & beyond US banks before its too late.
