There's plenty to be anxious about right now in the financial system. But something you may want to pay more attention to is commercial real estate. It’s a heavily-levered, $20 trillion industry that has enjoyed roughly four decades of declining interest rates. Now the rate story is reversed. And on top of the higher rates, for the office sub-sector, income is under threat due to people working from home. So how bad will it get? What are the industry’s financing needs? And who is holding the bag? On this episode of the podcast, we speak with Rich Hill of Cohen & Steers. The transcript has been lightly edited for clarity.
Key insights from the pod:
How big is the commercial real estate market? — 3:25
Which areas comprise commercial real estate? — 4:15
What makes NYC offices unique? — 5:15
Why is there a gap between public and private valuations? — 7:05
How do we measure CRE distress? — 9:06
Why do adjustments take so long? — 11:05
How long can CRE owners keep rolling over debt? — 14:22
What do CRE underwriting standards look like? — 18:00
Are any other sectors besides offices facing distress? — 24:02
What's the biggest risk now to CRE? — 33:15
Tracy Alloway: (00:09)
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe Weisenthal: (00:13)
And I'm Joe Weisenthal.
Tracy: (00:15)
Joe, people have been asking for this episode for a long time.
Joe: (00:19)
There's a lot going on right now. Definitely a lot of things, a lot of balls in the air, but one particular topic that's been brewing for a while is a source of concern: what's going to happen with commercial real estate, particularly office buildings.
Tracy: (00:34)
That's right. We've recently had the collapse of Silicon Valley Bank, which set off a bit of a banking crisis. A lot of people are talking about the next shoe to drop being on the property or the real estate side. And obviously, there's been a lot of concern about what exactly is going on with office buildings. Just interest rates going up in general tends to be bad for real estate as a broader category. So I think this is something that we really need to dig into.
Joe: (01:08)
Yeah, I mean, right. So, obviously real estate is a highly-leveraged industry in almost any factor, whether it's malls or office buildings or apartments or single-family homes. There's a lot of borrowing, so I think rates matter. Like every other industry, it's dealing with this reversal of a long downtrend.
And then with office REITs in particular, we all know that working from home is still a thing. Not everyone goes to the office every day like they used to. Companies are reducing footprints. So if you are the owner of commercial property, you may be looking at a double whammy in which your loan is set to reset, or your commercial mortgage that you planned to roll over is set to reset. At the same time, because of vacancies, your business is not as good as maybe it was in 2019. So potentially, a major stress point is emerging for a lot of players.
Tracy: (02:02)
And the other thing I would say is, even without the pandemic and even without the work-from-home trend, there was concern about excess in commercial real estate, or CRE, even prior to 2020. I remember when I was at the Financial Times, I was writing a lot about the bond markets and credit markets, and I used to write many stories about subpar underwriting in commercial mortgage-backed securities and investors really reaching for yield in that sector. There was one person I spoke to quite a lot when I was doing those stories. I am very pleased to say that we have the perfect guest for this episode. We are going to be speaking to Rich Hill. I knew him when he was an analyst at Morgan Stanley, but he is now over at Cohen & Steers as head of real estate strategy and research. So Rich, thank you so much for coming on Odd Lots.
Rich Hill: (02:59)
Yeah, thanks so much for having me.
Tracy: (03:01)
So maybe just to begin with, you know, Joe kind of alluded to this in the intro, but commercial real estate isn't a monolith. There are a lot of different sub-sectors within that broad category and a lot of different actors, like lenders and investors. Can you talk to us a little bit about the ecosystem? What does the ecosystem of CRE actually look like?
Rich: (03:25)
Yeah, it's a great question. And look, I actually don't disagree with anything you said in your remarks to start this. But maybe we just start off by talking about the size of the commercial real estate market. We estimate it's around a $20 trillion market. That's a pretty big market. And if you think about commercial real estate, everyone thinks about it as a singular asset class, but it's really 15 different property types under one umbrella. In many cases, those 15 different property types don't necessarily all act the same.
What drives multifamily fundamentals might be much different than what drives retail fundamentals. And we haven't even really started talking about some of the sub-sectors like healthcare, for instance, or data centers or cell towers.
There's a whole host of different property types that are out there. Yes, commercial real estate is a singular asset class, but in many respects, as a strategist and a researcher, I'm covering 15 different parts of the economy that all have a singular commercial real estate umbrella, but they have different fundamental drivers, right?
Joe: (04:49)
So this is really important. Some sort of midtown office space here in New York that maybe in 2019 was leasing out to tech startups is going to be very different from a building that's specialized in doctor clinics, in which probably there is not much work-from-home activity happening. And so they're both commercial real estate, but they might have very different fundamentals.
Rich: (05:15)
For sure. And frankly, I'll take that one step further. The office property in Tampa, Florida might be very different than the office property in New York City.
Joe: (05:24)
Are they going to the office in Tampa, Florida?
Rich: (05:26)
Believe it or not, they are.
Joe: (05:29)
What are the numbers like? I know there are trackers of different cities, and there's a lot of coverage in the media for obvious reasons, because many of us are here in New York City. But how does New York City compare?
Rich: (05:42)
If you're talking about New York City return to office, we're still well below 50% occupancy rates, people actually using office space, in the 30 to 50% range. But if you go to the Sunbelt, and there's a lot of reasons for this, return to office and use of office space is a lot higher than that. It's not surprising to see it at 60, 70, maybe even a little bit higher than that. So there is a big difference between how people in, let's say, New England states are using office space versus let's just say Tampa, Florida, Austin, what have you.
Tracy: (06:17)
One of the things I wanted to ask you is, in addition to there being a lot of sub-sectors within the umbrella of commercial real estate, there are a lot of different ways that people actually measure what's going on in that market. So, you know, one CRE-specific term that you hear a lot is cap rates.
You obviously have property prices and then you have valuations, and you also have what's going on with the mortgage rates for publicly-listed real estate investors. And, you know, depending on which one of those you look at at the moment, you kind of get a really mixed picture of what's actually going on with CRE. Can you explain that? Like why are these different things painting a different view of the market?
Rich: (07:05)
It's a really great question, and I think it's something that's maybe sometimes misunderstood. If you were to go back to Q3 2022, so not that long ago, the REIT market was down more than 30% year to date, but believe it or not, private valuations were still up more than 10% on a year-to-date basis. There's a huge divide, a 40% divide between what the listed market was telling you and what the private market was telling you. What happens is the listed market, so that's publicly traded REITs, is always a leading indicator for the private market. They go down before the private market and they go up before the private market. Why is that the case? Well, listed REITs get a mark on them every single day; people buy and sell stocks. On the other hand, valuing a property can be pretty hard.
You have to go get an appraisal for that. And so there is an inherent lag on when private markets actually correct to list markets. Do they always follow hand in hand? Not always. If you go back to the late 1990s post the Russian debt crisis and everything that was going on with tech, REITs were under pressure and the private market kept chugging along.
I don't think that's going to happen this time around. Case in point, in Q4 2022, the NCREIF ODCE index — that's a widely followed-index of open-ended mutual funds — was down almost 5% in the quarter. That is the greatest decline since 2009, and the second-greatest decline since 1978. So we're talking about almost a 20% decline on an annualized basis.
Not that much different than what REITs were pricing in; REITs were up 5% during that quarter as well. So there is a little bit of a lead-lag relationship that's going on here. We'll see what the year holds for us. For listed REITs, they're about flat on the year after a really good start to the year. But I think private's going to be down, and I wouldn't be surprised to see it down 10 to 20%.
Joe: (08:51)
So as you point out, even if my conception of commercial real estate is New York office buildings, we can't just form a view of all real estate or commercial real estate based on that. That being said, how much of the $20 trillion is distressed right now, or in some sort of trouble? And how much is chugging along? Where of that $20 trillion — how much should we be concerned about?
Rich: (09:16)
The right question to be asking involves the different ways we can think about distress. The first way we think about distress is distressed sales as a percent of overall transaction volumes. Before I go there, let me be clear that transaction volumes are down significantly on a year-over-year basis, almost 70% down. Distress is like someone having to sell a property when they don't want to, such as a foreclosure.
Distressed sales are very low right now. I don't think they're going to stay low; I think they're going to increase. But the reason distressed sales are low right now is that banks haven't started foreclosing on their loans, and the spread between buyers and sellers is pretty wide. Distressed sales are low, and while we can talk about delinquencies, like CMBS delinquencies and bank delinquencies, distressed sales are the first thing I look at. It's showing signs of ticking up, and I think it's going to rise.
Tracy: (10:26)
Going back to private valuations for a moment, how long can private valuations resist the gravity of lower prices and maybe deteriorating fundamentals? What is the catalyst or process for someone to take a hit on that property? Because clearly, if you are a big investor, you would want to resist crystallizing those losses for as long as possible.
Rich: (11:05)
To answer your question upfront, it can historically take 12 to 24 months for private property valuations to correct to what the listed market is pricing in. Why is that the case? Let's talk through how private valuations actually correct. The first thing that happens is transaction volumes bottom out. You have to see transaction volumes decline precipitously before property valuations begin declining.
That's because, at the early start of a correction, sellers don't want to sell at the level buyers want to buy. There's a huge bid-ask spread between the two. It's sort of like the grieving process: There's denial, anger, and then acceptance. We think we're starting to get to this place where transaction volumes are down 70% year over year, which feels okay. But I think this time will be different. I think the correction in private valuations will be much quicker than what we've seen previously, maybe for one of the reasons you mentioned at the beginning, like the rise in financing costs. So I’m going to try not to get too wonky here...
Joe: (12:10)
Feel free to get wonky.
Rich: (12:18)
Here's a great stat for you: Since 1980 — prior to 2022 — there have been fewer than five months since 1980 where the 10-year Treasury was not lower a decade forward. That means, in January 1990, the 10-year Treasury rate was lower than where it was in January 1980. In January 2000, it was lower than where it was in January 1990.
There has been a secular decline in 10-year Treasury rates. Why does that matter? It matters because, as you correctly said, commercial real estate is an inherently leveraged asset class. There are very few owners of commercial real estate that buy a property without some amount of debt on it. So as there has been a secular decline in 10-year Treasury rates, and typically commercial real estate is financed with 10-year debt, you have always been able to refinance at lower and lower financing costs over time.
Usually, cap rates decline into a rising interest rate environment because historically, that rising interest rate environment is symptomatic of an improving economy at a time when financing costs are rolling down. So, levered returns expand, which allows cap rates to contract. This time is different because financing costs are significantly higher, not just because of the risk-free rate and widening credit spreads, but also because growth is slowing. We were in a stagflationary environment in 2022 that hasn't really existed since the 1970s. It's a much different ball game than what we've played before.
Tracy: (13:53)
Just to play devil's advocate, what does the maturity wall look like? Even though financing costs are going up, as long as the market remains open, you can still roll over your loan, presumably to infinity. Can people just keep rolling these over?
Rich: (14:22)
In theory, sure. There's about $4.5 trillion of mortgage debt outstanding, which means the loan-to-value (LTV) ratio is around 25% for commercial real estate. REIT LTVs are less than 30%, and the NCREIF ODCE index (high-quality core and core-plus properties) is around 22%. Smaller borrowers with less capital might push LTVs up to 50-60%, which you typically see in CMBS transactions.
About 15-20% of maturing debt is coming due each year over the next five years, with an average of $500 billion per year. Most of the debt coming due in 2023 were loans originated in 2013 or 2018. Property prices have risen since 2013, so the effective LTV is actually lower than 50-60% for those who originated a loan in 2022 when buying a property.
Even if valuations fall 10-30% next year, there's a good chance these loans are not underwater yet. This is not the case for office properties or malls. Malls' effective LTVs are around 90-95%, which is probably a good case study for where the office market is going. Office properties account for only about 25% of the 15-20% of maturing debt that's coming due.
Joe: (17:10)
Who holds that debt? Is it at banks or private funds?
Rich: (17:15)
The CMBS market is at best 20% of the lending market, so it's not the biggest part of it. The majority of the debt coming due is held on bank balance sheets. We think more than 50% of the debt coming due in 2023 is held on bank balance sheets. That makes sense because there wasn't much capital markets activity in 2013.
Joe: (17:59)
So if a bank originated a CMBS loan, there's a good chance it's still on their books.
Rich: (18:07)
There's a very good chance it's still on their books.
Tracy: (18:25)
Can you talk more about underwriting standards throughout the years? What have you seen and what deals could be problematic now?
Rich: (18:55)
There are two ways people think about underwriting standards. The first one is headline underwriting metrics, like loan-to-value (LTV), and the second one is all the other things lenders might require or not require to provide a loan to a borrower. LTVs are fairly conservative right now and were conservative heading into the pandemic, approaching around 50%. This might surprise people, as lending standards were tightening from a headline perspective.
In 2014-2015, banks were giving out a lot of money, prompting regulators to intervene and banks to tighten lending standards. This coincided with risk retention under Dodd-Frank being mandated, requiring CMBS issuers to have skin in the game. As a result, headline LTVs went down and debt service coverage ratios (DSCR) went up. However, interest-only (IO) loans became more prevalent, and reserves and other requirements were softer than in the past.
Joe: (20:52)
Were interest-only loans more prevalent pre-financial crisis?
Rich: (20:59)
Interest-only loans were pretty prevalent over the past couple of years. While hard LTVs and DSCR were pretty good, soft underwriting requirements were softer than they had been in the past.
Rich: (21:44)
After the financial crisis, banks shifted to underwriting based on debt yield (NOI divided by loan balance) rather than DSCR. Some loans with strong debt yields might have poor DSCR in the future given how much interest rates have risen. The biggest risk here is debt service coverage ratios. NOI debt yields could still be above 10% or 12% because NOI is strong right now, but a big shock to financing costs could significantly lower the debt service coverage ratio, requiring recapitalization.
Joe: (22:54)
Let's set aside office and troubled cities for a moment. Are there any other weak pockets in the market? We hear about certain categories of weakness, such as office buildings in New York. How do other categories fare?
Rich: (23:17)
The REIT market was down 25% in 2022, and all property types experienced some level of weakness to various degrees. However, NOI growth overall in 2022 was close to a historical high, at around 10% to 11% year over year. We are seeing deceleration, but the answer to your question is, not really.
Joe: (23:51)
But a lot of that was presumably about multiples, right?
Rich: (24:02)
Yes, but multiples are just a fancy way of saying valuation. If you take the inverse of the multiple, that's the cap rate.
Joe: (24:07)
So are there any other sectors that are clearly seeing poor revenues or poor rental, like an office landlord would?
Rich: (24:25)
Not really. If you think about NOI growth overall in 2022, at one point, it was around 10% to 11% year over year, which is close to a historical high. We are currently seeing deceleration, and we're underwriting even slower growth in 2023 due to potential recessionary headwinds. A lot of what's happening is related to refinancing risk, as valuations are lower and costs are higher. Office is an exception to the fundamental story, and many other asset classes are experiencing quite decent NOI growth.
There will be some multifamily properties purchased at tight cap rates that won't achieve their expected revenue growth. This will pressure valuations lower across property types and lead to higher distress and delinquencies. Office is the poster child for this, but commercial real estate fundamentals aren't as bad as office in general. Office is the exception, not the norm.
Tracy: (25:25)
Regarding refinancing risk, where does refinancing come from? Is the assumption that banks will pull back on it in the current environment?
Rich: (25:46)
Refinancing comes from banks, insurance companies, the CMBS market, debt funds, mortgage REITs, and GSEs for multifamily, student housing, and seniors housing. There is a wide variety of financing sources, with banks and insurance companies being the largest portions. People are focusing on the cost of financing side, as the risk-free rate has increased to around 3.5% to 3.6%, which is 200 basis points higher than a year ago.
Credit spreads are wider as well. The AAA CMBS market is pricing about 130 basis points over the 10-year Treasury, and BBB- market is north of 900. The good news is that the debt markets are pricing in these risks. A yield of nearly 12.5% to 13% is attractive given the risk of loss.
The availability of debt capital will probably not be as robust as it was in previous years. Well-qualified sponsors with good business plans can probably still get debt, even for office properties. However, with office properties, it's binary: You either get debt at attractive levels or you don't.
Joe: (28:08)
Why is that? Is it just norms or does it not make business sense to deal with marginal cases?
Rich: (28:18)
It's a combination of factors. Lenders need to ensure they're making a sound decision, and their primary focus is getting their money back. If they don't get their money back, it doesn't matter what the spread was.
Joe: (28:45)
Regarding New York office space, the market seems to indicate that valuations will be down substantially. What is the market saying about this type of property and the situation they face when refinancing?
Rich: (29:36)
We're cautious on office properties, and our listed portfolio has very little office exposure. The public markets are signaling that office valuations will be down significantly due to three reasons: uncertainty about NOI growth, refinancing risks, and potential recessionary headwinds.
Joe: (30:04)
This is your net operating income?
Rich: (30:08)
Yes, net operating income (NOI) is revenue minus expenses. It's uncertain where NOI is going, how much CapEx is needed to generate it, and what amount of debt can be obtained. NOI, CapEx, and financing determine the levered IRR, and cap rate is a product of that. The market is signaling that cap rates have to go substantially higher. The listed market, on average across property types, is trading at a high 5% implied cap rate, while the private market, as measured by the NCREIF ODCE Index, is still at 3.9. That's a significant difference between public and private values.
Joe: (30:57)
Sorry, say that again.
Rich: (30:58)
The listed market is at a high 5% cap rate. So, multiples, after taking into account CapEx in the REIT space, are around 18.5 times. There's a 200 basis point difference between where REITs are pricing cap rates and where the private market's pricing cap rates. We are more constructive on REITs because the entry points are attractive, but we still think private-market valuations will face headwinds in 2023. If you have new capital to invest in private, it's probably good to buy low and sell high.
Tracy: (32:02)
It seems like the wild card here is the availability of capital.
Rich: (32:12)
Absolutely. Commercial real estate is inherently a levered asset class, so financing cost and availability of capital are crucial. As the tide goes out, we'll see who can swim strongly against it.
Joe: (32:29)
Why can't it keep getting worse? Do you worry about higher rates for longer, or that offices won't bounce back soon? In distressed cities, distress can build upon distress. Do you worry about acceleration of headwinds?
Rich: (33:15)
If you had asked me a month ago, I would have said the biggest risk was a stronger economy leading to higher inflation, which would force the Fed to take more action. If the terminal rate is closer to six or six and a half, the ten-year Treasury rates should probably be higher than 3.5%. Real rates, the difference between nominal rates and inflation expectations, are what drive commercial real estate valuations. If real rates are around one, that's good for real estate, but closer to two isn't favorable. That keeps me up at night.
We thought we were transitioning from a stagflationary to a stagnation market. Stagflation is when interest rates are rising, and growth is slowing. The Fed was in an awkward position in 2022 and had to raise interest rates to slow growth and tame inflation. We think we're moving into a stagnation environment, where interest rates come down, and growth slows. It's good for listed markets but not so great for private markets. The best-case scenario is that the Fed's medicine works, inflation slows, and they don't have to cut interest rates. The market pricing in six interest-rate cuts over the next 18 months is concerning, as it usually signals something bad is happening.
We still think we're moving into a stagnation environment, where interest rates come down and growth slows. This is good for listed markets but not as great for private markets. The best-case scenario is that the Fed's actions work, inflation slows, and they stop raising rates without having to cut interest rates. The market pricing in six interest rate cuts over the next 18 months is concerning, as it usually signals something bad is happening.
We thought we were in a not-too-hot, not-too-cold environment. The unintended consequence of these bank failures might show that the Fed's interest-rate hikes are finally working. It's the two extremes that keep me up at night: a much hotter and stronger economy where interest rates have to go higher, and a pretty hard recession.
Tracy: (36:14)
Could you have a situation where a lot of these offices get converted to residential properties, and what would that mean for commercial real estate investors and lenders in general?
Rich: (36:55)
We don't have enough housing in the United States. The highest and best use for many office properties may not be office, and in places like New York City, there's a significant shortage of affordable housing. Converting offices to multifamily makes sense, but it's much easier said than done due to various reasons, including zoning. Different municipalities have different zoning laws, and you have to go through rezoning. There are one-off examples where it can be done, but it's not a cure for everything.
Tracy: (38:16)
Alright, Rich, we're going to leave it there. You provided a great overview of the space, and you were excellent at walking us through the nuances of different sub-sectors and different ways of looking at prices and valuations at the moment. Thank you so much.
Rich: (38:31)
Sure. Thanks for having me again. That was great.
Tracy: (38:47)
Joe, I thought Rich's walkthrough of the different parts was really good. For me, the most salient thing is the discrepancy between public and private valuations at the moment. We've seen many mortgage rates collapse in recent months, but we haven't seen the same pressures on the private side, which isn't as transparent.
Joe: (39:14)
Right, if you look at some of the stocks like Vornado or SL Green, they're dismal, below the COVID lows when people were talking about no one ever going into an office again. The public market has clearly given a very grim assessment.
Tracy: (39:41)
The definition of commercial real estate as a leveraged bet on interest rates and the availability of capital is a good way to frame it going forward. There were already concerns about CRE before the recent events and the collapse of Silicon Valley Bank. It's going to be interesting to see how this financial crisis shakes out. If it leads to the Fed cutting interest rates, it might be better from a pure financing cost perspective. However, as Rich pointed out, it would mean something bad is going on in the economy and there would probably be less risk appetite in general.
Joe: (40:27)
Right, the same intuition with stocks is that if the Fed is cutting rates, it's probably at a time when revenues and net incomes are coming down. It often goes hand in hand. So, it might seem bullish, but the question is whether elevated rates will stay elevated for years or keep getting elevated. We don't really know for sure. It's easy for us in New York to think that all commercial real estate is just a few half-empty buildings, but there are also data centers and assisted-living spaces, among other categories.
Tracy: (41:37)
It's crazy to think that with the pace of interest-rate hikes last year, commercial property prices still went up overall. That's because it's not a monolithic sector and not just massive office buildings in Manhattan. I'm sure we'll end up talking more about this topic, but for now, shall we leave it there?
Joe: (42:01)
Let's leave it there.