In the last month or so, two macro risks have become top of mind for investors. One is the stability of regional banks. The other is the weakness in the commercial real estate market. On some level, they're separate stories, but they're also linked, since regional banks tend to do more commercial real estate lending than larger, national banks. Of course, the links are complicated. CRE is not a monolith — and banks are just one source of financing for CRE projects, alongside private credit funds, insurance companies and other sources of capital. On this episode of the podcast, we speak with Jim Costello, chief economist for real assets at MSCI, about what to watch for. This transcript has been lightly edited for clarity.
Key insights from the pod:
Who’s actually exposed to commercial real estate? — 04:38
People following the playbook of previous crises — 7:42
Regulatory shopping in CRE — 10:54
Regulators’ attitudes towards CRE and rule changes — 14:10
Differences between bank loans and private investors — 15:05
How will commercial properties be refinanced? — 17:49
Which commercial properties are in the most trouble? — 20:30
Who’s buying distressed properties now? — 25:43
Repositioning real estate for other uses — 28:42
The role of private debt investors — 30:22
Why shorting commercial real estate is so hard — 31:56
The financial impact of raising rates today versus in the 1970s — 37:12
Offices are the new dead malls — 40:51
---
Joe Weisenthal: (00:10)
Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Weisenthal.
Tracy Alloway: (00:15)
And I'm Tracy Alloway.
Joe: (00:16)
Tracy, there's two things that people, well, there's all kinds of things people are like very attuned to these days, but I would say what's going on with regional banks has obviously become a huge focus, you know, with the collapse of Silicon Valley Bank. And then what is going on with commercial real estate. And we talked about that recently. And everyone knows, like the office woes that are hitting major cities like New York. Two things that are like top of mind for many people.
Tracy: (00:44)
Well, and I think they, they started out sort of separate to each other, because there were concerns about commercial real estate even before Silicon Valley Bank went bust. But since then, and since we've had the turmoil in the banking sector, the deposit flight, there is a concern that that is going to also start affecting the CRE outlook. And basically these two things are impacting each other and compounding each other at the same time. Because of course, regional banks have quite substantial exposure to commercial real estate.
Joe: (01:18)
Right. So that was the interesting thing about SVB specifically, which is that there seem to be many problems there, but one thing it was not, it did not really seem to be about the credit quality of the assets. It was a rate story, it was a deposit concentration story, but it wasn't about like, “oh, they have some sort of asset side exposure to something troubled.” But then as you point out correctly in the immediate wake, a bunch of people sort of stuck up their finger and were like, “oh, by the way, guys, these regional banks you’re worried about, they also are sort of disproportionately the funders of commercial real estate.”
Tracy: (01:52)
Yeah. Well this is it. So there's two things here. So one, there's concern about the commercial real estate loans that some of these smaller regional banks might hold. Are those actually going to default? Are they going to become distressed in some way? Are they going to be able to refinance them in the current environment?
And then secondly, as you get the stress in the banking system, as you see deposits pulled from smaller banks, are they still going to be able to pour money into that sector? And those two things are sort of impacting each other.
Joe: (02:22)
They go in both directions as you clarify there. And I think the other thing too is, you know, people like doom. I mean, I don't, but you know what I'm saying? So this is the exact type of thing that gets people going and people post all these charts that most people, you know, aren't really an equipped to understand, including myself. I don't really, you know, I'm a novice on this stuff. And so I think it's kind of important to let's sort of get real, let's put some numbers and look at how big of a deal is this? Because there is a lot of oh, you know, people, they have these fantasies of 2008 in their head and stuff like that.
Tracy: (02:56)
Right, and I think people hear “this is a $20 trillion market” and they think, “oh, this is a very big deal.” But of course, as we spoke about in a relatively recent episode with Rich Hill, it's not a monolithic market. And a multi-family residential development is different to an office building in downtown New York that might be empty now. And also, you know, a big bank is going to have a different risk profile to the sector than a smaller regional bank. It's important to dive into the details here.
Joe: (03:28)
Yeah, totally. And you know, there's office, which we all know because you could just pull up like a chart of like a big office rate, like a Vornado or something. And then there's medical, which is probably fine. And there's all these different categories. So we really need to -- given the interest -- we really need to dive sort of deeper into, all right, let's talk about some of these exposures. Let's talk about these relationships. Let's get some like real numbers rather than just sort of like…
Tracy: (03:50)
Let's get granular, baby.
Joe: (03:52)
Let's get granular! All right. Well we have the perfect guest to speak about this. We are going to be speaking to Jim Costello, chief economist over at MSCI's Real Assets team. He was recommended to us by our recent guest, Ben Carlos Thypin. He said, “this is the guy you want to talk about.” That was a really good episode on New York City residential. So I always love it when a guest recommends another guest. So that's usually a good sign. Jim, thank you so much for coming on Odd Lots!
Jim Costello: (04:19)
Hey, great to be here.
Joe: (04:21)
Let's just start with the sort of key question that I see frequently asserted, which is that regional banks have more exposure to commercial real estate as a share of their assets than the big banks. Is this a fact? And what does that mean?
Jim: (04:38)
The thing that people have been highlighting is the fact that regional banks are a bigger share of bank lending to commercial real estate. And they've been taking that as a sign that maybe these regional banks are more of a problem for commercial real estate than anything else.
The challenge is people are looking at the Fed flow of funds number in a funny way, the Fed flow of funds database, it's a fantastic thing. There's a lot to dig into there, but if you're not careful, you can look at the wrong figures and people get hung up on the bank lending, but banks are not everything in the commercial real estate lending world. Banks, we have our own approach to getting at the lending universe, kind of working from the ground up from every transaction and every building that's sold and figuring out who made the loan. From 2015 to 2019, about 48% of all commercial real estate loans in the universe of properties $2.5 million and greater, that was in the banking realm.
So you know, already 48% in the banking realm. And of that maybe 60% was the local and regional banks. Now there's a difference there. You know, 60% and 70%, there's a 10% difference. And part of that comes into we're only tracking everything $2.5 million and up -- the institutional universe.
If you have a former gas station in Tupelo, Mississippi that's been converted to a barbecue shack, we're not tracking that. No institutional investor is really interested in that kind of property. The Fed, you know, from a regulatory standpoint, they have to think about all capital flows. So they're looking at everything that goes in there. But the key point is you can't just look at the banks, you have to look at the life insurance companies, you have to look at the debt funds, you have to look at the CMBS market, CLOs, everything.
Tracy: (06:22)
Right. So just on this point, maybe we can back up a bit and talk about what exactly the concern is here. Because my impression is before the collapse of SVB, a lot of it was, well, these commercial real estate loans, you know, whether they're unsecured or secured via CMBS, there's a concern that they're going to be in trouble. They aren't going to be able to refinance. They might default.
Banks -- I take your point about life insurers and other big investors -- but there are a lot of banks who are heavily invested in CMBS and then at the same time, now the concern seems to be that with the recent turmoil in deposits, maybe banks start to tighten their lending standards. Maybe that cuts off some financing for commercial real estate. And so you have that aspect of it too. But what exactly is the worry here?
Jim: (07:11)
Yeah. And banks have been tightening their standards over the last three quarters. You look at the Fed's survey of senior loan officers, they're all getting more cautious even before the news and SVB hit. And you know, Jay Powell has been saying that, you know, with this event, maybe they don't need to tighten as much because this turmoil is creating a little bit more constraint in the credit markets that is helping them to limit the kind of exuberant activity that was underway.
Tracy: (07:41)
The banks will do it naturally now.
Jim: (07:42)
Right. But it's a circular issue. And the issue that we faced during the financial crisis was that you had cash flow assets that couldn't get refinanced because lenders were afraid to issue a new loan. And so if somebody had to buy it, it was now available in a much lower price, which then got into the market data and then the lenders see, “oh well prices are falling. I want to be even more restrictive.”
And it was a vicious downward spiral until, you know, all the federal regulators stepped in and put a floor under that negative decline. So that was the safety net that to put a floor under prices. But this time you have that dynamic in play to some degree with pressure on prices to fall. Well they have been falling recently and lenders becoming more restrictive. When they do originate loan, it's at lower LTVs (loan-to-value) than before at higher interest rates. So you're not able to get the same kind of return expectation out of investment if you do that, which limits deal activity, which pushes volume down.
So it is a little bit different than the 2008 situation though. And this is the key thing. Every downturn that I've been working through, there's this human behavior to always try and fight the last war. Look at the last bad event and you'll look at it that, well here's what happened. So I gotta look out for those same things here.
But conversely, not just look out for the same bad things. A lot of the real estate people I talk to are looking for the best opportunities that come out of it, out of every downturn. Everybody's always trying to use the playbook of the person who made money in the last downturn. Everybody wanted to be Sam Zell for a bit, but there's only one Sam Zell. Everybody wanted at the beginning of the Covid crisis, they thought that we would have another downturn just like the global financial crisis.
And so buying all the distressed debt like before, was exactly the same way to make money. They were wrong then too because there was different factors at play this time. There are some things that rhyme with the financial crisis, but going in, we are in a much healthier place. We had loans that were being originated at more conservative terms than before. You know, it's not like you have all these toxic loans that were being made. The only challenge is that rates have gone up so much that things that were able to finance before, they're going to have to do something else when it comes up for refinancing.
Joe: (10:21)
All right. I have a ton of questions, but to start off, when it comes to the financing of commercial real estate, and I want to get into the breadth that is commercial real estate and that it's not just office buildings in New York City, but when it comes to the financing of commercial real estate generally, is there something about the business model of the small/regional banks that makes them more natural sources of financing to these projects than some of the, you know, the really big, too big to fail banks?
Jim: (10:54)
There is regulatory shopping in the financial world. You have some groups like the debt funds that they're really only regulated at the level of the SEC when they're raising capital. You know, they're making a private loan. There's no state bank regulator, no insurance regulator, you know, they're just doing their own thing.
The local banks, they don't have the same kind of restrictions placed on them as the large national banks. And over time some of the restrictions have been eased a bit. I know some banks have explicitly tried to keep their book of business below a certain level so they don't get that regulatory burden because you know, then there's extra costs that go into it and just the administrative cost starts to rise at an exponential pace once you get above a certain threshold level for those regulatory burdens.
And really since around 2015 when there were some tightening up of those standards and for the larger banks, the smaller banks started to gain more share of all the bank lending activity.
Joe: (11:58)
This is a slight diversion, but I actually am really curious about those administrative costs. You said they rise exponentially and so I'm curious what happens when a bank flips over to that larger size and they all want to avoid it and SVB tried to avoid getting these sort of larger designations, etc. But what actually does happen internally in terms of the regulatory obligations and how that sort of changes the way the bank must operate?
Jim: (12:26)
At that point they have to hire a lot more risk management people and do a lot more work on scenario planning around what happens to different Fed scenarios that the Fed will publish around the economy and potential changes to asset prices, not just in real estate but other sectors.
And you know, it's a big administrative burden. Some of the bank managers that I talk to, the presidents of some of these small local banks, you know, they've noted that when they were hiring during the aftermath of the financial crisis, they felt bad that they were hiring more administrative workers than loan officers -- not the folks who are going out and producing money for them.
And their worry was, you know, if I go above that threshold, I'm going to hire a lot more administrative folks to do all the CCAR testing that we were talking about back in the day and run all these different scenarios and just more compliance people. And so if you're hiring a third of your people are in compliance and not income producing, you're going to try and avoid that.
Tracy: (13:26)
Also, if you get really big, I think you start to get regulators who are situated on site in your bank, just to kind of monitor how things are going.
Jim: (13:35)
I don't know about that. I do know I was visiting one client once and all of a sudden regulators came in, there was sort of an announcement that morning they were coming in. And the atmosphere in the place was suddenly very tense
Tracy: (13:48)
So just on this regulation notion, it is true that commercial real estate has been on regulators’ radars, their collective radars as a source of potential risk for some time. What exactly was the concern there and can you kind of give us a quick synopsis of how that regulation has changed over the past few years?
Jim: (14:10)
Well, in 2015, that was a watershed for certain types of loans. The high volatility commercial real estate regulations came – HVCRE, so that loans with shorter terms lenders had to hold more capital in reserve. So suddenly it became more expensive to originate loans like that.
Construction lending was dead center for that activity because those are typically short term loans that just pay out very quickly once the construction project's done and we saw a distinct move in construction financing. There, it used to be something like 70% of construction financing was bank-driven. And that really declined. The debt funds who didn't face any of that kind of regulatory burden, they really stepped into that and started originating more construction loans. Banks are still the prime…
Joe: (15:04)
What's the number, what’s it down to?
Jim: (15:05)
My recollection was like 52% recently. So it's still majority bank financing, but the debt funds really ate into that business and they, you know, some of these lenders when I talk with them, they complain about their competitors, how they're just so aggressive compared to them.
And they kind of lifted the market in this period from 2015 to 2019 because they were originating loans at much higher LTVs, much lower interest rates and with very few covenants out there because they were underwriting differently than banks. Banks, they underwrite a loan wanting to avoid a foreclosure situation. They want to avoid what we call in the industry REO, not the band but you know, the real estate-owned situation.
They want to avoid that because, you know, if I'm a big bank, what do I know about running an apartment building? What do I know about managing an office building? I'd rather, you know, have the experts take care of that and I just collect a nice stable yield. So I want to underwrite to avoid that. So I'll put covenants in there to make sure that if occupancy falls below a certain level that there are scrapes of any revenue. So I make sure that I'm whole. So they put those kind of things in there.
The debt funds, they didn't do any of that because the debt funds, a lot of them started as equity shops that had their own investments and own management in place. And you know, they viewed it as an opportunity. It might be a situation where I have either a nice stable yield and I can help my investors that way. But if I had the tail situation where there's a foreclosure, I have this equity management shop on the side, I can just take the property at a lower basis than before and I know how to run a property and I could probably do it better than those people who were coming to me for a loan. So I'll put it into that shop and raise some capital to stabilize it and I'll be good.
So it's a different behavior and, you know, those were the folks who were the most aggressive and did some of the larger loans in that period of 2020, 2021 when interest rates were so low. And typically they had short terms as well. So we have a wall of maturities coming in 2023 through 2025 and those aggressive loans are the ones that I think are going to see the most attention.
Tracy: (17:25)
This was exactly what my next question was going to be, but talk to us about what the maturity wall actually looks like at this point in time, because again, this is where a lot of the worry is stemming from -- this idea that you have this sort of front loaded wall that is coming due in the next year or two. And how are banks/private investors, to your point, going to actually be able to refinance those loans?
Jim: (17:49)
The originators of loans for them, their ability to refinance, you know, they have a certain cost of capital, they'll offer a borrower. “Okay, we can refinance that loan, but it's a lower LTV than before. The rate is higher.” And if somebody bought a property back in 2013 and the loan matures in 2023, you've had a tremendous amount of price growth along the way. Even though we've had some price declines recently, there's probably still enough that they might be able to refinance that at a higher rate and keep that alive assuming that you don't have a problem on income.
And I'm going to put that to the side for the moment, because that's another challenge. But just dealing with one challenge at a time here. So if you had a long-term loan, you're refinancing. Maybe you're not going to get the same proceeds as before, but you might be okay.
But if you had a loan that was originated in 2021 when we saw a record low interest rate environment and you had a very high LTV and a record low interest rate thinking that game would continue forever, you may have a bad day as you try to get that refinance because you're going to go to a lender who will offer you money, but it's going to be at a very low LTV compared to a before and with a mortgage rate closer to a 7% than a 3.5% percent.
And so the numbers may not work for those folks and they're going to have to have, you know, there's three options for some of these folks. Maybe it can do a cash in refinancing where they bring more equity to the table themselves in their own pocket. And they might want to do that just so they don't end up in a default situation if the property, if they still have an expectation of price growth ahead or income growth or there's still some fees that make them whole and, you know, they'd think of it as a brand new investment at that point.
Or maybe they get some outside investor to bring that cash in a preferred equity situation. And that person gets some of the upside of the project moving forward so that you -- the investor -- can at least still collect some fees on the project. And then another opportunity is to, you know, literally hand the keys over to the lender.
Joe: (19:57)
Oh, jingle mail...
Tracy: (19:59)
I know we're making the point about how this might not be 2008, but these are all very ’08- type terms, real estate-owned and jingle mail…
Joe: (20:07)
Yeah, just in a different context. But I wanted to, you know, you mentioned setting aside the income question because we've been talking about rates, right? We've been talking about price appreciation. Can you break down where is there income stress? Where is there not income stress within the commercial real estate world? And how are you thinking about that particular aspect of it right now?
Jim: (20:30)
Yeah, the income stress is a bit of a challenge and there still is a lot of uncertainty around it. Let's start with offices, you know, you were saying earlier, “hey, everything is not Manhattan offices,” but let's talk about Manhattan offices.
It's Wednesday today when we happen to be recording. Walking around the city, there's more people out today because it's a Wednesday, that's when more people are around. But if you're around on a Monday or a Friday, it's usually pretty empty. And you know, so people see that and they see that “hey, there are less people coming in.” The subway ridership is like 65% of the previous peak levels. So obviously the space is being utilized less. That said the fiscal side of it, you know, the fiscal occupancy, the tenants who are still on the hook for the space, there still is some good occupancy in that direction.
You know, there's a lot of sublet space where firms are signaling that they want to get rid of it, but they still are paying. And so there's a short-term challenge that everyone knows that there's going to be a reduction in demand eventually, but right now there's still some income coming in.
And so there's that, there's a term in the industry – WALT -- weighted average lease term. And if you have a property that has a very long lease term ahead, even if people aren't using it as much, if you have some high quality tenants who are unlikely to default, that might seem like a safe investment. But if I've got a tenant who has one year left on the lease and I see that the building is half empty most days, I'm going to be concerned about what happens to income there moving forward.
So it's a slow motion thing, you know, everybody sees the direction it's going. That's one of the things about real estate. Forget about, you know, I used to work with a bunch of economists in Boston. There's a lot of complex math we did, but forget about all that. The real estate market, there's all these sticky things.
You just count the number of cranes and you can see whether you're going to have some construction challenges ahead. You just look at the number of people walking into a building and you can just get a sense of what the potential demand is. All those kind of rule of thumb measures have been telling people that there's going to be some sort of reduction in demand. And we know that's coming, but nobody's really been able to fully quantify it yet. It's something we just have to live through over the next few years before we see all the leases burn off. All
Joe: (22:48)
Right. That was great, but what about the non-Manhattan office? And two, I guess sort of two interrelated questions, but like Rich Hill, the number he said was $20 trillion. But when we think about that $20 trillion, how much is this sort of like prime city office that might not ever come back to pre-Covid levels? And then can you talk a little bit more about are there these other areas, medical, etc., are they doing fine in terms of income and income expectations?
Jim: (23:16)
There's a couple things to digest there. The office market, most of the US office market is a suburban market. And that goes back to the 1970s and 1980s when we saw a surge in construction in those areas. And it's not just, you know, suburban New York. A lot of it is the development of the Sunbelt states.
And as they entered the modern economy in that time and became service sector economies as opposed to agriculture and manufacturing, those office buildings in those areas, they do constitute a large part of the office market. Manhattan off the top of my head, I think is about 40% of all CBD office space in the United States. So that's why people like to focus on Manhattan because it's pretty significant. It's an indicator of where the whole CBD office market is going nationally.
But you know, that suburban market is a bigger market overall. And it's been bigger in terms of the deal volume recently. The last, you know, really since 2015 when the Chinese investors pulled back from investing in the US, deal volume fell off for the CBD locations. And in the past it’s always been sort of half and half. Half of all investment was in suburbs, half of all investment was in CBD locations.
And that really started to turn a corner then when the prices hit a record low. And you know, there was just very little upside left. So there's just been a lot less transaction activity than the CBD locations even before all CBD – central business district. And so there's been a decline ever since. So it has been important but it had been priced to perfection back around 2015. So there wasn't, you know, that same push to continue to invest in it as there had been for more suburban locations.
Tracy: (25:12)
I want to go back to what you were talking about when it comes to income deterioration and WALT, so you know, the weighted average lease terms and things like that. Is the implication that the old “extend and pretend” strategy, which, you know, another blast from the past from 2008 and the years after that is the implication that that just won't work in the current environment? That at some point you're not going to be able to refinance or there will be some sort of catalyst on the income side that makes it impossible?
Jim: (25:43)
Yeah, that is a good distinction. The extend and pretend it worked for a simple reason. Everybody understood it was a temporary credit market challenge. You had otherwise cash flowing properties and if you know the credit markets simply stabilized, given that there was some high quality cash flow, you'd be able to refinance at reasonable rates.
In fact, the folks who made a lot of money into the recovery period were folks who came in, took buildings that were otherwise cash flowing, just with bad debt situations, repositioned the debt, put an appropriate debt structure in there, and then ride the wave of recovery as the debt market stabilized.
This time through, you don't have that same opportunity of healthy cash flowing properties. You see properties that have uncertainty around the income moving forward. So it's just not going to work out the same way. We track distressed asset sales and we don't have a lot of distressed asset sales yet.
Again, everybody kind of sees this coming. But it's a slow moving sticky market and everybody knows there's some distressed sales coming, but it hasn't hit in a meaningful way yet. But when we do see some of the distressed sales, when we disaggregate who was buying, it's a different type of buyer of the distress we've seen so far compared to the aftermath of the financial crisis, the aftermath of the financial crisis.
There's a bunch of suits from New York, from private equity firms flying out to cities across the United States buying up these cash flowing assets. You know, repositioning the debt and flying home and just, you know, collecting a big return. And everybody sees that and thinks, “hey, I'm going to be just like those folks this cycle.”
But the folks who have been buying these properties so far are local developer owner operator types. It's people know how to swing a hammer. And that tells me that the distress is really more fundamental distress. It's not a cash flowing building in Nashville with a high quality credit tenant. It's a dead mall outside of Columbus with, you know, burnt orange tile and brown carpet from the seventies.
And you know, somebody has to reposition that and it's going to take somebody who has relationships with local regulators, you know, every zoning board wants to get their hands involved in that to be able to change the use and bring it into the modern economy again. And so that takes a lot of elbow grease, both literally from the physical side and then figuratively just talking with local zoning boards and getting changes and entitlements in land use regulation.
Joe: (28:21)
There’s a CRE guy I follow on Twitter who goes by the handle “Repositioning Play.” That's what that means. It just clicked to me that that's what that means. That it's like some mall and it’s like, oh maybe this could be like residential or maybe this could be like a big paintball sort of thing. But that's what that means -- that you have to identify the opportunity to make it something other than it was.
Jim: (28:42)
Yeah. And what those malls, you know, a lot of malls that are positioned well relative to transit opportunities for highways and so some of them would be great for logistics and local distribution activity, however that flies in the face of local zoning issues where you know, local city leaders feel that oh, it's too beneath them. It's not bougie, it's not a consumption area.
Plus, you know, we're not a low-class industrial town. We want them all, we want Bloomingdale's because you know we're high end. But they, you know, the reality is the market doesn't believe that and it's going to take a long time to get some local city leaders to kind of understand where they really sit.
But there's another issue that in many states we have, that those local city leaders want the retail because it generates more tax revenue without them having to tax residents as much. And so that's the other reason that it's a sticky issue keeping the market from converting the space to what it really needs to be.
Joe: (29:46)
So this is really fascinating, just this idea that the buyers we're seeing show up in some of these distressed [properties] are not the people who just know how to like, you know, do a spreadsheet
Tracy: (29:55)
How to flip it.
Joe: (29:56)
Yeah, that people who actually have to have these sort of like concrete connections. But I want to get back to some of the specific bank questions and specifically, you know, let's say we talk about CBD office, like some of these areas that are income stressed, of that debt out there, how solid are the numbers in terms of how much is bank, how much is private credit funds? How is that broken down?
Jim: (30:22)
I mean the originations -- we're tracking originations -- we don't have a good measure of the stock. We have some estimates of maturities, you know, given when we know all the loans were originated and the kind of terms that were in place. Measures of stock, they get tricky because some loans, you know, it might default and we're not going to hear about that.
So, you know, I can give a perspective on the share of originations and in the boom period when interest rates were so low and everyone was excited about the fact that there was some yield on offer in commercial real estate, those debt funds were around 13% of our originations. And given that they had typically short terms associated with those loans, you know, that's going to be a significant component of the maturities in the near term. And 13% of the market was high LTV low interest rate and very few covenants from these aggressive lenders. Could be an interesting situation with those deals.
Tracy: (31:22)
So just on this topic, how do you see banks and private investors actually hedging their CRE exposure at this moment in time if they're doing it at all? Because my impression of the space was it was always kind of a difficult one to hedge or go short and you do have synthetic instruments like the CMBX which is a derivatives index tied to not that many CMBS properties I think, which makes it, you know, sometimes a not perfect one for one hedge for this kind of exposure?
Jim: (31:56)
Yeah. Hedging the commercial real estate market has been, it's been the white whale for many folks in the industry over the last 15 years. The firm I'm with now, they bought this company Real Capital Analytics back in 2021 and Real Capital Analytics had been one of the folks trying to get a real estate derivatives index going based on our commercial property price index. We had licensed it out to a third party that was trying to get that going. There were a few other folks trying to get that going.
The trade organization NCREIF, some folks were trying to trade derivatives on that. So there were a lot of folks trying to get that going but never really took off and just they couldn't get enough buyers and sellers on opposite sides of a transaction to make any of that work.
Again, the market is highly predictable because there's so many sticky elements in the performance of the market that you know, if you just again forget about econometrics and forecasting, just very simple things. Talking to leasing brokers, any deal that's going to be done in the next six months, they're working on it right now. And so you can get a sense of just future demand that way. And so those kind of challenges, everybody saw that. So it's just been hard to make, you know, a product like that.
Tracy: (33:06)
Wait, can I just press you on that point because -- this is a fun episode for me because it's bringing up a lot of 2008 flashbacks, but you know, if you wanted to go short residential real estate pre-2008, you used the AB . Why is the commercial real estate market so different from the residential market that putting on that big commercial real estate short seems to be much more difficult?
Jim: (33:32)
Yeah. You know, I haven't gotten into that as much -- the comparison in that direction. There are fundamental differences in the two product types. There's much more of a subsidized finance side on the residential market. The residential market is vastly larger than the commercial market. There's many more single family homes out there. So just more information availability becomes an issue. You can do a lot more. You go in the academic literature, there's all kinds of folks doing stuff on residential real estate because that's where the data is. There's fewer folks doing work on commercial real estate because it's just harder to get information.
Tracy: (34:11)
Interesting. Okay.
Jim: (34:12)
I've been working in this sector since 1996 trying to help generate more transparency, more information, just better data sets for the sector. And as much as we've improved since that time, you know, when I talk to my public markets colleagues over at MSCI, I, they're like, “well you guys are doing okay.”
Joe: (34:33)
Well, all right. So again, on this sort of bank question, part of the reason we're even having this discussion again is because in the wake of SVB people are like, “what are the landmines, I guess, maybe that these banks could be stepping onto or something. What's lurking on the asset side of the bank balance sheets?”
And so when we sort of, and I imagine there's no one model bank, obviously they're all going to be different, but when it comes to the various things that a theoretical bank could have on its balance sheet, you know, Treasuries, Agency MBS, you know, sort of whatever it is, how significant is this really in terms of percentage of their own exposure to commercial real estate or how do you think about answering that question or how do you think about trying to dive into where this lies?
Jim: (35:25)
Yeah, diving into that, the FDIC call sheets have a lot of information about some of the exposure, sort of the stock of loans of different entities. And my colleague Tomasz up at Columbia, he did a study, I think it was released on March 13th of all days, and estimated that maybe 200 banks face some challenges in that direction.
Joe: (35:46)
But what do we mean like challenges, because that's a range of things, right? It's like they're going to take losses, they're going to have write downs versus people are worried about insolvencies, etc. So how seriously do you view the stress not to the commercial real estate market, but to the banking system from the exposure that they have?
Tracy: (36:04)
Sorry, can I just tack on to the end of that? What do loan loss provisions actually look like for CRE? Because you would expect that, you know, again, this has been sort of on people's radar for some time.
Jim: (36:15)
Yeah. I'm not sure what the loan loss provisions were, I don't have insight to that. I just know when they made the loans sort of the terms there, this is a challenge that that is out there for the sector. You know, as much as we've tried, there are still many things that are known unknowns.
It's still an opaque sector on performance. I'm in the office every day and part of that is every day I use it as a base of operations and I'm going around the city, you know, having a few meetings every week just talking to people because you pick up so much information that's not in a database that's not easily accessible because you just have a conversation with somebody. You get a few observations and sort of a sense of direction momentum. It is a challenging sector in that direction.
Joe: (37:02)
And just in terms of like…
Tracy: (37:04)
The seriousness…
Joe: (37:05)
The seriousness that CRE weakness poses to banks themselves. What is your judgment on that?
Jim: (37:12)
Everybody saw what happened with Silicon Valley Bank. You know, they had all this RMBS on their balance sheet, you know, it seemed like a safe product. You know, it was throwing off yield. But in a rising interest rate environment, you know the asset value needs to be written down. Other entities have the same kind of thing on their balance sheet. The question that I would be digging into is how many of them have actually taken those write downs so far and have they been able to replace that capital in other ways?
Before the bank runs started, SVB they were trying to bring in other assets. They were trying to raise capital to shore up their balance sheet. What I'd be looking at is have other banks been ahead of the curve there? Have they been able to start to step that up and you know, where do they stand?
That's what I would be looking for because anybody who held those kind of securities realistically if they're marking it to market, they're not worth what they were back when interest rates were so low. And this is the challenge of the medicine that the Fed has to deal with inflation, right?
The last time the Fed raised the Fed funds rate at such a rapid pace was in the early 1970s. You know, they had to put the pedal to the metal here to fight inflation, but it had unintended consequences. You know, back in the seventies you didn't have these complicated structured products like RMBS.
It just, it wasn't something that banks held and the financial environment was largely a bank and a life company market. You didn't have debt funds in the United States. They had a structure like that in the UK but not here as much. And you didn't have, CMBS didn't exist at all. So you didn't have complicated products on the balance sheet. So when rates were raised, you know, you didn't have as much of an immediate shock to the banks. This time through. I don't know if they were thinking about the fact that you have a more complicated financial environment today than the early 1970s with more unintended consequences.
Tracy: (39:17)
What are you hearing from the banks themselves? I mean give us some color because as you pointed out multiple times, this is a very opaque market. It is difficult to get a handle on whether or not people are writing stuff down and what the capitulation point actually is.
Jim: (39:31)
That is something that I always, like I noted walking around the city, just go visit clients, talk to people. You pick up a lot that way. Since mid-March it's been very quiet. No meetings and just no conversations with, you know, our clients there or with the regulators either. Not that I didn't want to talk with them, it's just they've been busy elsewhere.
Tracy: (39:54)
Interesting. One of my favorite forms of sell-side research is when they send all the analysts to go shopping at like a mall. But now it's going to be when they send analysts to just walk around downtown New York and observe how many people are going in and out of office buildings.
Joe: (40:07)
You know, like how many people are in line at a Starbucks or just those charts, which I'm sure everyone's still monitoring, those MTA usage charts. I just want to go back again and I think outside of you know, this sort of non-office, non-central business district real estate, I guess malls, there's some issues but by and large is this still more about a rate pressure than it is an income pressure? Is there income stress showing up in other parts?
Jim: (40:37)
Yeah, the income stress has mostly been a story of properties where the previous economic justification is evaporating. Malls we've been dealing with for a long time,
Joe: (40:49)
Right. That’s a pre-Covid story, right.
Jim: (40:51)
Offices now are kind of where malls used to be where everybody saw there was a change. They weren't sure how long it was going to take, but it's going to be there. Offices today are in some cases much like the malls in the past.
But you know the other property types, it's not as extreme on sort of the income uncertainty. Some elements of hotels with some of the convention center locations still not where they were in expensive urban markets. You don't see as much activity in some of those, although the nature of it has changed much more. Tourism and talking with hotel experts, there's sort of been a change in the patterns of daily room rates because there's many more folks who are not doing the “come in the middle of the week for a conference or to see clients.” It's many more tourists. So it's changed the nature of some of those hotels. But you know, it's largely all about the changing the economic justification of some of the assets.
Joe: (41:52)
Jim Costello, thank you so much for coming in. This is such a big topic and this was so helpful in terms of sort of understanding the various dynamics out there.
Tracy: (42:02)
Yeah, that was really great. Thank you.
Joe: (42:03)
Appreciate you coming on Odd Lots.
Jim: (42:05)
Yeah, great to be here.
Joe: (42:18)
Tracy, I thought that was really great. Obviously a lot there. But this idea that for the most part, and this speaks to why we really need to do a sort of office to resi episode soon, and the challenges there that this is not going to be a situation which the money is accrued to. Like people who know how to read a spreadsheet or enter numbers into a model and sit behind a computer in New York, but someone who knows about like actual construction and zoning and relationships, I think is really interesting. Yeah, this is not the last war.
Tracy: (42:51)
Absolutely. And also the parallels between where shopping malls were in say 2015 and, I mean I remember writing those stories from a CMBS perspective. You know, what are we going to do with all the shopping malls? And some of them are going to become like multi-family living centers and things like that, and the parallels with the office space now.
And the other thing I thought was really interesting was this idea, and I'd never thought of it before, but the idea that the local authorities might want to hold out for, you know, retail because they get higher tax income than for resi. That was really interesting to me. And then also just the point about why extend and pretend won't work in that environment, in an environment where, you know, the cash flow, the income is actually in doubt. It's not just a matter of refinancing again.
Joe: (43:41)
You know, I think obviously for understandable reasons there are these concerns about regional bank exposure to this space. But I do think that people need to remember that there is a diversity of what's meant by, you know, commercial real estate and that a lot of the risky stuff, the sort of fast money, the riskiest stuff, especially in this sort of low interest rate period with the worst covenants or the worst investor protections, the fastest time to refi, was by the private debt funds was a really interesting point.
And people who have money invested in those private debt funds, they're probably not going to do great, I would assume they're going to take some hits, but that seems better than having all those losses be born by the banks themselves, that have these sort of like key infrastructure purposes.
Tracy: (44:35)
Well, I mean the good news is to some extent that's what a lot of the recent regulation was trying to encourage, which was, you know, banks are more conservative on risky CRE and there was a lot of recognition that was an area of worry in recent years and that some of that risk would be pushed out into non-banking entities such as large debt funds. But I guess now we get to see well whether or not that was a good strategy.
Joe: (45:00)
Yeah. And then still though the point that part of the reason the regional banks have this exposure is because they're less burdened than the large banks in terms of the types of risks that they can take. So clearly there's still risks out there for multiple parties.
Tracy: (45:17)
I do want to do an episode though on why commercial real estate seems to be so difficult to short or to hedge. Because this has been a sort of, it's a little geeky or wonky, but this has been a perennial talking point in the industry. At various points in time, you see people come out with very creative ways of going short. But there hasn't been an obvious industry standard -- other than CMBX, which is definitely not a perfect hedge -- for a long time. So we should do an episode on that.
Joe: (45:45)
Yeah, that is interesting because I think people just sort of imagined that, and I remember these even go back to 2008, 2009, just with like credit default swaps. And people imagine you just like go and log into your brokerage, right? And like buy a CDS or whatever as if it's like buying a stock. It's like why don't you put on a hedge? Well was someone willing to sell you a hedge for this? Or was liquid?
Tracy: (46:07)
It’s very two-sided market.
Joe: (46:08)
It's sort of this idea that there’s just that always a hedge out there that someone could have bought. Sort of this naive fantasy about how these markets work.
Tracy: (46:16)
Right, or the idea that everyone has an ISDA agreement up their sleeve. Shall we leave it there?
Joe: (46:21)
Let's leave it there.
You can follow Jim Costello on Twitter at @JimCostelloCRE.