Ultimate Resource For What’s Taking Place In The Commercial Real Estate Sector

Storied real-estate investor is focusing on more mainstream deals, a strategy reflecting the dearth of distressed properties. Ultimate Resource For What’s Taking Place In The Commercial Real Estate Sector

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And indeed there has been a lot of talk lately about “office-to-resi” conversions.

So what does it take? In this podcast, we speak with Joey Chilelli, managing director at the Vanbarton Group, a firm that’s been involved with these projects for a decade and long before the pandemic upended both real estate markets. We discuss the challenges involved in actually pulling off these complex projects.

No Grave Dancing For Sam Zell Now. He’s Paying Up For Hot Properties

Sam Zell, who made a fortune buying distressed commercial properties, isn’t finding many bargains these days.

Instead, the storied real-estate investor is doing something he usually avoids: following the pack and spending big on something safer.

His most notable real estate deal during the coronavirus pandemic period came last month, when one of his companies agreed to pay about $3.4 billion for Monmouth Real Estate Investment Corp. Far from a hobbled company in distress, Monmouth owns 120 industrial properties in 31 states. The sector is one of the most profitable because of high demand for fulfillment centers from e-commerce companies such as Amazon.com Inc.

Mr. Zell also wasn’t able to drive as hard a bargain as he had in many previous distressed deals. The all-stock deal reached in May is valued at more than $18 a share, a near-record for Monmouth stock. He could conceivably have to pay even more, since Blackwells Capital, which made an $18-a-share all-cash bid late last year, said it is weighing options including a higher offer.

Mr. Zell declined to comment. But the 79 year-old’s more conventional investment strategy is the latest sign that the pandemic hasn’t produced the distressed opportunities many investors expected.

Hotels, malls and other properties have suffered enormous declines in revenue. But few owners have been forced to sell at steep discounts thanks to government stimulus programs and the Federal Reserve’s easy money policy which kept a lid on foreclosure.

“From both a monetary and fiscal perspective, authorities have made sure that distress would be extremely limited in all walks of life,” said Cedrik Lachance, Green Street Advisors’ head of global REIT research.

Meanwhile, the popularity of online shopping and remote working during the pandemic raised big questions over when or if office buildings, malls and other property types would ever rebound. That has greatly increased the risk of buying such real estate at what might seem to be an attractive price.

Mr. Zell is known in the industry as the “grave dancer” for his ability to pick up wounded real estate for cheap prices, and then selling them years later at a big profit. He purchased dozens of foreclosed office buildings in the 1990s at steep discounts. He eventually sold most of them through his $39-billion Equity Office Properties deal in 2007.

Yet on a recent conference call, Mr. Zell described retail real estate as a “falling knife”—investors who think they are getting a bargain might end up getting bloody themselves. Prices haven’t fallen enough in the sectors that are getting beaten up, he said.

“There obviously is going to be an opportunity in retail. I just don’t think it’s here yet,” he said. He added that hotels also look expensive: “I can’t relate…pricing to the way I see opportunity.”

Mr. Zell owns a range of real estate through private and publicly traded companies as well as other businesses. His largest real estate holdings include his stakes in Equity Residential, which owns nearly 80,000 apartments, and Equity LifeStyle Properties Inc., one of the country’s largest investors in manufactured homes. Neither of these two companies made major acquisitions or dispositions during the pandemic.

His firm Equity Commonwealth, which has agreed to buy Monmouth, was formed after a group including Mr. Zell seized control of an office building company named CommonWealth REIT in 2014 by ousting its board in an unusual proxy battle.

The new board raised cash by selling most of its assets, recognizing that private investors were paying more for office buildings than their public market valuations.

The strategy was applauded by analysts. “Normally companies sell a couple of buildings and give themselves a pat on the back,” Mr. Lachance said. “These guys just kept going.”

Mr. Zell’s goal was always to reinvest that cash. “What it tells you about the Covid era is that they just couldn’t find true distress,” Mr. Lachance said.

The $10 Billion Bright Spot In The Battered World of Office Real Estate

Blackstone, KKR and other investors are betting on laboratory space as vaccines fuel the economic rebound.

Even as the remote-work era clouds the future for offices, one segment of the business is drawing cash from investors including Blackstone Group Inc. and KKR & Co.

More than $10 billion has gone toward buying buildings used for life sciences and other research this year, according to Real Capital Analytics Inc. That accounted for approximately 4% of all global commercial real estate transactions through May, double the share from last year.

That estimate doesn’t count new construction, and fresh buildings are breaking ground in U.S. cities including Boston, San Diego and San Francisco — many without having signed major tenants. Unlike workers in conventional offices, many scientists don’t work remotely. And as vaccines help fuel the economic rebound, funding for medical innovations is expected to drive the need for more space, particularly in the U.S. and U.K.

“The pandemic only amplified the demand growth, but it’s a trend we think will continue for years,” Nadeem Meghji, Blackstone’s head of real estate Americas, said in an interview. “This is about, broadly, advances in drug discovery, advances in biology and a greater need given an aging population.”

Last year, as social-distancing emptied out office buildings and damped investor interest in malls and hotels, life science building sales and refinancing totaled about $25 billion, up from roughly $9 billion in 2019, according to Eastdil Secured.

Blackstone, a veteran investor in the sector, booked a $6.5 billion profit from refinancing BioMed Realty Trust, the largest private owner of life-science office buildings in the U.S. It also agreed in December to buy a portfolio of lab buildings for $3.4 billion.

KKR paid about $1.1 billion in March for a San Francisco office complex it plans to repurpose for life science tenants. DropBox Inc. had rented the entire site in 2017, but gave up the space so employees could work remotely. In one high-profile U.K. example, a science campus is planned for a Canary Wharf site once slated as the London headquarters for Deutsche Bank AG.

Overall, the U.K. life sciences market saw a 166% increase in the volume of transactions in the last three years, according to real-estate services firm Jones Lang LaSalle Inc.

Even before the pandemic, life science property was on the upswing. Over the last five years, asking rents for such space soared 90% in the San Francisco Bay Area compared with 20% for conventional office space, according to commercial property brokerage Newmark. In Boston, which along with nearby Cambridge is an epicenter of the industry in the U.S., asking rents climbed three times as fast.

Labs Lead

Life sciences specialist Alexandria out-gained office REITs through Covid-19.

Investors see the higher rents translating into higher property values, which explains why construction projects are moving ahead without tenants lined up. Among the biggest spec builders is IQHQ, a startup that raised $2.6 billion last year to develop laboratory buildings that are breaking ground without signed leases.

In April, the firm launched construction of Fenway Center, a $1 billion complex on a platform above Boston’s Interstate 90 with a rooftop view of the famed Red Sox ballpark. The firm isn’t concerned about filling up the space, according President Tracy Murphy.

“We build spec, but we don’t build blind,” Murphy said in an interview from San Diego, where her firm is pouring concrete for a 1.6 million-square-foot waterfront lab complex. “I don’t see any end in sight for money coming in.”

Harrison Street, a Chicago-based alternative real asset investor, has about $2.6 billion invested in lab properties and wants to double that over the next 24 months, Chief Executive Officer Christopher Merrill said in an interview. Alexandria Real Estate Equities Inc., the largest life sciences real estate investment trust, also has big expansion plans.

In January, it paid $1.5 billion for a project in Boston’s Fenway neighborhood. The company has 4 million square feet of space under construction — about 1 million of which still hasn’t been leased.

As investors clamor to break ground, there’s a risk of an oversupply of space, said Jeffrey Langbaum, an analyst with Bloomberg Intelligence. Another hazard for developers is that lab space construction can cost as much as 15% more than conventional offices. Science buildings require stronger structures and higher ceilings to accommodate features such as enhanced air filtration. That limits potential other uses for the property if health-industry tenants don’t materialize.

Lab buildings are trading for capitalization rates, a measure of returns for investors, of less than 4%, which is lower than apartment buildings or industrial properties. There’s been cap rate “compression” over the last year amid a surge in investor capital flowing into the sector, according to Sarah Lagosh, managing director in the Boston office of Eastdil.

The recovery of traditional offices is expected to take time as companies call employees back over the next few months. Even then, many firms have said they’ll let people stay home at least part of the time. That’s raised concerns about the future of downtown skyscrapers, while Covid-19 has added to the momentum for life sciences properties.

“The pandemic has pushed life sciences into warp speed,” said Jonathan Varholak, who runs the life sciences team in the Boston office of the real estate firm CBRE. “You can’t do chemistry from home.”

Updated: 6-29-2021

How A SoftBank-Backed Construction Startup Burned Through $3 Billion

Katerra’s downfall shows how Silicon Valley’s strategy of growth at any cost can backfire in complicated industries like real estate.

Venture-backed startup Katerra Inc. aimed to revolutionize the construction business by mastering every element of the trade at once. Instead, its June bankruptcy filing made clear just how difficult it is for Silicon Valley to disrupt this complex industry.

The firm’s downfall wiped out nearly $3 billion of investor money, making it one of the best-funded U.S. startups ever to go bankrupt. Katerra thought it could save time and money by bringing every step of the construction process in-house—from manufacturing windows to factory-built walls to making its own lightbulbs.

It sold the idea to a deep-pocketed roster of financial backers, including SoftBank Group Corp. , Soros Fund Management LLC and the Canada Pension Plan Investment Board. At its peak, the company was valued at nearly $6 billion.

But Katerra never managed to do very well at all the aspects of construction it hoped to master, former employees say, leaving some of them exasperated at its recent demise.

“You guys had the golden goose, you had all that money from SoftBank and at the end of the day it was all pissed away,” said Chris Severson, a former construction-cost estimator at Katerra.

Katerra’s failure is the latest sign that the hypergrowth strategy employed by social media and software companies faces challenges in complicated, slower-moving industries like real estate.

Its bankruptcy also highlights the difficulty of modernizing construction, which accounts for around 4% of U.S. gross domestic product but still operates largely the way it did 100 years ago.

The company is in the process of crafting a restructuring through a chapter 11 bankruptcy process—one that involves selling some assets and keeping its international operations, a Katerra spokesman said.

The Menlo Park, Calif.-based company was co-founded in 2015 by a group of entrepreneurs including Chief Executive Michael Marks, the former CEO of electronics manufacturer Flextronics International Ltd.

Katerra’s strategy was to bring the electronics industry’s end-to-end manufacturing process to the construction business. The firm would buy materials and fixtures like sinks and faucets in bulk, skipping the middlemen and selling them directly to general contractors. When the company found general contractors were reluctant to use their products, Katerra took on that role, too.

Properties would be built with assembly-line-made parts in its own factories and shipped to sites managed by its in-house construction business. Katerra would then turn them into apartments, hotels or offices designed by its architects, all with the help of its in-house software.

This would streamline the process and enable an apartment building to be built in as few as 30 days, slicing off many months that the process would take through traditional construction.

Katerra managed to succeed with some of this top-to-bottom process, but few developers were interested in everything Katerra offered.

Still, as Katerra’s business model became more complex, it found a new backer in SoftBank. With the help of the Japanese conglomerate’s nearly $2 billion investment, Katerra bought general contractors across the U.S. and a building-parts manufacturer in India.

It was further aided by $440 million in debt from Greensill Capital, a SoftBank-backed lender that tumbled into insolvency in March. Eyeing international expansion, Katerra signed a contract to build thousands of homes in Saudi Arabia.

“Everyone’s so excited about the mission that everybody just says yes to everything,” recalled Erica Storck, one of the company’s first employees. ‘It gets out of control.”

In its race to boost revenue, Katerra agreed to build properties before it had figured out how to mass-produce building parts and get them to its projects cheaply and quickly enough to make the model work, say former employees, customers and investors. Architects designed buildings with parts from Katerra’s factories, only to learn that the parts wouldn’t be ready. Losses on projects piled up.

The company often signed contracts with prices based on rosy projections and then turned to its in-house team of estimators to figure out how much it would actually cost. Often there was a gap of millions of dollars, said Mr. Severson, the former Katerra estimator.

“We just beat our heads against the wall going: ‘No you can’t, it’s not possible,” Mr. Severson recalled. In one case, the company briefly considered leaving air-conditioning units out of a California student-housing development to make the numbers work, he said.

When architects and engineers raised concerns, Katerra executives would at times hold up an iPhone, telling the skeptical workers that if it could be done for phones, it could be done for apartments, a former employee said.

Rather than mass-produce a single type of building, Katerra built offices, hotels, single-family homes and apartment buildings of varying heights. That made it much harder to mass-produce prefabricated parts in factories and reduce costs because a wall panel designed for a three-story apartment building didn’t work for a 10-story building, former employees said.

The contractors it acquired also often balked at buying parts from Katerra, preferring their old subcontractors and suppliers, these people said.

By early 2020, the company was in danger of running out of money. Mr. Marks’s solution was to go even bigger. To realize his seamless vision, he believed Katerra needed to also be a developer that would own stakes in the real-estate projects it built and get a cut of their profits. That, he said, was where the real money was, former employees recalled.

The company’s board, though, ousted him early last year. His successor, the former oil-field-services executive Paal Kibsgaard, cut costs in part by shrinking the company’s research and design and manufacturing divisions. The cuts came too late, and Katerra filed for bankruptcy protection on June 6.

Former employees said they still believe in the idea of a vertically integrated, automated construction company. Multiple former executives said they believe cost overruns on early projects obscured more recent progress elsewhere in the business, and Katerra could have been profitable if it pivoted to more development and stayed focused on growth.

Still, many in the industry think a more focused approach is better.

“The problem’s not money,” said Gerry McCaughey, whose Entekra LLC makes factory-built wood frames for houses. “They were trying to go end-to-end on everything—and that’s what failed.”

Updated: 8-16-2021

Billionaire N.Y. ‘Bottom Feeder’ Buys Malls As Others Run Away

Igal Namdar has made a fortune buying shopping malls no one else wants.

He scoops up struggling centers at bargain-basement prices after their landlords lose faith, betting he can turn a profit before the last tenants turn out the lights. So far, that strategy has netted big gains — as well as lawsuits accusing Namdar of allowing his real estate to slide into disrepair.

In building an empire of 268 properties in 35 U.S. states — most prominently aging malls in small cities — Namdar has accumulated a personal net worth of about $2 billion, according to the Bloomberg Billionaires Index.

The pandemic accelerated Americans’ years-long shift to e-commerce, forcing many already-ailing department stores and apparel shops to go dark. Landlords that own lower-end malls — with high proportions of tenants that have fallen behind on rents or shuttered stores — have been hit especially hard.

For Namdar, that smells like opportunity. He expects a flurry of deals in 2022 as more owners of troubled retail properties head for the exits.

“Any seller of retail — malls or open air — any size of portfolio, we’re there,” Namdar, 51, said in an interview from his headquarters in Great Neck, New York. “We can close immediately, as is, where it is, with no due diligence.”

The formula for Namdar Realty Group and partner firm Mason Asset Management is to recruit down-market retailers to fill vacancies while holding down costs by limiting debt and capital-improvement spending.

“They’ve been a bottom feeder, historically, buying on the cheap, for pennies on the dollar and making a go of it,” said Jim Costello, senior vice president at Real Capital Analytics Inc. “It’s not the high end of the market, but it’s solid retail if you can set it up right.”

Real Capital tracks 134 of the Namdar Realty Group’s properties and estimates that portfolio is worth about $2.7 billion.

Namdar declined to comment on the value of the properties his company owns, or his personal wealth, but said the figures Bloomberg is reporting are inaccurate.

Plunging Values

U.S. mall values have plunged 46% from their 2017 peak, including an 18% drop since the Covid-19 pandemic started, according to real estate information service Green Street. Declines have been fastest among B and C-rated malls like Namdar’s, where sales per square foot average a few hundred dollars.

Namdar’s bet is that he can pay a small enough price to outrun the decline. He said he sees value in the properties as malls, where other investors in the market are more interested in redeveloping them for other uses.

“It’s all about the cost basis,” said Cedrik Lachance, director of research at Green Street. “If you’re buying to harvest cash and not reinvest, it will work.”

Some of the biggest landlords, including Simon Property Group Inc. and Brookfield Asset Management Inc., have walked away from centers where values slumped below the property’s debt. Other companies — Washington Prime Group Inc., CBL & Associates Properties Inc. and Pennsylvania Real Estate Investment Trust — filed for bankruptcy, raising the potential for massive portfolios to come up for sale.

Namdar and Mason have averaged 20 acquisitions annually over the past decade, but could swallow 100 at a time if the right deal came along, Namdar said, declining to provide details on how much money they plan to spend.

Mason President Elliot Nassim, 40, whose cousin married Namdar, focuses on leasing and redevelopment while Namdar oversees property management.

Namdar and Nassim make no pretense of catering to luxury consumers. They say they charge affordable rents so stores such as Claire’s, Lids and Piercing Pagoda can fill vacancies.

One center, the Eastdale Mall in Montgomery, Alabama, is now 100% leased, up from 70% when it was purchased in January 2020 for $24 million.

“Is it where my wife would shop?” Nassim said about their properties. “It’s a different market.”

Buyer Lawsuit

Their first purchase, in 2012, was the DeSoto Square Mall in Bradenton, Florida, after Simon defaulted on the debt. They sold it in 2016 for $25.5 million to ML Estate Holdings LLC, which sued two years later, contending the property had lower revenue and higher costs than represented.

“Namdar’s approach to its real estate business generally is to purchase marginally performing properties, drain them of cash and operating funds, and then sell them,” the lawsuit in New York Supreme Court in Brooklyn alleged.

DeSoto Square closed permanently in April, according to local news reports. Meyer Silber, an attorney for ML Estate, declined to comment.

Namdar has also been sued by retailers, including International Decor Outlet, which in 2017 accused the landlord of contract breaches such as malfunctioning air conditioning, substandard repairs and inadequate security at the Regency Square Mall in Jacksonville, Florida.

“Landlord is an absentee landlord with a reputation as a ‘slumlord,’” the complaint in Duval County Circuit court alleged.

At the same property, Impact Church of Jacksonville accused managers of avoiding upkeep, making the “building look abandoned.” Impact paid $7.4 million in 2016 to buy a former Belk department store on the site, where it now runs a school as well as a church. The price was more than half the $13 million Namdar paid for the entire mall, which names 46 other tenants on its website.

Namdar declined to discuss individual cases but said such complaints are rare.

“There were factors that led to this, such as not having the rent to pay,” he said. “Properties that are marked for redevelopment are few and far between, so we maintain our assets.”

In addition to buying properties, the company has acquired potential tenants. Last year, Namdar and Mason paid $12 million to buy cinema chain Goodrich Quality Theaters Inc. out of bankruptcy. They also invested in the furniture chain formerly known as Jennifer Convertibles.

Among recent mall deals was the $10.3 million purchase in April of Marketplace at Brown Deer outside Milwaukee, valued at $45 million in 2005, according to loan documents and an announcement by the seller, Retail Value.

“We’d like to improve our quality but we’re not going to pay a crazy premium for an A-mall,” Namdar said. “Our goal is to stick to those B and B-plus assets. Those A’s get to be too crazy. The Ferraris of the world — that’s not the kind of car we’re looking for.”

Updated: 9-8-2021

Bill Gates Takes Control Of Four Seasons In Deal With Saudi Prince Alwaleed

Bill Gates will take control of the Four Seasons hotel chain after his investment firm agreed to acquire a stake from Saudi Prince Alwaleed bin Talal’s Kingdom Holding Co., in a bet that luxury travel will rebound from a pandemic-induced slump.

Gates’s Cascade Investment LLC will pay $2.2 billion in cash to boost its stake in Four Seasons Holdings to 71.25% from 47.5%, according to a statement Wednesday.

The lodging industry has been hobbled by a drastic slowdown in global travel as the world struggles to halt the spread of Covid-19. Vaccination campaigns helped fuel a lodging rebound led by leisure travelers, but luxury hotels are still lagging behind lower-quality properties, according to data from STR.

Gates, 65, and Alwaleed, 66, have known each other for decades. In 2017, the Microsoft Corp. co-founder described the prince as an “important partner” in their charitable work, and he was one of a few Western executives to voice support for Alwaleed after he was detained and accused of corruption by Crown Prince Mohammed Bin Salman.

Four Seasons shareholders took the company private in 2007, when it managed 74 hotels, with Gates and Alwaleed leading the deal. The new owners expanded the company’s footprint to more markets in a bid to capitalize on what was then a booming market for luxury travel.

The chain now manages 121 hotels and resorts, and 46 residential properties, and has more than 50 projects under development, according to the statement. Its landmark Kingdom Tower in Riyadh is among the two dozen hotels it owns across the Middle East and Africa. That property is popular among the consultants and bankers who commute from nearby Dubai and have helped transform Saudi Arabia’s economy.

It has also expanded efforts to attach its brand to luxury homes, as real estate developers realized that affluent buyers would pay more to live in a condominium or residential community associated with the hotel brand.

Kingdom Holding, which will retain 23.75% of the hotel chain, plans to use proceeds from the transaction for investments and to repay debt. Four Seasons Chairman Isadore Sharp, who founded the company in 1960, will keep his 5% stake. The deal is expected to be completed in January.

‘Confirmed Understanding’

Alwaleed has made a series of deals since he reached a “confirmed understanding” to secure his release from detention in 2018. Shortly after, he invested about $270 million in music streaming service Deezer. In February, he sold a stake in his Rotana Music label to Warner Music Group Corp.

Cascade, which is run by Gates’s money manager, Michael Larson, first invested in Four Seasons in 1997, when it was publicly traded. The investment firm also manages the endowment of the Bill and Melinda Gates Foundation.

Gates and Melinda French Gates ended their 27-year marriage last month. He has a net worth of $152.2 billion, according to the Bloomberg Billionaires Index, and she has received almost $6 billion of shares in public companies, filings show. More precise details of how the ex-couple’s fortune is being split remain confidential.

Alwaleed’s wealth has been almost cut in half since 2014 and now stands at $18.4 billion. In an earlier interview, he attributed the decline to a slump in Kingdom Holding’s shares and not because of any agreement or settlement he made during his detention. About half of the prince’s wealth is tied to shares in the holding company, in which he owns a 95% stake.

Alwaleed’s holdings include shares of Citigroup Inc., ride-hailing firm Lyft Inc. and Accor SA.

His investment company reported a loss last year of 1.47 billion riyals ($392 million). The value of his other holdings — including Saudi real estate, public and private equities, jewelry and a superyacht — helped mitigate some of the losses, according to figures previously provided by the firm.

Shares of Kingdom Holding rose 1.1% on Wednesday, giving it a market value of almost 40 billion riyals.

Updated: 9-14-2021

Pimco Sets Its Sights On Commercial Real Estate

As the Covid-19 pandemic reduces property values, the bond investor pursues higher yields by acquiring hotels and office buildings.

Pimco, one of the world’s largest fixed-income investors, has been ramping up its commercial real-estate holdings at the same time that historically low interest rates have undercut bond returns.

The firm, which is officially known as Pacific Investment Management Co. and has $2.2 trillion under management, has been seeking higher yields than those offered by investment-grade corporate bonds by buying hotels, office buildings and other property types that have lost value during the Covid-19 pandemic.

Pimco also has become more active because last year its parent, German insurer Allianz SE, put the firm based in Newport Beach, Calif., in charge of managing its Allianz Real Estate investment business. Between its own investments and those made by Allianz, Pimco acquired $12 billion in private commercial property between January 2020 and June 2021, the firm said.

The combined Pimco and Allianz real-estate business also originated or invested in $7 billion in real-estate loans during that time, a Pimco spokeswoman said.

In its biggest real-estate investment during the pandemic, Pimco agreed this month to pay $3.9 billion for Columbia Property Trust, a real-estate investment trust that owns a portfolio of office buildings in New York City, Washington, D.C., Boston and San Francisco. The purchase, subject to Columbia shareholder approval, would be the first acquisition of a pure office real-estate investment trust since 2019, according to Thomas Catherwood, an analyst with BTIG LLC.

Columbia owns 6.2 million square feet of space mostly in decades-old downtown office buildings, such as the former New York Times headquarters and 315 Park Avenue South in Manhattan.

The big bond manager’s recent property-buying spree stands in contrast to many dedicated real-estate investment funds and private-equity firms, which have mostly held on to money raised for distressed sales in hopes that prices might fall further.

In the early months of the pandemic, Pimco was the rare active competitor in the distressed public-securities market. The firm invested $1 billion in shares of real-estate investment trusts and commercial mortgage-backed securities. Pimco also was active last year restructuring properties as a lender, taking advantage of the retreat from the market of traditional lenders.

More recently, Pimco has been one of the first investors to begin buying downtown hotels. That sector has been slower to rebound than resort hotels because business travel has yet to make a big comeback.

Pimco’s recent hotel deals have included the W Washington D.C. hotel, which the firm agreed to buy for more than $200 million. The firm plans to rebrand the property, which opened in 1917 and offers views of the White House from its rooftop, as an independent hotel.

Pimco has been more optimistic than many other investors in the office sector. Some investors are steering clear of these buildings because the success of remote work has raised questions about whether office demand will ever return to previous levels.

But Pimco is bullish on well-located offices in major markets, as well as those “in high-growth markets like the Southeast that benefit from population migration,” the spokeswoman said.

By being a contrarian, Pimco is able to buy office buildings for lower prices. Pimco’s purchase of Columbia Property Trust amounted to $19.30 a share, or 20 cents below what an investment group led by Arkhouse Partners and the Sapir Organization offered in March. The price dropped as Covid-19’s Delta variant spread around the U.S.

“As recently as June, when vaccinations were going up and case counts were going down, there was a little more optimism,” said John Kim, analyst at BMO Capital Markets Corp. “But since Delta spread out, office REITs started to fall with the delay of return to office.”

Updated: 9-14-2021

Distressed Retail Debt Pile Collapses

Distressed debt tied to retail enterprises is putting on something of a vanishing act.

The overall amount of tradeable troubled debt has shrunk from near $1 trillion in March of last year to less than $60 billion as of September 10, data compiled by Bloomberg show. And the portion of that from the retail industry has collapsed at an even faster clip.

In late March 2020, about $60 billion of distressed bonds and loans could be traced to the retail industry, data compiled by Bloomberg show. That pile stands at some $1.1 billion now, representing about a 98% decline.

The retail industry has been in a tailspin for years, with brick-and-mortar sellers decimated by shifting consumer preferences and booming online rivals. The Covid-19 pandemic quickly made matters worse: lockdowns sent dozens of hobbled retailers into Chapter 11 bankruptcy, including the likes of J.C. Penney Co. and Brooks Brothers Group Inc.

Since then, a number of once-troubled retail giants have slashed their debt in bankruptcy, cut their store count or tapped wide-open credit markets to resolve immediate liquidity issues. Plus, massive government spending and a resurgent economy have helped troubled businesses more broadly.

“The pandemic accelerated restructuring plans for the weakest players, while the recovery narrative and, to no small extent, retail traders, facilitated a strong rebound for most survivors,” said Noel Hebert, director of credit research at Bloomberg Intelligence.

Elsewhere

So far this year, 95 companies with at least $50 million of liabilities have filed for bankruptcy in the U.S., according to data compiled by Bloomberg. That’s about half the pace seen last year, but still higher than the 10-year average of 93 filings as of September 13.

The total amount of traded distressed bonds and loans fell 6.9% week-over-week to $56.9 billion as of September 10, data compiled by Bloomberg show. The amount of traded distressed bonds dropped 3.9% week-on-week, while distressed loans slipped 14.6%.

There were 174 distressed bonds from 97 issuers trading as of Monday, down from 175 bonds and up from 94 issuers about one week earlier, according to Trace data.

Diamond Sports Group LLC had the most distressed debt of issuers that hadn’t filed for bankruptcy as of September 10, data compiled by Bloomberg show. Its parent company, Sinclair Broadcast Group Inc., said in a March filing that it expects Diamond to have enough cash for the next 12 months if the pandemic doesn’t get worse.

Updated: 9-24-2021

Home Builders Might Be A Home Run Once Supply Woes Ease

Lumber prices drop, but materials and labor hold back supply and send U.S. new home prices higher.

If only lumber had been all that was keeping home builders from selling more homes.

The Commerce Department on Friday reported that 740,000 new homes were sold in August, at a seasonally adjusted, annual rate. That was above July’s 729,000 but is nothing close to the 977,000 homes sold in August of last year.

The continuing problem is that builders have struggled to meet the increase in demand for homes that the pandemic helped set off. That struggle has been compounded by their difficulties obtaining materials and labor. Many builders have delayed putting homes on the market to bring their inventory levels back in balance with demand and taken other actions such as limiting how much buyers can customize homes.

One of the first indications of how severe builders’ supply-chain problems were came when framing-lumber prices began shooting higher last year. But many problems affecting lumber supplies have since been ironed out, and framing-lumber futures prices are now down over 60% from their May high. Yet there is a lot more that goes into building a house than lumber, and builders are dealing with myriad other materials that are in short supply, from garage doors to vinyl siding.

On Monday, Lennar said that in its fiscal quarter ended August 31 that it delivered fewer homes than it expected, blaming “unprecedented supply chain challenges.” Also on Monday, D.R. Horton said that it expects to close on fewer homes in its fiscal quarter ending this month than it earlier thought. It, too, cited supply-chain issues, as well as difficulties finding workers. KB Home on Wednesday reported fiscal third-quarter home deliveries that fell short of expectations and said that disruptions to its supply chain had intensified as the quarter progressed.

Even so, this is an especially profitable time to be a home builder. The Commerce Department reported the median price for a new home in August was $390,900, versus $325,500 a year earlier, and the drop in lumber prices is now providing them with a boost. D.R. Horton said that it expects the gross margin on its home sales in the current quarter to be 26.5% to 26.8%, for example, compared with its previous forecast of 26.0% to 26.3%.

It would be nice to have some assurances on when builders’ supply-chain woes will be worked out, but so far—and understandably given how uncertain the environment is—they aren’t giving them. If and when they are able to build enough houses to meet demand, they could be rolling in money.

Updated: 9-28-2021

Big Tech Companies Amass Property Holdings During Covid-19 Pandemic

Google, Amazon and Facebook acquire offices and retail space, helping prop up commercial real-estate markets.

The biggest U.S. companies are sitting on record piles of cash. They are getting paid next to nothing for holding it, and they are running out of ways to spend it.

So they are buying a lot of commercial real estate.

Google’s announcement last week that it would purchase a Manhattan office building for $2.1 billion is the latest in a string of blockbuster corporate real-estate deals since the start of the pandemic. Amazon.com Inc. last year paid $978 million for the former Lord & Taylor department store in Manhattan. Facebook Inc. bought an office campus in Bellevue, Wash., for $368 million.

Overall, publicly traded U.S. companies own land and buildings valued at $1.64 trillion, according to S&P Global Market Intelligence. That is up 38% from 10 years ago, and the highest for at least the past 10 years, according to S&P.

Retailers such as Walmart Inc. and restaurant chains such as McDonald’s Corp. have long been major property owners of their own stores. Big technology companies are now joining them, scooping up offices, data centers, warehouses and even retail space.

Buying real estate is a way for these companies to avoid sometimes pricey and cumbersome leases, because they often occupy these buildings and become their own landlords. These usually modern or renovated and sometimes custom-built properties are the kind of buildings that have appreciated in value over the years. But owning real estate also puts companies at risk of losses if urban property values fall.

For now, the corporate buying spree is helping prop up commercial real-estate markets at the same time many investors are shying away from office and retail buildings amid rising vacancy rates.

Many private-equity and real-estate funds have also raised hoards of cash, but for the most part they have been reluctant to spend during the pandemic in hopes that prices could fall further. And unlike real-estate investment firms, big corporations often buy their buildings without taking out mortgages, allowing them to spend more of their money and to close on deals more quickly.

A number of factors have converged to unleash the buying spree. For one, firms have more money to purchase real estate. Big, profitable companies that dominate their industries have grown even bigger, allowing them to accumulate more cash.

More recently, uncertainty over how much Covid-19 will harm the economy has prompted more companies to hoard cash, said Kristine Hankins, a professor of finance at the University of Kentucky.

U.S. publicly traded companies hold $2.7 trillion in cash, cash equivalents and short-term investments, not counting real-estate and financial companies, according to S&P Global. That is up more than 90% from the fourth quarter of 2011.

Interest rates are hovering around their all-time lows, so companies can get higher returns buying real estate than by keeping their money in low-risk bonds or other public securities, said Brian Kingston, chief executive of real estate at Brookfield Asset Management.

“That cash is just sitting there in a not particularly productive way,” he said.

Office prices, meanwhile, have fallen in Manhattan, San Francisco, Chicago and other big cities during the pandemic, making investing in this real estate cheaper than it was 18 months ago, investors say.

Google and its deep cash coffers have set it apart from most every other company in terms of an increasing appetite for real estate. Alphabet Inc., Google’s parent, held $135.9 billion in cash, cash equivalents and short-term investments as of the second quarter of 2021, more than any other publicly traded company, not counting financial and real-estate firms, according to S&P Global.

Alphabet is now one of the biggest real-estate owners in New York City and the U.S. It held $49.7 billion worth of land and buildings as of 2020, up from $5.2 billion in 2011.

Google buys real estate because it wants to control the buildings it occupies, for example to make changes without having to get a landlord’s permission, said the company’s director of public policy and government affairs, William Floyd.

Amazon, which owns a lot of warehouses, held $57.3 billion worth of land and buildings—more than any other U.S. public company except Walmart. The online retailer doesn’t care whether it buys or leases as long as the building is right, according to the company’s vice president of real estate and global facilities, John Schoettler.

“We’re really agnostic about it,” he told The Wall Street Journal last fall.

The Beauty of Buying A Ski Home In Idaho? Nobody Knows A Thing About It

Not typically regarded as a high-end ski destination, the state is attracting a wave of home buyers who want smaller resorts, shorter lift lines and a more low-key, laid-back vibe.

Schweitzer Mountain has 2,900 acres, great snow and stunning lake views; it’s Idaho’s largest ski terrain area.

Most people have never heard of it.

“We have no lift lines. It’s low-key, it isn’t pretentious and there’s a strong sense of community,” says David Thompson, a retired surgeon from Houston who bought a ski-in, ski-out house there with views of Lake Pend Oreille in 2009 for $850,000.

It isn’t easy to get to Schweitzer—the closest major airport is in Spokane, Wash., about a two-hour drive, including a steep road with sharp switchbacks. The two fastest routes from Idaho’s capital, Boise, are 10-12 hours and involve going through either Washington or Montana.

There aren’t many shops and hotels right at the mountain’s base, and cell and internet service can be spotty in the area. Residents have to pick up their mail in the village.

But Schweitzer is in the midst of a dramatic transformation, aiming to become a destination resort. Last season it added seven runs and two lifts and joined the Ikon Pass, a 47-mountain destination ticket that gives members access to elite ski areas around the world, including Aspen, Colo., Jackson Hole, Wyo., Utah’s Deer Valley, Vermont’s Killington and Zermatt in Switzerland.

The resort village, with a year-round population of about 65, currently looks like a giant construction site, as the resort embarks on a multiphase rollout of residential development. An angled, contemporary glass-and-steel hotel and restaurant, designed by hip Portland, Ore., firm Skylab Architecture, is rising amid the more traditional alpine condos and lodges.

The skeletons of new modern houses and townhouses bolstered by steel rods now inundate the steep slopes.

Demand for real estate is so high that there are currently no houses on the market for sale and only two condos—a stark difference from the 40-50 units for sale in the wider area at any given time in the past, says Patrick Werry, an agent with Century 21 Riverstone. Home prices have risen 40% over the past year in this resort village of about 700 homes.

“Everyone is trying to get on the bandwagon,” says Craig Mearns of M2 Construction, which has a three-year waiting list to even start building a custom house. Its latest spec project sold out in a month, even when prices increased from $550,000 to $950,000 for a unit.

What’s happening at Schweitzer is happening all over Idaho. The state is in the midst of a ski renaissance. As its resorts expand their ski terrain and add amenities, demand for homes is booming.

“Idaho is attracting people who want a smaller resort experience—the feel that other Western resorts used to offer but don’t anymore,” says Thomas Wright, president of Summit Sotheby’s International Realty.

Idaho’s ski resorts are scattered across the state and their characters are as different as the terrain that surrounds them, from the arid, celebrity-infused Sun Valley, to the insular, pine-tree dense village of Tamarack, north of Boise.

All the way east is the wilder, remote Grand Targhee, in the Teton Range, located in Alta, Wyo., just on the border with Idaho. But the appeal of all these places is the same: low-key, uncrowded skiing with consistent snow.

Real-estate agents say the demand for ski resort homes is an offshoot of the demand for homes in Idaho overall, a movement fueled by the pandemic, with people looking for properties with more space and, in some cases, more lax Covid restrictions.

(Idaho is currently in a hospital resource crisis because of its high rate of Covid.)

Idaho’s home prices have grown 42% in the past two years—twice the national average and the highest of all the states, according to Nik Shah, CEO of Home LLC., a down payment assistance provider.

“Most of my friends are like ‘Idaho, what’s there?’ My response is, ‘exactly—it’s because you don’t know about it,’ ” says Harmon Kong, a 57-year-old investment adviser from Lake Forest, Calif.

Mr. Kong and his wife, Lea Kong, fell hard last year for Tamarack and bought two places: a ski-in ski-out, three-bedroom, three-bathroom penthouse condo in the fall of 2020 for $1.8 million, and three-bedroom, three-bathroom chalet nearby for $1.28 million.

Mr. Kong was used to skiing at Heavenly Ski Resort in Lake Tahoe, Calif., which he likens to Disneyland because of the crowds. At Tamarack, he says the snow is routinely powdery, there are hardly ever lift lines and there’s lots of backcountry skiing.

Opened in 2004, then shut in 2008 due to bankruptcy, Tamarack is in the midst of a resurgence. The resort’s lifts currently service about 1,000 acres of skiable terrain and it has applied to the U.S. Forest Service for permits to add seven to nine new lifts, including a gondola, and more than double its size by adding 3,300 new acres of ski terrain and a new summit lodge.

Building is underway on ambitious, multiphase residential development projects, which will result in 2,043 residential units, including about 1,000 hotel rooms and a mix of condos, estate homes, townhomes, cottages and chalets.

Tamarack is in the process of starting a charter school. The average sold price for a home in Tamarack, which has about 450 homes in all, has grown 80% over the past two years, according to the Mountain Central Association of Realtors.

To attract more skiers, this past year Tamarack joined the Indy Pass, which includes small, independent resorts around North America.

The resort’s president Scott Turlington is aiming for 500,000 skier visits over the next couple of seasons (up from 120,000 last season), which he acknowledges might make him persona non grata among some of the current homeowners. “If I do my job properly I won’t be the most popular person,” he says.

Still, Mr. Turlington says, “We want to maintain our rugged individualism and independent spirit. It’s a very different feeling here than at one of the top resorts.”

The top ski resort in Idaho is Sun Valley. In fact, Ski Magazine readers voted Sun Valley the top ski resort in Western North America in 2021, in part because of its comparably short lift lines.

It’s located in an arid, high-altitude and desert-like environment and its famed Sun Valley Lodge has walls lined with photos of celebrities like Marilyn Monroe, Ernest Hemingway and Tom Hanks. Business moguls and world leaders convene there every summer for the annual Allen & Company conference.

Sun Valley has also been growing its ski operations. Last season, it added 380 acres of skiable terrain on Bald Mountain and a new high-speed chairlift. It became a partner in the Epic Pass, which includes mountain resorts like Colorado’s Vail, Utah’s Park City and Whistler in Canada, a move to bring more skiers to the mountains.

Sun Valley Resort’s vice president and general manager Pete Sonntag says the resort has no plans to expand further for now. “Our goal is never about competing for the most skiers. It’s about improving the guest experience,” he says, adding, “The remote location will keep it from feeling overrun.”

But, like many resort towns, the issue of development and affordable housing is a hot topic right now. “There’s a huge concern about people getting priced out,” says Katherine Rixon, a real-estate agent with Keller Williams Sun Valley. Property values have appreciated so much that many owners of rental properties are cashing out of the market, leaving their tenants having to find a new place to live in an already tight rental environment.

And at the same time, rental rates have doubled in the past year. There are a number of government and nonprofit groups working on increasing housing for the workforce, she says.

The number of sold homes was up 71% in August compared with a year earlier, the median price was up 20%, and the number of homes for sale down 56%. A three-bedroom, three-bathroom townhouse Ms. Rixon sold at Sun Valley last year for $2 million just resold for $3.6 million.

“People here complain when there’s four people in the lift line,” says Jean-Pierre Veillet, a real-estate developer. He moved with his family this summer from Portland, Ore., to Bellevue, about half an hour from Sun Valley’s main town of Ketchum, in part because his 15-year-old son Oliver is a ski racer and was attending a boarding school in the area.

Mr. Veillet, 50, and his wife, Summer Veillet, 45, bought a four-bedroom, two-bathroom, 3,000-square-foot house with a library, a three-car garage and a barn on 10 acres for $1.3 million in March. They’d been looking for a house in Ketchum and Hailey, the two towns in the area which are closer to the slopes, but gave up after not finding anything for a year.

Mr. Veillet still works in Portland, and even though that’s not far geographically, getting back and forth is strenuous because there are no nonstop flights to the small Sun Valley airport.

The Veillets say there are pros and cons of living there: the skiing is great, Oliver is thriving, and their younger son, Zealand, who is 10 and is home-schooled, is getting a great education from the growing, fishing and renovating the family is doing.

On the other hand, the internet is terrible, there can be fierce windstorms and there’s no food delivery service. “It’s been a hard transition. It can be hard to slow down and make a change in life,” says Mr. Veillet.

David and Kimberly Barenborg just moved to Ketchum, into a five-bedroom, five-bathroom, over 4,000-square-foot log cabin-style house with a guest cottage in a quiet neighborhood right along a stream. They bought it for about $4 million in August after they sold their house in the Seattle suburb of Mercer Island.

Mr. Barenborg, 60, who co-founded a financial advisory firm, wanted somewhere that had sun, felt safe and where he could ski, bike and fish. “It’s just play time,” he says. “I’m so happy here.”

The only catch is the threat of development on a 65-acre dog park and green space that’s directly across the creek from their new home. He is working to help the town raise the $9 million the developer is asking for the property.

He says the process has been slow going but the community is starting to see the value of protected green space. “Everyone is overwhelmed by what’s going on,” says Mr. Barenborg, referring to the rapid growth that’s stressing the town’s infrastructure.

The rapid growth is also increasing jobs, but Heidi Husbands, a council member in Hailey, says Sun Valley is currently facing a shortage of workers because people can’t afford to live there anymore. Ketchum approved funding for an affordable housing project, but it is still controversial. At one point the town considered allowing workers to put tents in a park, but that idea was canceled.

Some residents of Schweitzer are also worried about more crowds, traffic and a shortage of housing. The resort, owned by Seattle-based McCaw Investment Group, just sold out a 35-lot subdivision and broke ground on an addition to a condo building. In a few weeks, it will start building a new residential neighborhood with cabins before embarking on several others later next year. In five to 10 years, the resort plans a whole new area, with four new lifts and a new lodge.

The potential impacts from climate change are also an issue. Schweitzer CEO Tom Chasse says, “Strategically, we are concerned about the snow level. We are seeing a change in precipitation. The snow lines have been moving up for the last few seasons. So we want to make sure we have lift access to the higher elevations and we are doing feasibility studies on adding snow-making on the lower levels.”

However, Mr. Chasse says the resort has plenty of room to grow. “We want to increase our sophistication level,” he says.

Updated: 11-2-2022

Blackstone’s $70 Billion Real Estate Fund for Retail Investors Is Losing Steam

A retail boom that supercharged private equity and real estate is slowing, challenging one of the firm’s most ambitious efforts.

In just over five years, a Blackstone Inc. real estate fund for small investors has turned into a $70 billion force in the US economy.

It has swallowed up apartments, suburban homes, dorms, data centers, hotels and shopping centers. It owns Las Vegas’s lavish Bellagio hotel and casino; a 76-story New York skyscraper designed by Frank Gehry; and a sprawling Florida complex for interns working at the Walt Disney World Resort.

Unlike with many real estate investment trusts, its shares don’t trade on exchanges. But fueled by billions of dollars from affluent individuals, Blackstone Real Estate Income Trust has become one of the firm’s top profit drivers, expanding property investing in private markets to the masses.

Now, the money machine is facing its biggest test. Rising interest rates threaten to drag down property values and make cheap debt harder to come by. The Federal Reserve hiked its key rate by another 75 basis points on Wednesday and said “ongoing increases” will likely be needed.

Even though the BREIT strategy is outperforming stocks — total net returns for its most popular share class were 9.3% in the nine months ended September — inflows are slowing and redemptions are up.

Wealth advisers at some banks are growing cautious about client exposure to more illiquid investments. At UBS Group AG, some advisers have been shaving their exposure to BREIT after the fund’s massive growth made it too big a piece of clients’ savings, according to people close to the bank.

Staffers at Bank of America Corp.’s Merrill Lynch have been reviewing client portfolios more closely in this market to assess customers’ exposure to REITs that don’t trade on exchanges, other people said.

After years of attracting investors chasing yield at a time of rock-bottom interest rates, BREIT is coming under new pressure. It has thresholds on how much money investors can take out, meaning if too many people head for the exits, it may have to restrict withdrawals or raise its limits.

BREIT was built to weather challenging markets, said Nadeem Meghji, head of Blackstone Real Estate Americas, with its portfolio heavily weighted toward rental housing and warehouse assets in the US Sun Belt.

“This is exactly what you want to own in an environment like we are in today,” he said in a statement.

The REIT has piled into $21 billion worth of interest-rate swaps this year to hedge against higher debt costs. Such swaps have appreciated by $4.4 billion, helping to buoy the portfolio’s overall value.

BREIT “is operated with substantial liquidity and is structured to never be a forced seller of assets,” Meghji said. “All of this enables BREIT to deliver outstanding performance for its investors.”

Blackstone executives are personally invested: President Jon Gray has put $100 million more of his own money in BREIT since July, as has Chief Executive Officer Steve Schwarzman, according to a person close to the company. All told, the firm’s employees have some $1.1 billion of their own money in the REIT.

Still, money going into BREIT fell sharply in the third quarter. It took in $1.2 billion in net flows, down from roughly $7.7 billion in the year-earlier period. Investors added about 50% less new money.

Withdrawals have risen approximately 15-fold. A chunk of redemptions have been tied to Asian investors seeking cash in volatile markets, the person close to the firm said.

Blackstone set up BREIT as a semi-liquid product. It has an overall limit on investors cashing out of 2% of the fund’s net asset value each month, or 5% each quarter, although the fund’s board has final discretion to raise or lower these thresholds.

In June, the most recent date where monthly data was publicly available, the REIT had redemption requests of 1.96% of the fund.

If BREIT were to limit investors’ ability to take out money, it would send ripple effects through the real estate world because of the fund’s size and importance as a bellwether for financial markets.

“It doesn’t mean it’s bad, wrong, or it’s going to happen tomorrow,” said Rob Brown, chief investment officer for Integrated Financial Partners, a wealth advisory firm based in Waltham, Massachusetts. But some retail investors may be caught off guard if they assumed they could get their money when they wanted, he said.

Concerns about sluggish fundraising and a broader slump in dealmaking have been weighing on Blackstone shares: The stock is down 31% this year, after dipping 2.8% to $89.76 at 11:48 a.m. on Thursday, exceeding the 22% decline in the S&P 500.

Behemoth Rising

BREIT’s launch in 2017 was seismic for nontraded real estate investment trusts. That was a corner of finance with a tarnished reputation because of high fees, low returns and an accounting scandal that roiled the then-largest sponsor of such REITs.

The pitch for the trusts can be compelling: A person can take a stake in a swath of properties and collect dividends, benefiting from rising real estate values without stock-market gyrations.

BREIT stood out. It let smaller investors come in with as little as $2,500 and stay on as long as they wished, allowing for limited redemptions each month. That’s a contrast to most buyout funds that take in money from pensions and big investors, which require multiyear commitments. BREIT was less expensive than unlisted REITs of its time but more expensive than typical mutual funds.

At first, people inside the firm weren’t sure if BREIT could live up to the ambitions of top Blackstone leaders.

Kevin Gannon, chief executive officer of real estate investment bank Robert A. Stanger & Co., recalls telling Blackstone staffers just after the fund’s launch: “If you don’t raise $20 billion, you should be ashamed of yourselves.”

Blackstone employees at the meeting looked concerned, Gannon said, “as though I put a target on their backs.” Gray, one of the fund’s masterminds, had a different response, telling lieutenants: “I told you so.”

BREIT gave Blackstone an early mover position in the untapped multitrillion-dollar market for individual investors. It was a key plank of the firm’s bid to become a bigger retail brand.

Other private equity firms followed suit over the years in pursuit of individuals’ cash, while the fundraising circuit for pensions and large investors’ money became more crowded.

The entry of the world’s largest alternative-asset manager into nontraded REITs sparked an arms race, with Starwood Capital Group, KKR & Co. and others launching similar funds.

When markets surged, BREIT and other rivals in 2021 and early 2022 were key players in a fundraising boom “as action-packed as Pete Davidson’s love life,” analysts with real estate analytics firm Green Street wrote in May, referring to the comedian who dated Kim Kardashian and Ariana Grande.

When someone invests money in BREIT, they put in more than $150,000 on average, according to a person familiar with the matter. The constant flows fueled a hunt for acquisitions that one Blackstone real estate staffer described as unrelenting.

BREIT was Blackstone’s biggest driver of earnings in the last quarter of 2021. The fund takes in 1.25% of assets in fees and 12.5% of returns — higher fees than traditional stock-and-bond funds. Advisers have won big too, collecting upfront commissions on some BREIT customers.

Publicly-traded companies have been a frequent target, including Preferred Apartment Communities Inc. and university-housing landlord American Campus Communities Inc.

The student-dorm deal accounted for almost $13 billion of the $21 billion of announced REIT take-private transactions in the first half of 2022, according to Jones Lang LaSalle Inc.

BREIT parked some 20% of its money into warehouses and logistics centers, in a bet that e-commerce would buoy rents. Even more money went to residential property, which now accounts for about half of its portfolio.

Executives have a thesis that a housing shortage would give property owners leverage to constantly reset rents. This way, the fund could squeeze enough cash to offset inflation, which Gray had predicted in early 2021 would be persistent and stubborn.

BREIT last year took over Home Partners of America, which now owns 30,000 homes. It was a platform through which Blackstone could say it was giving renters a chance to to become homeowners.

The REIT expanded further into affordable housing with a roughly $5.1 billion purchase of properties from American International Group Inc. last year.

Blackstone executives concede that going forward, landlords across the board will find it harder to raise rents for apartments and single-family homes at the same pace as before, said people close to the firm.

But rental rates for warehouses, especially those in urban areas, are poised to continue to show strong growth as companies look to shore up inventory with supply chains snarled, the people said.

Rising interest rates have led BREIT to lower expectations on what it could earn from exiting its bets, though rising cash flows from rents have supported property values for now.

Rising Rates

With markets churning, some deals that BREIT was chasing earlier this year don’t make sense. BREIT and others had been looking at a sizable block of affordable housing apartments this year but recently lost interest, according to a person familiar with the matter.

BREIT ramped up swap trades to counter the effect of rising interest rates across the fund’s portfolio. The swaps will generate cash for BREIT as long as interest rates are above certain levels.

A floating-rate mortgage on the Cosmopolitan of Las Vegas, a 3,000-room hotel BREIT acquired alongside partners for $5.65 billion, has risen to about 7%, up almost two percentage points from the loan’s initiation in June.

Another adjustable-rate loan on a slice of debt on its takeover of American Campus Communities has also climbed to about 7%. Those increases have been canceled out with interest rate swaps, according to people familiar with the matter.

Those swaps, combined with cash flows from BREIT’s properties, have helped bolster the fund’s value. Meghji said the firm has locked in or hedged 87% of BREIT’s debt for the next six and a half years.

Blackstone representatives told one wealth management group recently that BREIT plans to consider doing more deals as a debt investor than it has before. That’s in contrast to buying equity, in an effort to protect money better in a downturn.

BREIT’s 9.3% net return in its most popular share class in the nine months ended September stand in stark contrast with publicly traded REITs, which tumbled about 30% in value this year through September. Meanwhile, BREIT’s returns are narrowing compared with the same period last year, when that share class delivered 21.5% returns.

“Before interest rates were so low and BREIT always had growth,” said Gannon of Robert A. Stanger. “Now it’s a bit more difficult.”

Updated: 12-1-2022

Blackstone Limits Redemptions From Real Estate Vehicle, Stock Sinks

Blackstone Real Estate Income Trust Inc. posts letter saying withdrawals requested in October exceeded limits.

Blackstone Inc. shares took a big hit after the investing giant’s real-estate fund aimed at wealthy individuals said it would limit redemptions.

Blackstone Real Estate Income Trust Inc., more commonly known as BREIT, said Thursday in a letter posted to its website that the amount of withdrawals requested in October exceeded its monthly limit of 2% of its net-asset value and its quarterly threshold of 5%.

That spooked Blackstone shareholders, who sent the company’s stock down nearly 10% at one point Thursday morning. More recently, they were down 7.1% Thursday, giving the company a market value of more than $100 billion.

BREIT, a nontraded real-estate investment trust whose net-asset value now totals $69 billion, has been one of Blackstone’s biggest growth engines in recent years.

It has helped the private-equity firm attract a new class of investors who might not be wealthy enough to invest in its traditional funds but want access to private assets.

BREIT is designed to generate steady cash flows for its investors. It has delivered net returns of 9.3% year-to-date and 13.1% annually since inception, with an annualized distribution rate of 4.4%, according to its website.

Despite those healthy returns, the vehicle has had an increase in redemption requests from investors in recent months.

The fund has invested heavily in rental housing and logistics in the Sunbelt region of the U.S. where valuations have held up, he said.

Blackstone executives have said BREIT’s withdrawal thresholds were designed to prevent it from having to become a forced seller. The firm said the vehicle has $9.3 billion of immediate liquidity and $9 billion of debt securities it could sell if needed.

BREIT said separately on Thursday it agreed to sell its 49.9% stake in MGM Grand Las Vegas and the Mandalay Bay to its co-owner Vici Properties Inc.

The deal values the properties at $5.5 billion and will deliver a profit of more than $700 million to Blackstone, which bought them less than three years ago. The deal was struck at premium to where BREIT was valuing the assets on its books, according to a person familiar with the matter.

“Our business is built on performance, not fund flows, and performance is rock solid,” a Blackstone spokesman said in a statement. “BREIT has delivered extraordinary returns to investors since inception nearly six years ago and is well positioned for the future.”

The sale of the casino properties will give BREIT $1.27 billion in cash that it can use in part to cover the uptick in its redemptions, The Wall Street Journal reported.

With the stock market down and bonds performing poorly, wealthy investors in need of liquidity have few areas of their portfolio where they can sell at a profit. The bulk of the redemption requests for BREIT are coming from Asia, according to a person familiar with the matter.

Updated: 12-2-2022

Why Blackstone’s $69 Billion Property Fund Is Signaling Pain Ahead For Real Estate Industry

The property industry is grappling with a pullback from investors, financing challenges and even more layoffs.

Pain is deepening across the US real estate industry.

Two of the biggest players — Blackstone Inc. and Wells Fargo & Co. — took steps this week to contend with weaker demand as the industry faces a rapidly cooling property market, rising interest rates and waning investor appetite.

The well-heeled investors in the $69 billion Blackstone Real Estate Income Trust Inc. learned Thursday the fund will limit withdrawals as people seek to pull money from what’s been a cash magnet for one of the largest owners of real estate globally.

Also Thursday, Wells Fargo, the biggest home loan originator among US banks, confirmed it’s cutting hundreds more mortgage employees as soaring borrowing costs crush demand.

“It’s a one-two punch,” Susan Wachter, real estate professor at the University of Pennsylvania’s Wharton School, said in an interview. “Both are realistic pullback responses to the overall economic weakness we’re seeing now as well as the spike in interest rates.”

In the past decade, the real estate industry reaped the benefits of the Federal Reserve’s policy of low rates. Homebuyers, taking advantage of record-low borrowing costs, went on a spree that fueled double-digit price gains.

Ultra-low rates also drove a refinancing boom that put more money in homeowners’ pockets and spurred the creation of jobs for mortgage brokers, title insurance agents and appraisers.

Now, real estate has been among the hardest-hit sectors of the Fed’s campaign to quash inflation by boosting interest rates at the fastest pace in decades.

In the housing market, mortgage rates that have doubled this year are sidelining potential buyers and causing sellers to pull back on new listings. A measure of prices has dropped for the last three months, while pending home sales have fallen for five months in a row.

The volume of mortgages with rate locks plunged 61% in October from 2021 levels, according to Black Knight Inc.

Commercial real estate is also feeling the sting. Property prices have slumped 13% from a peak this year, according to Green Street’s October price index.

The financing environment has become trickier as some big lenders have scaled back, leading property owners such as a Brookfield Asset Management Inc. unit to warn that it might struggle to refinance certain debt.

Industry Fallout

The industry fallout has been wide-ranging. Reverse Mortgage Funding, a home lender backed by Starwood Capital Group, filed for Chapter 11 bankruptcy this week.

Layoffs have been widespread. Opendoor Technologies Inc., which pioneered a data-driven spin on home-flipping known as iBuying, laid off about 18% of its workforce and wrote down the value of its property holdings by $573 million.

Brokerage Redfin Corp. went through two rounds of layoffs and shuttered its iBuying business, while competitor Compass Inc. also made deep cuts to its technology teams in a quest for profitability.

Layoffs only tell part of the story of the pain. While mortgage firms and real estate technology companies cut costs by firing workers, real estate agents make up a large share of the industry’s workforce.

They’re usually considered independent contractors and depend on commissions for a living. They don’t show up in layoff tallies but are also exposed to slowing home sales.

“There are hundreds of thousands of real estate agents who are not going to be practicing because people are buying and selling fewer homes,” said Mike DelPrete, a scholar-in-residence at the University of Colorado Boulder. “It’s like a silent culling of the ranks.”

Search For Yield

When interest rates were ultra low, investors turned to commercial real estate as a source for higher yields than they could get by owning Treasuries and other low-risk bonds.

That was part of BREIT’s appeal, drawing in high-net-worth clients lured by the 13% annualized returns in one major share class through October.

BREIT raked in money to buy apartments and industrial buildings, properties that the private equity firm bet would keep growing in value because demand outstripped supply.

People who couldn’t afford to buy a house needed to rent, the reasoning went, and shoppers increasingly buying online drove up the need for warehouse space.

“Our business is built on performance, not fund flows, and performance is rock solid,” a Blackstone spokesperson said Thursday after the firm announced the redemption limits.

Much of the money withdrawn from BREIT was from overseas, with offshore investors redeeming at eight times the rate of US ones in the past year. Blackstone shares dropped 2.7% Friday to $82.76 at 10:47 a.m., after tumbling 7.1% the day before.

Commercial-property owners are getting hit with financing challenges after years of paying for deals with cheap loans. Expensive debt has pushed some borrowers into negative leverage, which means that debt costs are outpacing expected returns.

Dealmaking has also frozen, with transaction volume plunging 43% in October from a year earlier, according to MSCI Real Assets.

“With the benefits of leverage severely limited and owners who are not being forced to sell, the price expectations gap between sellers and potential buyers has been wide enough to limit deal closings,” Jim Costello, an MSCI economist, wrote in a Nov. 16 report.

Despite all the pain points, the housing and commercial real estate industries are in better shape than in some previous downturns, with more tightly underwritten loans and less of a risk of markets being oversupplied.

With BREIT, the fund is still outperforming the S&P 500 Index, even as investors increasingly want out. And Thursday’s announced sale of a stake in two Las Vegas hotels is expected to generate roughly $730 million in profit for BREIT shareholders, Bloomberg previously reported.

Relative Value

What’s changing most drastically across the industry is the relative value of real estate to other investments.

Thanks in part to the Federal Reserve’s hiking campaign, investors have other places to earn money that could generate more yield than in years past and tend to be more liquid than commercial real estate, including Treasuries, investment-grade bonds, and mortgage-backed securities.

“Real estate is quite cyclical,” Wharton’s Wachter said. “It’s bad for real estate when rates go up and you can get higher yields from Treasuries and other assets.”

Updated: 12-12-2022

Blackstone’s BREIT Highlights Looming Dangers of Private Funds

In a world increasingly demanding liquidity, Blackstone is selling illiquidity.

declared themselves baffled that so many retail investors want their money back from its giant private property fund, given its strong performance.

They shouldn’t be surprised. The very design of the fund encourages investors to withdraw when they see others doing so. My worry is, those same incentives could hit other parts of the financial system as central banks pull back from easy money.

A slow-motion dash for cash is under way across the whole of finance as the Federal Reserve sucks liquidity out of the system. Most harmed will be those who piled into private assets without thinking about how much cash they might need.

The basic principle of the Blackstone Real Estate Income Trust, or BREIT, is that it took $46 billion from ordinary investors, added debt and bought a bunch of property, mostly Sunbelt housing and warehouses. It was good at it, or perhaps lucky, and the value of the fund went up a lot, so it was very popular.

But this year mortgage rates soared and recession fears rose, and house prices began to come down. They have dropped only a bit so far, and not everywhere, but enough to make it less obvious to investors that they ought to be piling cash into a leveraged bet on property prices.

Blackstone isn’t dumb, and it thought in advance about the possibility that one day people would want their money back. The contracts limit withdrawals from BREIT to 2% of the fund each month, or 5% a quarter, to avoid the need for fire-sales of property. Now people want some of their money back, and the limits have kicked in.

The problem is that investors in BREIT now know that other investors in BREIT (and a similar fund, from Starwood Capital Group, known as SREIT) are trying to withdraw.

Just as with a bank run, an investor who thinks others will try to withdraw should get out first. Even those who think everything will soon calm down—and there are reasons to think it might—should still be concerned about the effects of others leaving.

It isn’t just BREIT. Private credit funds became wildly popular over the past decade and mutual funds bought into private equity, part of increasingly creative attempts to make money in a world of zero interest rates. Some, which hold hard-to-trade assets and allow withdrawals, are also vulnerable to self-fulfilling fears about liquidity.

I See Four Areas Of Vulnerability In BREIT That Could Apply To Other Funds:

(1). Anyone who thinks they might need to cash in over the next year will withdraw earlier than planned. Investors who tried to pull out in November got only 43% of what they asked for, and in December the cap will limit withdrawals far more. The longer the cap is in place, the more people will need to join in.

(2). Investors can buy much more cheaply in public markets. REITs listed on the stock market trade at a fat discount to the value of their holdings. Investors happy to hold REITs managed by others could sell BREIT at the still-elevated estimated value of its holdings, and buy a listed REIT at less than the estimated value of its holdings.

(3). BREIT borrows about $1 for every $1 of investor value, but as investors pull out, the proportion of its holdings financed by loans goes up. That’s great when prices rise—one of the big reasons for investing in property is that it can use a lot of leverage—but if prices go down, more leverage amplifies losses.

(4). Withdrawals make the fund less liquid. BREIT sits on $9.3 billion of cash and bank facilities, so it won’t have any problem repaying the investors who have asked to get out, and it is a long way from liquidity trouble. But if withdrawals continue, those who remain will be holding a fund with less and less cash, giving it less flexibility to snap up bargains in the markets or to satisfy future withdrawals.

The third and fourth problems can be delayed by Blackstone selling buildings, as it just did with its stake in the MGM Grand and Mandalay Bay casinos in Las Vegas, or converting the billions of dollars of other easy-to-sell assets into cash.

Delay long enough and investors’ concern may abate.

Hedge funds discovered all these problems in 2008, when clients rushed for the exits. Their ventures into unlisted assets—often pre-IPO stocks, but some funds bought assets as exotic as African farmland and art—left many investors holding hastily-created “side pockets” full of unsalable stuff from their funds. Others simply refused to allow withdrawals, to avoid penalizing investors who remained.

Blackstone says withdrawals from BREIT have come primarily from overseas investors, particularly in Asia, who chairman and CEO Stephen Schwarzman suggested were hit by margin calls when Hong Kong stocks plunged.

These are exactly the sort of people one doesn’t want to invest alongside, because they will become forced sellers when markets are falling.

Ultimately it is a confidence game. If you think others have lost faith, it makes sense to pull out too. This is why Blackstone is going out of its way to point out all the good things about BREIT—which this year includes a cool $5.1 billion made on interest-rate derivatives.

“Our business is built on performance, not fund flows, and performance is rock solid,” Blackstone said.

The problem Blackstone and its peers have is that in a world increasingly demanding liquidity, it is selling illiquidity.

Updated: 1-4-2023

BlackRock Halts Withdrawals From £3.5 Billion UK Property Fund

* UK Property Fund Is Deferring Requests Made In September 2022
* Pension Scheme Clients Have Been Rebalancing Their Portfolios

BlackRock Inc. has suspended withdrawal requests from investors in its £3.5 billion ($4.2 billion) UK property fund, in a move that highlights the sector’s ongoing challenges when markets are volatile.

The world’s largest asset manager told clients in the BlackRock UK Property Fund in the past few days that it will defer redemption requests made at the end of September 2022 and due around now, according to a person familiar with the matter.

The fund is based in Jersey and is only open to professional investors, including several pension schemes that in recent months have been shifting their portfolios into liquid assets after months of market volatility left them overexposed to holdings that are harder to sell.

A spokesperson for BlackRock declined to comment. Reuters reported the news earlier.

BlackRock and other asset managers previously limited withdrawals from UK property funds in October. At the time the firms said the move was unrelated to the sell-off in gilts following the UK’s “Mini-Budget” at the end of September.

UK property funds have suspended redemptions at times of market stress in recent years, including during the coronavirus crisis of 2020 and following Britain’s referendum to leave the European union in 2016. Some funds have put properties in those funds up for sale to meet investors’ wish to cash out.

Selling commercial real estate in order to raise cash to pay out departing investors can take months if managers want to avoid fire sales. Some property funds for retail investors that gated following the Brexit vote in 2016 managed to reopen within weeks while others remained shut for as much as six months.

Blackstone’s Leaky Property Fund Pays For A Thumbs-Up

Private-equity firm’s nontraded BREIT fund receives a welcome cash injection from the University of California.

Blackstone’s flagship property fund got a boost that bosses hope will deter investors from asking for their money back. There is a catch, though: It had to agree to sweeter terms than normal.

The New York private-equity firm said on Tuesday that the University of California will buy shares worth $4 billion in BREIT.

The nontraded real-estate fund has been receiving more applications from clients asking to take their cash out than it can contractually pay.

In December, investors put in redemption requests equivalent to 5.44% of the fund’s total net asset value, above both BREIT’s 2% monthly and 5% quarterly limits.

The university has bought in at BREIT’s current net asset value, or NAV, which rose last year and values the underlying property at an exit capitalization or cap rate—a measure of yield—of 5.6%. The price Blackstone is putting on the fund’s real estate, roughly half of which is housing, has come under scrutiny.

As interest rates rise, a gap is opening up between the valuations used by private landlords and the sharper property-price falls implied by the shares of listed real-estate investment trusts.

That means the University of California could have gotten a slightly better deal in the public market, where residential property stocks have a cap rate of around 5.9%, according to estimates by research company Green Street.

However, BREIT also owns industrial real estate, such as e-commerce warehouses, which are valued more highly.

A more reassuring sign would have been for the University of California to buy in at NAV on precisely the same terms as other shareholders. Instead, in return for keeping its money locked up for six years, the university has been guaranteed an annual return of at least 11.25%.

If BREIT doesn’t hit this hurdle, Blackstone will make up the difference to a certain limit. The firm has provided BREIT shares worth $1 billion as collateral.

Factoring in this collateral together with its fees, Blackstone needs to make a minimum annual return of 8.7% between now and 2028 to make money on the deal. This would be a slowdown for the fund, which has delivered 12.7% annually since it was set up six years ago.

Its best bet for keeping this record on track is further rent growth in warehouses and residential housing. In its absence, the fund might be able to take on more debt to boost returns, but this comes with its own risks.

BREIT wasn’t under serious pressure for money to meet redemptions as it has several billion dollars’ worth of cash on hand. But the backing of a big institutional investor might calm clients’ nerves and stop the situation from getting out of hand.

It also means the Blackstone fund has more money to buy new properties. Management says the next few years will be ripe for snapping up real estate. If that is so, BREIT will have to explain how it thinks other property owners will be forced to offer bargains without an impact on its own valuations.

It could be that some landlords need to sell real estate at less-than-ideal prices as refinancing becomes more expensive, but if this becomes a broad trend it will hit the whole market.

However the property market fares in 2023, a fresh chunk of cash means Blackstone won’t be under pressure to sell. Having to accept discounts on its own real estate would make it tough to justify BREIT’s current valuation. While the University of California hasn’t given as fulsome an endorsement as the fund’s bosses might like, it is still a good result for Blackstone.

Updated: 1-10-2023

Top Office Owners Don’t Want To Own Only Office Buildings Anymore

Apartment-building acquisitions spur quick returns, require ‘minimal capital expenditure’.

Many of the most prominent office developers in the U.S. are shifting gears, looking to buy or build real estate that isn’t office.

Boston Properties Inc. is planning to develop 2,000 residential units up and down the East Coast. The firm, which owns more U.S. office space than any other publicly traded company, also is developing millions of square feet of lab and life-science space.

New York office owner SL Green Realty Corp. is teaming up with Caesars Entertainment Inc. in a bid to convert a Times Square office tower into a casino.

Even the companies behind some of the world’s most glamorous skyscrapers are seeking out other types of real estate. Empire State Realty Trust, owner of the Empire State Building and other office towers, late in 2021 started adding multifamily properties to its portfolio for the first time.

Silverstein Properties, best known for developing the World Trade Center in lower Manhattan, is raising a $1.5 billion fund for converting obsolete office buildings into apartments.

The efforts come as the Covid-19 pandemic and rise of remote work have reordered American habits around the workplace, dimming the importance of office towers that populate city business districts.

Shares of publicly traded office owners have broadly declined as investors and analysts worry that the companies’ growth prospects have been hurt by the likelihood of a long-term decline in office demand.

The U.S. office vacancy rate was 12.3% at the end of the third quarter, about where it was at its peak during the global financial crisis, according to data firm CoStar Group Inc. The rates in some major metro areas—including New York, Washington, D.C. and San Francisco—are at the highest levels that CoStar has recorded in more than two decades of tracking this data.

Corporate tenants are flooding the sublease market with office space, the main way to reduce their footprint before their leases expire. About 211.8 million square feet of sublease space is now available, nearly double the amount available compared with the end of 2019, and the highest ever recorded for major office markets, CoStar said.

Companies are also putting off searches for new space as they brace themselves for a possible economic downturn in 2023. New business searches for office space fell in 2022 to 44% of what they were in 2018 and 2019, according to VTS, a firm that operates a data platform that tracks tenant demand.

Other real-estate sectors, especially residential, seem to offer more promise.

“Office is in a state of flux these days,” said Rich Gottlieb, president of Keystone Development + Investment, a West Conshohocken, Pa.-based developer specializing in offices that has four residential projects in the pipeline in South Florida and the Philadelphia region. “But there’s still a housing shortage out there.”

Office developers pivoting toward residential or other property types say they remain bullish on the office business. Many have predicted throughout the pandemic that businesses will return in greater numbers because, they have said, the best collaboration requires face-to-face meetings in a workspace—not over Zoom.

And more recently, office owners can point to encouraging signs, including the growing number of employers who are ordering workers back to the offices and the strong demand for space with the best facilities and locations.

But developing state-of-the art office space requires an enormous capital investment to meet workers’ desire for the highest possible air quality, energy efficiency and amenities.

The economics of the residential business are currently more compelling, said Tony Malkin, chief executive of Empire State Realty Trust. He would still buy office buildings at the right price.

But apartment-building acquisitions produce an immediate return and require “minimal capital expenditure,” he added.

An office landlord known as New York City REIT, whose share price has fallen below $2 during the city’s recent office slump, said it was moving beyond a focus on New York office buildings, according to a December filing with the Securities and Exchange Commission. The company said it would seek to acquire hotels and parking lots, among other non-office investments.

The shift away from new office development already is having a moderating impact on new construction. About 153 million square feet of office construction was under way in the third quarter of 2022, down from 184 million in the first quarter of 2020, according to CoStar.

Meanwhile the popularity of residential projects is having the opposite effect on the apartment pipeline. Close to 500,000 units—the most since 1986—are expected to be completed in 2023, according to a CoStar estimate. That is up from 368,000 in 2019, the firm said.

Some office developers began expanding into residential projects in the years leading up to the pandemic. AmTrust Realty Corp., which has a portfolio of about 12 million square feet of office space in Chicago, New York, Toledo, Ohio and other markets, completed its first residential development in 2020, a 270-unit project in Brooklyn.

The pandemic intensified AmTrust’s appetite to do more residential investment, said Jonathan Bennett, president of the family-controlled business. As one example, he noted that AmTrust has owned for years an office building in Tarrytown, N.Y., on a 7-acre site facing the Hudson River.

AmTrust has long considered the building a good candidate for residential conversion. Now, with the Tarrytown building’s vacancy rate high, the company is moving ahead with planning and obtaining local-government approvals for a development with scores of apartments.

“There was so much vacancy in the building, I said to my board, there will be no better time for us to put forward this plan,” Mr. Bennett said. “If this is what you want to do, this is the time to do it.”

Third of Dublin’s Office Supply Is Leased But Dormant Amid Tech Job Cuts

* Technology Job Cuts And Hybrid Working Leave Desks Unfilled
* Smaller Firms May Move Into Unused Space, Estate Agent Says

Spare office space is rising in Dublin as some of the world’s biggest technology firms grapple with post-pandemic working practices and global industry uncertainty.

So-called ‘grey space,’ — surplus office accommodation that is leased but not being used — currently accounts for about 32% of all available supply and is set to increase further, according to estate agents Lisney. The overall vacancy rate in Dublin now stands at around 13%.

The trend comes amid a wave of job cuts from large tech companies such as Twitter Inc. and Salesforce Inc, which have a big presence in Ireland’s capital. Meta Platforms Inc. last month decided not to occupy part of its recently completed European headquarters in the city.

Big tech accounted for between one-third and half of activity in the office property market in recent years, with hiring ambitions to match, Lisney said in a report.

“Many of the large tech companies had very ambitious staffing targets over the last three to four years and may never have been able to fill all the office space they hold,” the firm said. A shift to hybrid working has also driven a reduced need for office desk space, according to the report.

Even so, overall take up volumes in the Dublin office market have improved since the pandemic, with activity increasing about 35% from 2021, according to CBRE Ireland.

Professional, financial, pharmaceutical, and public sector tenants were the most active in the fourth quarter rather than tech, it said.

Meanwhile, spare fully-fitted office space may be attractive to smaller local players, looking for flexible arrangements without high renovation costs, Lisney said.

“We now expect to see some of the smaller scale companies, many of whom are indigenous, take advantage of recent trends; hiring staff and taking additional office space.”

Updated: 1-17-2023

Investors Seek To Pull $20 Billion From Core Real Estate Funds

JPMorgan and Morgan Stanley are among fund managers facing withdrawal requests as property values decline.

Some of the biggest investors in US commercial real estate are looking to cash in before property values slide further.

A group of property funds for institutional investors ended last year with $20 billion in withdrawal requests, the biggest waiting line since the Great Recession, according to IDR Investment Management, which tracks an index of the open-end diversified core equity funds.

“It’s like the nightclub where everybody lines up to get in and then lines up to leave when it closes,” John Murray, head of global private commercial real estate at Pacific Investment Management Co., said in an interview.

Institutional investors sought to cut their exposure to some of the biggest funds at managers including JPMorgan Chase & Co., Morgan Stanley and Prudential Financial Inc., according to people familiar with the matter who asked not to be identified citing private information.

The UBS Trumbull Property Fund had a $7.2 billion queue for withdrawals — 40% of its value — as of the third quarter of 2022, according to a December presentation by Callan, a pension consultant.

The capital outflows are ratcheting up the pressure on institutional fund managers as higher interest rates batter the commercial real estate market. At the same time, managers such as Blackstone Inc. are seeing retail investors — wealthy individuals in particular — pulling money from real estate bets amid volatile markets.

One of Blackstone’s biggest retail pushes, its Blackstone Real Estate Income Trust, limited how much money investors could take out in December. The ODCE funds — pronounced like “odyssey” — don’t specify quarterly limits on withdrawals.

Soaring borrowing costs pushed commercial property prices down 13% last year, an index by Green Street shows, while a Bloomberg gauge of publicly traded real estate investment trusts tumbled 29%.

But ODCE funds move more slowly, valuing properties based on comparable sales — and those have become scarce recently, with few sellers willing or forced to take a loss.

That’s why the ODCE index posted a 7.5% gain for all of 2022, according to preliminary data released Jan. 13 by the National Council of Real Estate Investment Fiduciaries.

The first sign of a pullback came in the fourth quarter, when the index dropped 5%.

“Do the math,” said Cathy Marcus, global chief operating officer and head of US equity at Prudential’s PGIM Real Estate, which manages $204 billion in property globally, including the oldest ODCE fund. “This is not calculus. We’re going to end up with some valuation decline, but it’s not going to be earth shattering.”

The capital outflows are both a symptom and a cause of problems ahead for commercial real estate.

Redemptions are “prompting many core funds to attempt to sell their most liquid assets, like industrial and multifamily assets, which implies a headwind for even the most relatively resilient sectors” of commercial real estate, Murray wrote in a December note.

For institutional investors, the exit queue is at least partly a response to what’s known as the denominator effect. Investment managers often have certain targets for how much they want to have invested in stocks, bonds, real estate and other assets.

As markets slumped last year, their stock and bond holdings shrunk in size while real estate held up better, meaning it often constituted a bigger slice of their portfolios than they initially intended.

About 32% of institutional investors with $11 trillion in total assets considered their portfolio overallocated to real estate in 2022, up from 8.7% in 2021, according to a survey by Hodes Weill & Associates and Cornell University’s Baker Program in Real Estate.

“Real estate appreciated itself into having a denominator issue,” PGIM’s Marcus said. “Some investors are looking to take money off the table.”

Exit Queue

Most investors are reducing exposure to ODCE funds, not abandoning their stakes. And the exit line may be inflated by investors who assume they’ll only receive a fraction of their request, so they ask for more than they expect to get, according to Garrett Zdolshek, chief investment officer of IDR Investments, which manages about $5 billion.

IDR runs a fund tracking the $350 billion of gross assets in the NCREIF Open-End Diversified Core Equity Index.

The outflow backlog can quickly flip to a waiting line for investors wanting to get back in, as happened briefly in 2020 and more dramatically after the 2008 global financial crisis when stocks recovered and the investing pie grew.

“We saw a 15% redemption queue in 2009 reverse to a 14% entrance queue at the end of 2010,” Zdolshek said.

Because of the lag in revaluing the assets, the ODCE funds are still outperforming the broader stock market. The PGIM Prisa fund had a total return of 19% in the 12 months through September, when the S&P 500 posted a 15% loss, Callan reported.

Other returns during that period include 21% for the Morgan Stanley Prime Property Fund, 19% for Invesco Core Real Estate USA, 18% for the JPMorgan Strategic Property Fund and almost 17% for the UBS Trumbull fund, according to Callan.

The UBS fund, where the redemption line began building before the pandemic, paid $1.85 billion last year through October to clients who wanted their money back, according to Callan.

Spokespeople for PGIM, Morgan Stanley, JPMorgan, Invesco and UBS declined to comment on their funds’ performance or redemptions.

A historic benefit of the ODCE funds is their returns are less volatile than REITs. But their slower reaction to revaluing assets may now leave them susceptible to an arbitrage trade as public REITS appear to have more upside.

“We are taking advantage of the arbitrage between public and private markets and funds in need of liquidity,” Morgan Stanley research analyst Tony Charles wrote in a December note.

Updated: 2-14-2023

Brookfield Defaults on Two Los Angeles Office Towers

* Properties Include The Gas Company Tower And The 777 Tower
* Brookfield DTLA Fund Had Warned It May Face Foreclosures

Brookfield Corp., parent of the largest office landlord in downtown Los Angeles, is defaulting on loans tied to two buildings rather than refinancing the debt as demand for space weakens in the center of the second-largest US city.

The two properties in default, part of a portfolio called Brookfield DTLA Fund Office Trust Investor, are the Gas Company Tower, with $465 million in loans, and the 777 Tower, with about $290 million in debt, according to a filing. The fund manager had warned in November that it may face foreclosure on properties.

The company had the option to extend the maturity on the loans tied to the Gas Company Tower, but elected not to, according to its latest filing. It also elected not to get interest-rate protection that was required for loans for the 777 Tower property, which amounts to an event of default, the filing said.

“We believe DTLA’s decision to default on these two assets increases the risk for the remaining loans in their portfolio,” Barclays Plc research analysts Lea Overby and Anuj Jain wrote in a note Tuesday.

Brookfield declined to comment.

The values of comparable office buildings have broadly dropped, according to the Barclays analysts. Office vacancies have increased across the country since the pandemic made working remotely more routine.

The vacancy rate in the Los Angeles central business district vacancy rate was 22.7% in the fourth quarter of 2022, according to a Jones Lang LaSalle Inc. report.

The Brookfield DTLA portfolio has a total of $2.28 billion in secured debt, according to a November filing. Other buildings with maturing debt include the Wells Fargo Centers North Tower with $500 million in debt due in October and the Wells Fargo Centers South Tower with $263 million maturing in November.

The buildings have about $1.8 billion of floating-rate obligations, generally hedged with interest-rate derivatives, which can translate to increased payments as the Federal Reserve raises interest rates.

The lenders have not foreclosed on the two properties or exercised other remedies available to them, according to Brookfield’s filing.

In January, Oaktree Capital Management wrested control of the building known for providing the exterior shots for the main office in the television series “L.A. Law” after the owner, Coretrust Capital Partners, went into default on a loan tied to the property.

The Brookfield news was previously reported by real estate publication CoStar.

Updated: 3-1-2023

Two Office Landlords Defaulting May Be Just The Beginning

With at least $92 billion of office mortgages maturing this year, landlords are under increasing pressure.

A Pacific Investment Management Co. office landlord that defaulted on $1.7 billion of mortgage notes sent shockwaves through a troubled part of the real estate market.

For years, property owners have been grappling with the rise of remote work — a problem so large that one brokerage estimates roughly 330 million square feet (31 million square meters) of office space will become vacant by the end of the decade as a result. But low interest rates allowed the investors to muddle along more easily without worrying about the debt.

Now, many office landlords are seeing borrowing costs skyrocket, leading owners such as Pimco’s Columbia Property Trust and Brookfield Corp. to default on mortgages.

While remote work hurt the office market, rising rates could push landlords, which often use floating-rate debt, closer to a tricky edge.

“It’s just a group psychology, like, ‘Now that one of my peers has done it, everyone’s going to do it,’ so I wouldn’t be surprised over the next six months, if you just saw a wave of defaults and keys getting handed back, because the offices are not getting filled up,” said Nitin Chexal, chief executive officer of real estate investment firm Palladius Capital Management. “A lot of these assets will never recover.”

The clock is ticking for more office owners with the Federal Reserve on the path to raising its benchmark rate even higher, more than 17% of the entire US office supply vacant and an additional 4.3% available for sublease.

Nearly $92 billion in debt for those properties from nonbank lenders comes due this year, and $58 billion will mature in 2024, according to the Mortgage Bankers Association.

“If you have a loan coming due this year, you’re in trouble,” GFP Real Estate Chairman Jeffrey Gural said. “If you have a loan coming due in three years and you don’t have a lot of vacancy, you’re going to just wait it out.”

Gural’s GFP recently defaulted on a Manhattan office building on Madison Avenue and is in talks with lenders to extend the loan. But the recent defaults by other landlords could help negotiations because lenders may not want to take back the assets, he said.

“It’s helpful for me, that we’ve seen some big players basically give the keys because it makes it easier to negotiate with the banks,” Gural said.

Floating-Rate Debt

The financing challenges are a particular problem for the real estate industry given the proliferation of floating-rate loans, where interest rates reset more frequently. About 48% of debt on office properties that matures this year has a variable rate, according to Newmark Group Inc.

Landlords often have to purchase interest rate caps, which limit payment increases when rates rise and have also become more expensive.

The price for one-year protection on a $25 million loan with a 2% rate cap soared to $819,000 in February from $33,000 in early March 2022, according to Chatham Financial.

Even for owners who haven’t defaulted, the math has become a lot more complicated. Blackstone Inc.’s Willis Tower in Chicago, for example, has roughly $1.33 billion of commercial mortgage-backed securities and has seen monthly payments on that debt jump nearly 300% in February from a year earlier, according to data compiled by Bloomberg.

A Blackstone spokeswoman said the building is highly occupied with long lease terms.

“We are extremely selective in the types of office we want to own, which is why US traditional office represents only approximately 2% of our portfolio today,” Jillian Kary, a Blackstone spokeswoman, said in a statement.

Defaults don’t necessarily mean owners are giving up on offices entirely. In many cases, such as GFP’s Madison Avenue tower, the investors are looking to negotiate better terms with lenders, or explore other options such as converting the buildings to apartments.

“Every situation is unique,” said Dustin Stolly, a vice chairman at Newmark. “If you’ve got a building that’s well-leased, well-located and has an institutional owner, you’ll be fine. There’s high likelihood the lender you have in place will play ball on an extension. If it’s private ownership, the building is overleveraged, and sponsorship doesn’t have access to liquid capital, that’s where we are seeing situational loan sales or forced asset sales.”

Vacant Space

Higher rates are the latest of the office market’s woes. Many buildings have been struggling to lure workers back after the pandemic, a problem that’s worsened as companies lay off employees and cut back on real estate.

Falling demand will leave the US with an excess supply of 330 million square feet of office space by 2030, according to a Cushman & Wakefield report.

Some cities have fared better than others. The average occupancy rate in Austin, Texas, was 66% of pre-pandemic levels for the week through Feb. 22, compared with 47% in New York and 44% in San Francisco, according to security firm Kastle Systems.

But the financing fallout has spread across the US. The default by Columbia Property Trust, which was bought in 2021 by funds managed by Pimco, involves seven properties, ranging from a Manhattan tower that used to house the New York Times, to a San Francisco building that’s battling Elon Musk’s Twitter over some missed rent payments.

One building in the group of properties, 245-249 W. 17th St., is also seeing Twitter, a key tenant, look to sublease its space at the building.

Another one of the properties entangled in the default, 201 California St. in San Francisco, had roughly 42% of its office space available for lease, either directly or via sublease, as of Feb. 28, according to Savills. For 315 Park Ave. South in Manhattan, that figure stood at nearly 39%.

Overall, the seven-building portfolio is 84% leased, down from 87% when Columbia Property Trust was acquired in 2021, according to Columbia spokesperson Bud Perrone, who cited data that doesn’t include subleases.

Columbia said last week that it had engaged with lenders to restructure the loans on the seven properties.

New York landlord RXR is looking to pare back its office buildings, negotiating with its lenders on at least two offices in the city for potential conversions. RXR declined to comment.
Seeking Relief

A Brookfield business defaulted on loans tied to two Los Angeles office towers earlier this year. Brookfield Property Partners, which owns a range of real estate including office and retail spots, said in a Feb. 24 filing that it had stopped payment on only about 2% of all of its properties while trying to negotiate a modification or restructuring of its debt.

“We are generally seeking relief given the circumstances resulting from the current economic slowdown, and may or may not be successful with these negotiations” the filing said. “If we are unsuccessful, it is possible that certain properties securing these loans could be transferred to the lenders.”

Brookfield declined to comment.

The office market’s pain has also ratcheted up as lenders pull back, with major banks weighing sales of office loans. For owners wanting out of this market, there have been few sales of the properties: Transactions in January fell to their slowest pace for the month since 2010, according to MSCI Real Assets.

US office values are down 20% through January from March 2020, according to a Green Street index. Ultimately, the decline in office prices is likely to outpace the drop for commercial real estate prices broadly, according to Matt Rocco, chairman of the Mortgage Bankers Association.

“It’s going to be a very tough two years until the market finds an equilibrium,” said Ran Eliasaf, founder of investment firm Northwind Group. “In the meantime, there’s going to be a lot of hurt and unfortunately, a lot of money lost.”

Short Sellers Step Up Bets Against Commercial Office Building Owners On Bank Turmoil

* Short Interest On Office Owners Has Jumped, CMBX Declines
* Office Landlords Have Much Higher Leverage Than Other REITs

Money managers have stepped up their bearish bets against office landlords, wagering that the US regional banking crisis will slash the availability of credit to property owners that were already suffering from the pandemic and rising interest rates.

Hedge funds are using credit derivatives and equities to bet against the companies and their debt. Almost 40% of shares in the iShares US Real Estate ETF are sold short, the highest proportion since June, according to data from analytics firm S3 Partners.

At Hudson Pacific Properties Inc., short interest reached a record 7.4% earlier this week before dropping to about 5% of shares outstanding, according to data compiled by IHS Markit Ltd. That’s almost double the level a month ago. For Vornado Realty LP, short interest is the highest since January.

Three regional banks have failed in the US, raising concerns about the implications for commercial real estate finance. Many lenders are losing deposits, which might cut into their ability to finance real estate in the future. Regional banks account for about 80% of bank lending to commercial properties, according to economists at Goldman Sachs Group Inc.

“What’s changed in the last few weeks is the credit markets,” said Rich Hill, chief of real estate strategy research at Cohen & Steers Capital Management Inc. “It went from a story of work-from-home and the impact on occupancy and the lack of rent growth to also the compounding of tighter financial conditions given everything happening with banks.”

Fears of tighter credit are adding to risks for offices that have been building for some time, Green Street analysts wrote in a Tuesday report. Hedge fund manager Jim Chanos, Marathon Asset Management and Polpo Capital Management founder Daniel McNamara are among those who have been betting for months that landlords will struggle to lure staff back to workplaces.

“This regional banking crisis is just throwing fuel on the fire,” McNamara said in a telephone interview. “I just don’t see a way out of this without a lot of pain in the office sector.” 

Vulnerable Landlords

Real estate was already the most shorted industry across global equities, according to a March 17 report by S&P Global Inc. It was the third most-shorted sector in the US.

That’s in part because interest rates have been climbing for the last year, which pressures real estate owners. Defaults remain low for now. But office assets are the collateral for about $100 billion of the $400 billion of US commercial real estate debt maturing this year, according to MSCI Real Assets.

Workplaces worth nearly $40 billion face a higher probability of distress, more than apartments, hotels, malls or any other type of commercial real estate, MSCI said on Wednesday. Almost $20 billion of office loans that were bundled into commercial mortgage-backed securities and are due to mature by the end of next year are already potentially distressed, Moody’s Investors Service estimates.

Credit availability for commercial real estate was already challenged this year as investors have grown less interested in buying commercial mortgage bonds, JPMorgan Chase & Co. analysts including Chong Sin wrote in a note. Sales of CMBS deals without government backing have fallen more than 80% this year, according to data compiled by Bloomberg News.

Smaller banks potentially retreating may bring a credit crunch to smaller markets, the JPMorgan analysts wrote.
Lenders advanced a record $862 billion to commercial real estate last year, a 15% increase from a year prior, data provider Trepp estimates.

Much of that was driven by banks, which originated 50% more loans in the period. The pace of growth has slowed since then, Federal Reserve data show, as the outlook for real estate grows increasingly negative.

The pressure on offices means lending standards are now being tightened, bad news for landlords that have high levels of leverage and putting lenders at a higher risk of defaults.

“Recent developments have increased downside risk to commercial real estate values from expectations of tightening lending standards,” Morgan Stanley analysts including Ronald Kamdem wrote in a note on Monday. Office REITs may have to sell assets to help them successfully refinance, they said.

Shorts soared on office landlords last year as rising interest rates weighed on the industry. They dropped subsequently as investors wagered that borrowing benchmarks would top out at a lower level than initially expected or the Federal Reserve would begin to cut the rates earlier than previously expected.

Cohen & Steers, which oversees about $80 billion, including $48 billion in real estate investments, went under weight on offices during the pandemic and will steer clear until the market shows signs of hitting a floor.

“I actually want to see more signs of weakness,” Hill said. “The more headlines I see that things are really, really bad, the closer I think we are to the end.”

Chanos Short

Chanos said on CNBC in January that he had been betting against SL Green Realty Corp., short interest in which reached the highest since the financial crisis in recent days.

The landlord’s assets include a New York building occupied by Credit Suisse Group AG, the lender taken over by UBS Group AG after government-brokered talks. Short sellers borrow stock and sell it, planning to profit by buying it back at a lower price later.

An SL Green spokesperson directed Bloomberg to company comments at a March 6 investor conference, before the recent bank failures.

The landlord plans to sell $2 billion of properties, cut its debt by $2.5 billion and refinance a $500 million mortgage, Chairman and CEO Marc Holliday said at the Citigroup Inc. conference. Because the securitization market and life insurance financing weren’t receptive to deals, the firm is dependent on banks, which were already an uphill challenge.

“Banks are more likely to say no these days than to execute,” Holliday said. “Knock on wood, hopefully we can get that done.” 

Mark Lammas, president of Hudson Pacific, said in an emailed statement that the firm is confident in its business fundamentals and long-term prospects. The company is investment-grade, a majority of its assets are unencumbered, it has $1 billion of liquidity, and no material debt maturities until 2025, Lammas said.

Chanos and representatives of Vornado and Boston Properties didn’t immediately reply to requests for comment.

‘The Widowmaker’

Hedge funds have also been using credit-default swaps indexes known as CMBX to bet against CMBS that are most exposed to offices. The derivatives are tied to portions of bonds backed by commercial mortgages and a number of them reached a record low this week amid fears about a number of regional banks.

Betting against commercial real estate has historically been a hard way to make money, because it can take a long time for losses to emerge, and the range of possible outcomes for even troubled property can be wide.

“Shorting CMBX BBB- is regarded as the widowmaker — the undoing of many a young trader’s career,” Morgan Stanley trader Kamil Sadik wrote in a March 6 note.

But the spate of bad news means the BBB- portion of the 14th CMBX index is at the lowest level ever and the same part of the 13th index is at its lowest since the pandemic in 2020. Similar declines are also being seen in share prices of office landlords.

“Our conversation with investors suggests that there has been some capitulation and forced selling as the stocks have continued to underperformed,” Morgan Stanley analysts led by Kamdem wrote.

Updated: 3-16-2023

Silicon Valley Bank Collapse Incites Construction Loan Chaos In California

The failed bank was also key lender for urgently needed affordable housing projects.

Silicon Valley Bank’s collapse has shaken not only the tech startups that power the region’s economy, but also Bay Area nonprofits struggling to build affordable housing in one of the most expensive markets in the US.

The bank, which was shut down by federal regulators this weekend, put more than $2 billion into affordable housing investments and loans in the Bay Area over the past two decades, along with other investments in Massachusetts and Los Angeles.

While the federal government promises to protect depositors, affordable-housing developers that relied on the bank for construction loans are in a more uncertain position.

The implosion of SVB threatens to create construction delays and disrupt financing deadlines developers must meet to qualify for federal subsidies.

“If it takes two months to replace your construction lender, that will cost millions of dollars in interest, but you will also potentially blow by federal deadlines,” says Matt Schwartz, president and chief executive officer of the California Housing Partnership.

“We need clarity from the federal government agencies that are restructuring Silicon Valley Bank that affordable housing commitments will be fulfilled immediately.”

All of this comes as California cities are being challenged by Governor Gavin Newsom to comply with new state laws that mandate more housing construction, including affordable units.

In San Francisco, there are at least five affordable-housing projects that have exposure to SVB, according to the Mayor’s Office of Housing and Community Development.

Three of the projects are still under construction with budgets dependent on construction loans financed by SVB. Another, the Kelsey Civic Center, was set to close on a $52 million construction loan last week but was unable to because of SVB’s dissolution.

“Some of these projects could be stuck in limbo, or scrambling to find the financing to pay workers,” says Anne Stanley, a spokesperson for the mayor’s office of housing and community development.

She said some projects may have access to other buckets of money to pay contractors and construction teams. But others are reliant on those loans. “If these people can’t be paid then the work stops,” she said.

Matthew Franklin, president and CEO of MidPen Housing, a Bay Area nonprofit developer with more than 9,000 affordable units and 1,500 under construction, says that his organization has significant exposure to Silicon Valley Bank.

MidPen currently has two construction loans with SVB for Shirley Chisholm Village, San Francisco’s first educator workforce housing project.

In San Jose, MidPen is developing a 108-unit project targeted entirely to homeless people. And in Livermore, in the East Bay, the nonprofit is building a 44-unit complex for developmentally disabled adults.

Franklin says that the Livermore project is due to receive about $14.5 million in funds through housing tax credits on April 1, and for the San Jose project, there is a $2.3 million construction draw on the loan pending at any moment.

“If you’re in the middle of construction, the worst thing that could happen is cutting off financing midstream,” Franklin says.

According to Franklin, the community development finance team at SVB — his longtime banking partners — have a guarantee of employment for at least 45 days, and have advised MidPen to proceed with construction as planned.

Yet Franklin says that he and other nonprofit developers are worried that without SVB, there will be fewer strong options for financing future projects.

Future Financing

The FDIC is looking for a buyer for SVB now, and the financial institution that takes over the bank will also likely take over their loans.

Luckily for the developers, says Rebecca Foster, the CEO of the San Francisco Housing Accelerator Fund, SVB construction loans tend to be locked in at a fixed interest rate.

“In this pretty uncertain and relatively squirrelly interest rate environment, that provides a lot of budget certainty,” she says.

(While several of their nonprofit partners do business with SVB, Foster says the housing accelerator does not have any accounts or loans with the bank.)

Another complicating factor is that most affordable housing projects rely on subsidies through the federal Low Income Housing Tax Credits (LIHTCs) program, the primary engine for building new affordable housing in the US.

The tax credits give investors a reduction in their federal tax liability in exchange for investing in affordable housing developments. Owners of properties backed by LIHTCs are required to keep rents below market rate for 30 years.

Housing tax credits also carry with them federal requirements and compliance deadlines. Beyond the questions facing developers who are midstream on projects backed by SVB, the uncertainty could spill out to future proposals.

In many states, the application window for this year’s allocation of LIHTCs is set to open soon. California developers who were planning to apply for credits in April may be scrambling to find a different financial partner.

“The clock is ticking on all of these transactions that have tax credits in them,” the California Housing Partnership’s Schwartz says.

For affordable housing projects that fail to proceed, unused housing tax credits are returned at the end of the year to the state agencies that allocate them.

That means that over the long term, it’s unlikely that there will be any net loss of affordable housing units, since these credits are in high demand.

But the precarious new circumstances have made an already challenging process more difficult, and delays could have a cascading effect that could thwart the viability of shovel-ready affordable housing developments.

“The challenging thing with the projects is that they typically need to move on a timeline, in order to keep all the other funding sources intact,” says Mark Hogan, a principal architect and founder of the architecture firm OpenScope Studio, who has worked on affordable housing projects in San Francisco.

Starting over with another lender could cause projects to miss subsequent financing deadlines — while accruing interest and racking up overall building costs.

SVB announced investments of $17.5 million in four community-based organizations in December 2022, including Housing Trust Silicon Valley, which is itself a lender to affordable housing developers in the region.

Julie Mahowald, Housing Trust’s chief financial officer, says losing SVB’s community development finance team, which is well-respected by housing providers, would have a heavy impact.

“Whatever the new bank puts together, that space needs to be filled by someone as committed to community development finance as Silicon Valley Bank was,” she says.

Updated: 3-20-2023

Where Stress Is Building In The $20 Trillion Commercial Real Estate Market

Here’s something else to be anxious about.

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?

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.

Updated: 3-21-2023

Commercial Property Debt Creates More Bank Worries

Large number of office defaults could force banks to mark down value of these and other loans.

A record amount of commercial mortgages expiring in 2023 is set to test the financial health of small and regional banks already under pressure following the recent failures of Silicon Valley Bank and Signature Bank.

Smaller banks hold around $2.3 trillion in commercial real estate debt, including rental-apartment mortgages, according to an analysis from data firm Trepp Inc. That is almost 80% of commercial mortgages held by all banks.

With the banking industry in turmoil, regulators and analysts are growing increasingly concerned about commercial real estate debt, particularly loans backed by office buildings, according to industry participants.

Many skyscrapers, business parks and other office properties have lost value during the pandemic era as their business tenants have adopted new remote and hybrid workplace strategies.

High interest rates also have wreaked havoc with commercial property valuations. Many owners with floating-rate mortgages have to pay much more monthly debt service, cutting into their cash flows. Owners with fixed-rate mortgages will feel the pain of higher rates when they have to refinance.

This year will be critical because about $270 billion in commercial mortgages held by banks are set to expire, according to Trepp—the highest figure on record. Most of these loans are held by banks with less than $250 billion in assets.

If those loans pay off, it would reassure markets. But a large number of defaults could force banks to mark down the value of these and other loans, analysts say, reinforcing fears over the financial health of the U.S. banking system.

Many of these borrowers will have a hard time paying off their loans, said Tomasz Piskorski, the Edward S. Gordon professor of real estate at Columbia Business School. “The destruction of value is quite big,” he said.

While a number of banks have seen drops in the value of their bondholdings—a key factor in Silicon Valley Bank’s collapse—figuring out by how much the value of their mortgages has dropped is trickier because they aren’t publicly traded and every building is different.

In a recent paper, a group of economists including Mr. Piskorski estimated that the value of loans and securities held by banks is around $2.2 trillion lower than the book value on their balance sheets.

That drop in value puts 186 banks at risk of failure if half their uninsured depositors decide to pull their money, the economists estimate. Real-estate loans account for more than a quarter of the shortfall, said Mr. Piskorski.

At the median U.S. bank, commercial real-estate loans account for 38% of loan holdings, according to an analysis by KBW Research.

The good news is that banks lent more conservatively in recent years compared with the period before the 2008 financial crisis. Many buildings might still be worth more than their mortgages even if they suffer a loss in value.

“The saving grace here is that you do have a decent-sized cushion,” said Frank Schiraldi, a stock analyst at Piper Sandler.

Also, government regulators have given banks ways to avoid taking losses even when loans are in trouble and are restructured to give borrowers more time and more flexibility to pay what they owe.

Much of the guidance the Federal Reserve and other regulators are following was enacted during the global financial crisis to shore up the economy.

For example, in 2009 regulators issued a policy statement that allowed banks to keep loans on their books at full value in many situations even if the property backing the loan was worth less than the loan balance.

While banks had a reasonable expectation of being repaid, critics warned at the time that this guidance would hurt the economy in the long run because the pain was only being deferred.

But the strategy was successful. Commercial property values rose steadily in the years after the crisis thanks in large part to low interest rates.

Eventually, many borrowers were able to pay off the loans that were modified and extended during the tough years. Regulators “turned out to be correct,” said Tyler Wiggers, a senior staff member at the Fed in the aftermath of the fiscal crisis who is now an adjunct instructor at the University of Cincinnati’s department of finance.

The Federal Reserve in September said it planned to revisit its financial-crisis-era guidance regarding commercial property restructurings but noted that new policy would “build on existing guidance.”

The new policy “is timely in the postpandemic era, as trends such as increased remote working may shift historic patterns of demand…in ways that adversely affect the financial condition and repayment capacity” of commercial property landlords, the Fed said.

Still, a flexible approach to real estate workouts among regulators has limitations. Banks are still typically required to cut the value of the debt on their books if a borrower defaults.

Already the number of defaults is growing, partly because of high interest rates, work from home and tech layoffs. Landlords that have defaulted include Pimco and Brookfield Asset Management.

Trepp reported earlier this month that the delinquency rate for commercial mortgage-backed securities increased 0.18 percentage point in February to 3.12%, the second-largest increase since June 2020.

Moreover, if interest rates stay at current high levels, low rates won’t come to the rescue of banks’ commercial property portfolios as they did in the years following the financial crisis. Indeed, a rise in interest rates would further erode the values of these portfolios.

The Fed recently said it would accept bonds and other assets at face value as collateral from banks, making bank runs less likely. Still, small and regional banks could run into trouble quickly if they have to sell commercial property loans to raise capital, said Richard Jones, a partner with law firm Dechert LLP.

In such a situation, the banks likely would be required to reclassify loans as being held for sale and that often means valuing them at what their collateral is currently worth rather than the face value of the loan, he said.

“We are in a very precarious position now.” said Mr. Piskorski, the Columbia Business School professor.

Updated: 3-24-2023

Short Sellers Step Up Bets Against Office Owners On Bank Turmoil

* Short Interest On Office Owners Has Jumped, CMBX Declines
* Office Landlords Have Much Higher Leverage Than Other REITs

Money managers have stepped up their bearish bets against office landlords, wagering that the US regional banking crisis will slash the availability of credit to property owners that were already suffering from the pandemic and rising interest rates.

Hedge funds are using credit derivatives and equities to bet against the companies and their debt. Almost 40% of shares in the iShares US Real Estate ETF are sold short, the highest proportion since June, according to data from analytics firm S3 Partners.

At Hudson Pacific Properties Inc., short interest reached a record 7.4% earlier this week before dropping to about 5% of shares outstanding, according to data compiled by IHS Markit Ltd. That’s almost double the level a month ago. For Vornado Realty LP, short interest is the highest since January.

Three regional banks have failed in the US, raising concerns about the implications for commercial real estate finance. Many lenders are losing deposits, which might cut into their ability to finance real estate in the future. Regional banks account for about 80% of bank lending to commercial properties, according to economists at Goldman Sachs Group Inc.

“What’s changed in the last few weeks is the credit markets,” said Rich Hill, chief of real estate strategy research at Cohen & Steers Capital Management Inc.

“It went from a story of work-from-home and the impact on occupancy and the lack of rent growth to also the compounding of tighter financial conditions given everything happening with banks.”

Fears of tighter credit are adding to risks for offices that have been building for some time, Green Street analysts wrote in a Tuesday report.

Hedge fund manager Jim Chanos, Marathon Asset Management and Polpo Capital Management founder Daniel McNamara are among those who have been betting for months that landlords will struggle to lure staff back to workplaces.

“This regional banking crisis is just throwing fuel on the fire,” McNamara said in a telephone interview. “I just don’t see a way out of this without a lot of pain in the office sector.”

Vulnerable Landlords

Real estate was already the most shorted industry across global equities, according to a March 17 report by S&P Global Inc. It was the third most-shorted sector in the US.

That’s in part because interest rates have been climbing for the last year, which pressures real estate owners. Defaults remain low for now. But office assets are the collateral for about $100 billion of the $400 billion of US commercial real estate debt maturing this year, according to MSCI Real Assets.

Workplaces worth nearly $40 billion face a higher probability of distress, more than apartments, hotels, malls or any other type of commercial real estate, MSCI said on Wednesday.

Almost $20 billion of office loans that were bundled into commercial mortgage-backed securities and are due to mature by the end of next year are already potentially distressed, Moody’s Investors Service estimates.

Credit availability for commercial real estate was already challenged this year as investors have grown less interested in buying commercial mortgage bonds, JPMorgan Chase & Co. analysts including Chong Sin wrote in a note.

Sales of CMBS deals without government backing have fallen more than 80% this year, according to data compiled by Bloomberg News.

Smaller banks potentially retreating may bring a credit crunch to smaller markets, the JPMorgan analysts wrote.

Lenders advanced a record $862 billion to commercial real estate last year, a 15% increase from a year prior, data provider Trepp estimates. Much of that was driven by banks, which originated 50% more loans in the period.

The pace of growth has slowed since then, Federal Reserve data show, as the outlook for real estate grows increasingly negative.

The pressure on offices means lending standards are now being tightened, bad news for landlords that have high levels of leverage and putting lenders at a higher risk of defaults.

“Recent developments have increased downside risk to commercial real estate values from expectations of tightening lending standards,” Morgan Stanley analysts including Ronald Kamdem wrote in a note on Monday. Office REITs may have to sell assets to help them successfully refinance, they said.

Shorts soared on office landlords last year as rising interest rates weighed on the industry. They dropped subsequently as investors wagered that borrowing benchmarks would top out at a lower level than initially expected or the Federal Reserve would begin to cut the rates earlier than previously expected.

Cohen & Steers, which oversees about $80 billion, including $48 billion in real estate investments, went under weight on offices during the pandemic and will steer clear until the market shows signs of hitting a floor.

“I actually want to see more signs of weakness,” Hill said. “The more headlines I see that things are really, really bad, the closer I think we are to the end.”

Chanos said on CNBC in January that he had been betting against SL Green Realty Corp., short interest in which reached the highest since the financial crisis in recent days.

The landlord’s assets include a New York building occupied by Credit Suisse Group AG, the lender taken over by UBS Group AG after government-brokered talks. Short sellers borrow stock and sell it, planning to profit by buying it back at a lower price later.

An SL Green spokesperson directed Bloomberg to company comments at a March 6 investor conference, before the recent bank failures.

The landlord plans to sell $2 billion of properties, cut its debt by $2.5 billion and refinance a $500 million mortgage, Chairman and CEO Marc Holliday said at the Citigroup Inc. conference.

Because the securitization market and life insurance financing weren’t receptive to deals, the firm is dependent on banks, which were already an uphill challenge.

“Banks are more likely to say no these days than to execute,” Holliday said. “Knock on wood, hopefully we can get that done.”

Mark Lammas, president of Hudson Pacific, said in an emailed statement that the firm is confident in its business fundamentals and long-term prospects. The company is investment-grade, a majority of its assets are unencumbered, it has $1 billion of liquidity, and no material debt maturities until 2025, Lammas said.

Chanos and representatives of Vornado and Boston Properties didn’t immediately reply to requests for comment.

‘The Widowmaker’

Hedge funds have also been using credit-default swaps indexes known as CMBX to bet against CMBS that are most exposed to offices. The derivatives are tied to portions of bonds backed by commercial mortgages and a number of them reached a record low this week amid fears about a number of regional banks.

Betting against commercial real estate has historically been a hard way to make money, because it can take a long time for losses to emerge, and the range of possible outcomes for even troubled property can be wide.

“Shorting CMBX BBB- is regarded as the widowmaker — the undoing of many a young trader’s career,” Morgan Stanley trader Kamil Sadik wrote in a March 6 note.

But the spate of bad news means the BBB- portion of the 14th CMBX index is at the lowest level ever and the same part of the 13th index is at its lowest since the pandemic in 2020. Similar declines are also being seen in share prices of office landlords.

“Our conversation with investors suggests that there has been some capitulation and forced selling as the stocks have continued to underperformed,” Morgan Stanley analysts led by Kamdem wrote.

Another Shakeout Is Coming For Shopping Malls

Stress in the market for commercial mortgage bonds and a retrenchment by regional lenders are a recipe for distress in the retail property sector.

Malls came out of the worst of the pandemic with the upper hand. Shoppers eager to get back into stores helped fill vacant space and operators were able to wrestle rents higher.

But the calm has shattered quickly for the long-beleaguered sector as a crucial funding market seized up and the collapse of a string of regional banks compounds the pain.

All that amounts to another moment of reckoning for malls, particularly mid-tier names that failed to use the brief post-lockdown window to upgrade their mix of tenants, lock in loan extensions and lower borrowing costs.

As painful as it might be, one more washout is just what the sector needs to finally put it on a sustainable path.

Even before Silicon Valley Bank’s collapse raised the odds of a recession, malls were facing a challenging year with consumer spending slowing, borrowing costs spiking ever higher and big box stores like Bed Bath & Beyond hanging on by a thread.

Interest rate volatility and economic uncertainty has constrained the market for commercial mortgage backed securities, prompting banks to become a more active source of funding for the retail property sector, Abby Corbett, the head of investor insights at Cushman & Wakefield Plc. told me.

The recent string of failures among regional lenders now further threatens liquidity.

Like other commercial real estate, malls are built on debt. Owners typically provide some equity and depend on bank loans and CMBS lenders for the rest.

This mix not only helps them generate better returns, but also fund capital improvements like outside lawn areas and food courts. Debt is literally the lifeblood of malls, says Chad Littell, who leads U.S. capital markets analytics at CoStar Group.

Recently, much of the concern swirling around commercial property has focused on the office space. Hedge funds like Polpo Capital Management and Marathon Asset Management are betting that a fall in demand for less-desirable workplaces will make swathes of office property obsolete and put loans linked to them at risk of delinquency.

But Fitch Ratings estimated in November that the highest rates of CMBS loan delinquencies will be in retail; climbing to as much as 11.3% by the end of this year from 5.7% in October.

The bulk of maturing class B and C mall loans will likely default as access to capital gets harder, it said — and that was before banking troubles sent a shudder through markets.

Regional and local lenders represented about 46% of financing for retail real estate in 2022, according to a report from MSCI Real Assets.

It’s not all doom and gloom though. Some mall owners saw the writing on the wall early and used the short window of easier lending conditions and high shopping demand to refinance under more favorable rates and extend their payment deadlines.

For instance, the Macerich Co. scrambled to close refinancing deals on several of its maturing loans before the economic headwinds ramped up this year. Like other malls, Macerich has seen occupancy rates recover after being crushed by the pandemic.

The company last year managed to extend loans or refinance with fixed rates or rate caps for several of its most important properties.

It negotiated a three-year extension on a $300 million loan on its prized Santa Monica Place in California, giving it time to fill in empty anchor stores with experiential art exhibition company Arte Museum and the popular Taiwanese dumpling chain Din Tai Fung.

Simon Property Group Inc. is among those that focused on high-quality properties well before the pandemic shook the industry.

Its dominant position in productive, class A malls “runs counter to the view in some circles that malls are dinosaurs destined for extinction,” Bloomberg Intelligence analyst David Havens wrote last month.

“That may be valid for vulnerable class B and C malls losing tenants and anchor department stores.”

No doubt there are many mall operators less prepared for the rough economic waters ahead. Take CBL & Associates Properties, which represents some of the challenges facing mid-tier malls.

It was slow to pivot to a growing economic divide between wealthy and middle, and low-income shoppers even as peers like Macerich picked a lane.

As mid-market retailers floundered, the company hung on to tenants including Victoria’s Secret & Co. and Gap Inc. The pandemic threw the company into bankruptcy and while it emerged with a cleaner balance sheet, it continues to struggle. By the end of 2022, it lost three of its malls to receivership and foreclosure.

CBL malls aren’t alone. The American Dream mall, owned by Canadian mall developer Triple Five Group, was sued by bondholders after it refused to make more than $8 million in interest payments. Malls are a deeply local business which means even strong national operators have weak assets.

For instance, Unibail-Rodamco-Westfield, which owns a portfolio of high quality mall properties, missed its deadline to pay off a $195 million loan on its Valencia Town Center mall in Santa Clarita, California, as occupancy rates dragged down sales.

Unibail-Rodamco-Westfield expects to sell the property or let it fall into foreclosure, according to its annual report.

The mall business can’t survive without access to debt. But mall owners will need to carefully balance servicing debt with investing in their properties to keep sales afloat.

As CBL notes in its annual report, “significant debt payment obligations” could force them to use a large chunk of their cash flow to pay down debt rather than invest in capital expenditures.

More debt, less investments to update drab, underperforming malls doesn’t sound particularly sustainable.

For a long time, malls have been siphoned into winners or losers. It was clear heading into the pandemic that losing malls would likely die off and find a second life as apartment buildings or healthcare offices.

While some of these malls have managed to hang on, this latest upheaval will likely see the debt-burdened operators buckle. For those that are still lagging behind in correcting their business, the mall doors are quickly closing in front of them.

Updated: 3-28-2023

Distress In Office Market Spreads To High-End Buildings

Amenities gave many an advantage earlier in the pandemic, but defaults and vacancies are rising as interest rates climb.

Defaults and vacancies are on the rise at high-end office buildings, in the latest sign that remote work and rising interest rates are spreading pain to more corners of the commercial real-estate market.

For much of the pandemic, buildings in central locations that feature modern amenities fared better than their less-pricey peers. Some even were able to increase rents while older, cheaper buildings saw surging vacancy rates and plummeting values.

Now, these so-called class-A properties, whose rents generally fall into a city’s top quartile, are increasingly coming under pressure.

The amount of U.S. class-A office space in central business districts that is leased fell in the fourth quarter of last year for the first time since 2021, according to Moody’s Analytics.

The owners of a number of high-end properties recently defaulted on their mortgages, highlighting the financial strain from rising interest rates and vacancies.

“Any property owner that says ‘Oh we’re fine’ is a little bit fooling themselves,” said Thomas LaSalvia, director of economic research at Moody’s Analytics.

Some office landlords invested heavily in their buildings in recent years, adding spas, gyms, restaurants and modern elevators.

The hope was that by modernizing their properties, these owners could benefit from a flight to quality as more tenants seek out environmentally friendly buildings with plenty of amenities and natural light.

This strategy has worked for some buildings, especially those developed in the past decade. Some new buildings like One Vanderbilt in Manhattan managed to add tenants at high rents.

But new leasing data and recent defaults indicate that many of these high-end properties aren’t immune to the office market’s crisis.

Take 777 South Figueroa St. in downtown Los Angeles. Completed in 1991, the 52-story tower features a lobby with 30-foot ceilings and rose-marble-covered walls, a landscaped plaza, valet parking and concierge services.

Many of its tenants are financial companies and law firms, according to data from CoStar Group.

The owner, Brookfield Asset Management, recently defaulted on more than $750 million in debt backing the building and another Los Angeles tower. Meanwhile, asset manager Pimco recently defaulted on a mortgage backed by a portfolio of office buildings including Twitter offices in New York and San Francisco.

Older high-end properties are struggling in part because they face competition from towers built in recent years. In downtown Los Angeles, 28 office buildings have been completed since 2000, according to Moody’s Analytics.

In New York, new developments like One Vanderbilt and Hudson Yards have lured tenants from Park Avenue towers while pushing up Manhattan’s overall vacancy by adding new supply.

Close to 19% of all high-end office space in Manhattan was available for lease in the fourth quarter of 2022, according to brokerage Savills, up from 11.5% in early 2019.

The availability rate for top-shelf office space was slightly higher than the availability rate at cheaper class-B and class-C buildings, Savills said.

Rising interest rates have hit the entire commercial real-estate sector hard. Higher mortgage costs eat into landlords’ earnings and make it harder to refinance expiring loans.

Rising yields on bonds and other securities also make real estate look less profitable in comparison, making buyers more reluctant to pay high prices and pushing down property values. Real estate analytics firm Green Street recently estimated that U.S. property values are down 15% since March 2022.

Not all commercial property sectors are suffering equally. While the values of hotels and rental-apartment buildings have fallen, these properties are also benefiting from inflation, which is pushing up room rates and apartment rents.

Office buildings have seen a steeper drop in values partly because they are also grappling with weak demand from tenants who are cutting back on workspace. Green Street estimates that office values are down 25% over the past year.

During a recent earnings call, the president of office landlord Boston Properties Inc. Douglas Linde said many office buildings are obsolete and could be converted to other uses such as apartments.

“A meaningful amount of the existing office inventory may have a higher and a better use as an alternative product, and it’s not relevant to users searching for space today,” he said.

Analysts expect office defaults to increase as more mortgages that were signed before the pandemic expire. Around $2.6 trillion in commercial mortgages are set to mature between 2023 and 2027, according to Trepp Inc. Many of these loans are held by smaller banks.

Pressure on office occupancy is expected to continue for much of 2023. Weakening demand during the pandemic era initially came from companies cutting back on space by letting employees work from home part of the week.

Now demand also is tumbling because big technology companies are hunkering down and cutting expenses for fear of a possible economic downturn.

Landlords who benefited from long-term leases are becoming more vulnerable as leases signed before the pandemic expire. Michael Silver, chairman of Vestian Global Workplace Services, said law firms he advises on their real estate often look to cut their space by around 30% when their leases expire.

And unlike in 2021, more companies are worried about a recession and looking to cut costs.

“That’s just going to contribute to overall vacancy, and it doesn’t matter whether you’re in an A building or a B building,” he said.

Updated: 3-30-2023

Manhattan Office Vacancy Hits Record As Landlords Add Space

* The Renovation Of 660 Fifth Ave. Added More Office Space
* Rising Vacancy Rate Puts Pressure On Office Landlords

Manhattan’s office-vacancy rate is at a record high as new developments add even more space to the struggling market.

More than 16% of space was empty as of the first quarter, according to brokerage Jones Lang LaSalle Inc., which tracks about 470 million square feet (44 million square meters) of Manhattan offices. Leasing is at its lowest levels since the second quarter of 2021.

“You’re having this anemic leasing activity, more space is being added in the form of newly constructed or newly renovated space, but also sublease space continues to pile up,” said Andrew Lim, director of research at JLL.

The market was inundated with more than 1.5 million square feet of office space in the first quarter with the completion of 660 Fifth Ave.’s redevelopment.

Not all of that space will stay empty as landlord Brookfield Properties has signed leases with finance firms including Macquarie Group Ltd. The building, formerly known as 666 Fifth Ave., has gained traction after undergoing $400 million in renovations that include a new lobby, elevators and facade.

Still, the increase in space ramps up the pressure on landlords that own older buildings across the city. With the rise in remote work, tenants are favoring newer developments or towers that have been recently renovated.

“We have to reinvent our office space,” New York Mayor Eric Adams said in an interview with Bloomberg Thursday, adding that empty spaces should be converted to housing. “We have a housing crisis. We already have structures that are built.”

Average rents remained flat at $76.96 a square foot, buoyed by growing rates at top-quality buildings, especially newly built ones. That helped balance out falling rents at older spaces and offices up for sublease.

Updated: 4-4-2023

Apartment-Building Sales Drop 74%, The Most In 14 Years

Interest-rate increases and banking upheaval push down demand for multifamily buildings.

Sales of rental apartment buildings are falling at the fastest rate since the subprime-mortgage crisis, a sign that higher interest rates, regional banking turmoil and slowing rent growth are undercutting demand for these buildings.

Investors purchased $14 billion of apartment buildings in the first quarter of 2023, according to a preliminary report by data firm CoStar Group.

That represents a 74% decline in sales from the same quarter a year earlier and would be the largest annual sales decline for any quarter going back to a 77% drop in the first quarter of 2009.

The $14 billion in first-quarter sales was the lowest amount for any quarter since 2012, with the exception of the second quarter of 2020 when pandemic lockdowns effectively froze the market.

The recent drop in building sales follows a stretch of record-setting transactions that peaked in late 2021, when the multifamily sector was a top performer in commercial real estate.

Cash-rich investors had a strong appetite for apartment buildings. Their top choices were in Sunbelt cities such as Dallas, Phoenix and Tampa, Fla., where rental housing is largely unregulated and rents were rising 20% or more annually until last year.

Sales have plummeted because the math for buying an apartment building makes a lot less sense now. The cost to finance building purchases has jumped alongside the fast rise in interest rates. Rents are running flat, or are even declining in some major metro areas, after record increases.

A upheaval in banking is also making it more difficult to buy buildings, investors and analysts said, as more lending institutions pull back or lend only at high rates.

As a result, most apartment-building values are falling, and many landlords won’t sell at today’s lower prices.

“Nobody wants to take a loss when they don’t have to,” said Graham Sowden, chief investment officer at RREAF Holdings, a real-estate investment firm based in Dallas.

The decline of apartment-building sales is similar to a pullback in the broader residential housing market, where home prices fell year over year in February for the first time in 11 years and sales declined sharply from a year earlier.

Home sales, too, have remained limited because of rising interest rates, and home prices have been falling for months in some parts of the country.

Prices of multifamily buildings dropped 8.7% in February compared with the same month a year earlier, according to the MSCI Real Assets pricing index. A separate measure by Green Street, which tracks publicly traded landlords, found an even sharper drop, with building values down 20% from their late 2021 highs.

Mr. Sowden said his firm has started investing in new property types, such as recreational-vehicle parks, while buyers and sellers remain at an impasse over what apartment buildings are really worth.

Fewer sales might be good news for apartment tenants, because buyers say they aren’t able to raise rents as quickly as they once could.

Many real-estate owners had ramped up their multifamily businesses when borrowing costs were much lower, enacting business plans that called for raising rents before selling properties to pay out investors.

Nationally, apartment rents in March were up 2.6% compared with a year earlier, according to Apartment List. But the pace of annual rent growth continues to fall, and is well below the pandemic high of nearly 18% set in 2021, Apartment List said.

Rents fell on a monthly basis between September and January, and though they are up slightly again this spring, it hasn’t been enough to reverse an overall downward trend.

Now that landlords can’t raise rents as before, they are trying to maintain the value of their properties in other ways, said Trevor Koskovich, president of multifamily at the Northmarq brokerage firm.

That includes cutting costs, making repairs and working harder to keep their current tenants from leaving. When rents were growing at blistering speed, “it was OK to be less discerning in your operations,” Mr. Koskovich said.

Brokers and investors said they don’t expect building sales to pick up meaningfully until next year, in part because nearly half a million new units are slated for delivery this year, the most in nearly 40 years.

The recent troubles hitting regional banks are also a blow to the sector. These lenders became the second-largest source of multifamily loans last year, after government-agency-backed loans, according to MSCI. Many of these smaller banks are now reducing their lending.

But there is one type of sale most everyone expects more of: forced sales. A number of investors bought buildings in recent years with short-term, floating-rate debt. Because of rising interest rates, those loans cost a lot more to pay down than they did when building owners first borrowed the money.

The remaining balance of many floating-rate loans will come due this year, and borrowers whose buildings aren’t bringing in enough cash every month might have to sell their buildings to pay off their debts.

“We’re in the very early stages,” Mr. Koskovich said.

Updated: 4-10-2023

What Commercial Real Estate Stress Means For Banks And Bond Funds

Where two big macro themes intersect.

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.

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.

Updated: 4-11-2023

American Dream Mall Lenders Owed $389 Million Can Collect, Judge Says

* A Judge Granted Summary Judgment In Lenders’ Suit On Monday
* Suit’s Plaintiff Is Linked To Western Asset, Nonghyup Bank

A group of junior lenders to the troubled American Dream mall won the right to collect on at least $389 million of defaulted debt after a judge ruled in their favor on Monday.

Judge Andrew Borrok granted the lenders’ request for summary judgment against an entity used to finance the $5 billion mall and entertainment complex in New Jersey’s Meadowlands, according to a court order.

The lawsuit, filed in New York Supreme Court in February, was brought by an entity that serves as an administrative agent for firms linked to Western Asset and South Korea’s Nonghyup Bank, court documents show.

The complaint demanded payment of “no less than” $389.2 million with interest at “the minimum contractual default rate of 13.75%” as well as other costs.

The New Jersey mall, which broke ground in 2004 and ultimately opened in 2019, has struggled under a series of owners and fallen behind on its debt payments amid construction delays, cost overruns and the pandemic shutdown.

Last year, it received an extension on some of its debt from lenders led by JPMorgan Chase & Co., part of a deal that stripped the junior lenders of their collateral.

Investors who purchased a slug of $290 million of municipal bonds backed by state grants to finance the project, haven’t received semi-annual interest payments since last August.

American Dream reported about $422 million in gross sales in 2022. That was a 38% increase from 2021, its first full year of operations. A 2017 study had projected that the mall would bring in roughly $2 billion in its first year.

“The case and claim are filed against a single purpose entity, which has no ownership of American Dream,” a representative for American Dream said in a statement.

Public documents show that the entity the judgment was awarded against is an affiliate of the company created to develop and own the American Dream project.

Lawyers for the administrative agent and representatives of Governor Phil Murphy and the state Economic Development Authority didn’t immediately respond to requests for comment.

The case is SOL-MM III LLC v. Ameream Mezz I, LLC New York Supreme Court, New York County.

Updated: 4-18-2023

Omnicom To Reduce Global Real-Estate Space Even As Employees Return To The Office

The owner of ad agencies including BBDO and TBWA predicts continued growth throughout 2023 as clients spend on performance- and event-based marketing services.

Omnicom Group Inc. said it will significantly reduce its real-estate footprint and formalize return-to-office requirements for all U.S. employees as the company said it expects growth to continue through 2023, an indication that executives believe marketers’ continued spending will help the advertising giant largely avoid the economic headwinds that have hit the tech and finance industries.

Omnicom, which owns agencies such as BBDO, OMD and TBWA, will require all U.S. employees to return to the office at least three days per week, Chief Executive John Wren said on a call to discuss the company’s first-quarter earnings.

“The great resignation is over,” said Mr. Wren. “Naturally, there will be individual cases where people won’t want to come back, and they’ll seek other alternatives. But in the scheme of things, it is not going to be significant.”

Organic revenue grew 5.2% year-over-year in the first quarter, beating analysts’ consensus estimates of 3.9%, according to Wells Fargo.

Total revenue for the quarter was $3.44 billion, a 1% increase over the first quarter of 2022, and Omnicom is on track to meet its own predictions of 3% to 5% organic growth for the year, said Mr. Wren.

Organic revenue is a metric that removes the effects of currency fluctuations, acquisitions and disposals.

Omnicom was the first of the major ad holding companies to report its earnings for the first quarter. Its share price hit a 52-week high of $96.78 before the market closed Tuesday and continued to rise in after-hours trading.

Omnicom plans to reduce its global real-estate holdings by more than 1.6 million square feet, said Mr. Wren. Since 2018, the company’s total headcount has increased by approximately 4,000 while office space decreased by 35%, he said.

Mr. Wren acknowledged that Omnicom would spend more money in the short-term to reintroduce employees to in-office requirements.

In order to facilitate the transition, Omnicom has also invested in U.S. satellite offices such as locations in Connecticut, New Jersey and Long Island, N.Y., designed to reduce New York-area employees’ commutes, he said.

The company reported $119.2 million in pretax real-estate repositioning costs for the quarter, but this upfront payment will significantly reduce rent and occupancy expenses in the long term, said Chief Financial Officer Philip Angelastro.

Mr. Wren noted continued uncertainty related to the war in Ukraine and rising instability in the Middle East, as well as the collapse of several banks that served the tech industry.

“Clients are getting cautious, and they’re trying where they can to avoid long-term commitments and create as much flexibility in their spending as possible,” said Mr. Wren. “Therefore we’re doing the same.”

One way Omnicom will try to control costs is by opening three company campuses in India as hiring and offshoring operations in that country continue to grow, he said.

The company’s strongest revenue growth came from so-called precision marketing services, which allow advertisers to target consumers directly by using behavioral data, as well as experiential, or event-based, marketing, with the latter seeing especially strong growth outside the U.S., Mr. Wren said.

The company will also increase its investment in AI tools, primarily through a partnership with Microsoft Corp. Clients that want to participate in related projects will combine their data with Omnicom’s own database in order to find new ways to target consumers, according to Mr. Wren.

“There’s a lot of ethical questions as well as privacy questions,” he said. “We’re testing it, playing with it, but certainly not deploying it to the full extent of the power that it has.”

Updated: 4-24-2023

Commercial Real-Estate Woes Run Deeper Than In Past Downturns

Remote work and e-commerce are reducing demand for office and retail space.

Commercial real estate has experienced its share of busts in recent decades. This one is different.

Landlords are contending simultaneously with a cyclical market downturn and with secular changes in the way people work, live and shop. The sudden surge in interest rates caused property values to fall, while the rise of remote work and e-commerce are reducing demand for office and retail space.

Investors and economists say these two forces haven’t come together on this scale since the 1970s, when a recession followed surging oil prices and a stock-market rout while new technologies enabled jobs to move out of major cities.

This time, the pandemic is largely responsible for accelerating the commercial property upheaval.

The U.S. office vacancy rate reached a milestone in the first quarter when it rose to 12.9%, exceeding the peak vacancy rate during the 2008 financial crisis.

Despite low unemployment, that figure marked the highest vacancy rate since data firm CoStar Group Inc. began tracking it in 2000.

It is unknown how bad the commercial property downturn will get. Some analysts say it may well end up less severe than the previous two downturns, in the early 1990s and after the 2008 financial crisis, especially if the U.S. economy avoids a deep recession and interest rates start to come down quickly.

But the deeper problems facing office and certain retail landlords mean building values are less likely to rebound to new highs the way they did after those previous meltdowns.

That, in turn, suggests that commercial real estate won’t contribute as much to the country’s economic growth as it had during previous rebounds. Depressed building values could hurt cities, which depend on property-tax revenue, and weigh on bank balance sheets, leading to less lending throughout the economy.

It is also bad news for the banks, pension funds and asset managers that are among the biggest lenders to and owners of commercial buildings, which means they could face losses for years to come.

Commercial mortgages account for around 38% of the median U.S. bank’s loan holdings, according to KBW Research. North American public pension funds on average hold around 9% of their assets in real estate, according to Preqin.

“You literally have trillions of dollars of investment that are suddenly just massively impaired,” said Dan Zwirn, chief executive of Arena Investors, a New York-based asset manager and real-estate investor.

During previous downturns, fundamental trends usually worked in property owners’ favor once the economy showed signs of rebounding.

Increasingly white-collar workers crowded into cities, filling office towers and ensuring a reliable stream of customers at shops and restaurants. Meanwhile, red tape and zoning restrictions made it harder for developers to build, protecting property owners from competition.

That helped building values bounce back and reach record highs after the crisis was over. Since these property market routs coincided with economic slumps, the Federal Reserve cut interest rates to lower borrowing costs and boost the economy.

Between late 1993 and mid-2022, U.S. commercial real-estate prices grew almost fourfold, according to MSCI Real Assets, easily outpacing inflation.

Now, new technologies and changes in the way people live and work are threatening many landlords, said Ben Miller, CEO of property investment firm Fundrise.

Retail owners for years have grappled with the rise of e-commerce, which has pushed down the value of storefronts and is still a threat to shopping malls throughout the country.

Store closures increased significantly this year, said UBS Group AG, which estimated this month that around 50,000 retail stores in the U.S. will close over the next five years.

Bed Bath & Beyond Inc. became the latest major chain retailer to falter when it filed for bankruptcy protection on Sunday after years of losses and failed turnaround plans.

The company said it expects to close all of its 360 Bed Bath & Beyond and 120 Buybuy Baby retail locations eventually.

Office owners are at the beginning of the process of working off their glut and could face many years of falling tenant demand.

The growing popularity of remote work, made possible by technologies like email, Zoom and Dropbox, means offices are far emptier than they were before the pandemic.

The occupied space per office worker is 12% below where it was in 2015, CoStar said, a sign that corporate tenants may want less space when they renew office leases.

“People thought of these office buildings as forever, because of course it’s going to be 98% leased forever,” Mr. Zwirn said. “People were not planning on this secular change.”

Not all commercial real estate looks imperiled. Data centers and warehouses have benefited from e-commerce and remote work.

Apartment rents are well above prepandemic levels and most analysts expect the country’s housing shortage to persist, which supports higher rents. Retail rents are rising again in Manhattan, while some major chain stores are expanding after years of store closures.

Even for the beleaguered office market, there are some mitigating factors. Landlords mostly hold less debt as a share of property values than they did in 2008.

Still, most analysts expect vacancies to keep rising as more leases expire and companies cut back on space. Office-building prices are down 25% since early 2022, estimates real-estate analytics firm Green Street.

Prices of malls are down 19% since early 2022 and down 44% since 2016.

The last time landlords in big U.S. cities suffered market downturns alongside a secular shift was in the 1960s and 1970s, said Jim Costello, chief economist at MSCI Real Assets.

The spread of highways, fax machines and cheap long-distance calls allowed factories and offices to move from big cities to cheaper places, he said. More families ditched urban centers for the suburbs. Inflation and rising unemployment took a toll.

Many owners of urban apartments, offices and retail space saw their wealth wiped out. In the Bronx, some landlords set fire to their properties to collect insurance money.

This time, vacancies and rising interest rates are coming together to hit office owners. Take the Meridian at Deerwood Park, a sprawling office complex in suburban Jacksonville, Fla. The property’s sole tenant, Deutsche Bank, moved out in late 2022, according to data from Trepp Inc.

With debt costs surging and building values plummeting across the U.S., the owner didn’t get a new loan and defaulted on the property’s mortgage when it expired on April 1, according to Trepp.

Updated: 6-3-2023

How Scared Should You Be About Commercial Real Estate?

If troubles hit banks and the wider economy, they will probably start in offices you wouldn’t want to work in, let alone own.

Nothing gets the blood running in the veins of U.S. property investors like interest from Japanese buyers. The legendary prices paid by Japanese buyers of American trophy assets culminated in Mitsubishi Estate taking control of New York’s Rockefeller Center in 1989—just before Japan slumped. It defaulted on its mortgage just six years later.

The blood ran hot again this week after a different Japanese buyer, Mori Trust, bought half an office block next to Grand Central Terminal from real-estate investment trust SL Green.

The deal put a value of $2 billion on 245 Park Avenue, with plans to invest more to spruce it up. SL Green’s stock jumped 30% in two days, before falling back a bit, helping to lift the entire REIT sector almost 4% and make it by far the best performing part of the market.

Should investors take heart from the sale, even though it is just a single Manhattan office block? Does it mean the disaster in office ownership is a bit less bad than thought?

The answers will reverberate well beyond the narrow group of buyers of high-end New York real estate. A crash in office values could start a doom loop with banks, with falling prices leading to less finance and thus lower prices.

Gloomsters think that could spread across the multitrillion-dollar commercial real-estate sector, sucking money out of the economy as banks and institutional investors turn more cautious.

I suspect this deal doesn’t help as much as hoped. First of all, as Ronald Kamdem at Morgan Stanley points out, this office block is different from most.

It is in an unbeatable location and represents a bet on redevelopment. Crucially, in these high interest-rate times, it comes with existing low-rate debt locked in for four years. That locked-in low-rate debt alone is perhaps worth half the equity value.

Unlike in 1989, there is no wall of Japanese money. True, Mori Trust has picked up a few buildings since its first foray into the U.S. in 2017.

But Japan is struggling with its plunging currency—it is the opposite of the late-1980s boom that made everything outside Japan look cheap in yen terms.

Still, the building turned out to be worth more than many thought. Given that investors have little to go on in a market where there are few transactions, this is an undoubted positive.

Bulls think that the worst might be priced in and that this deal marks a turning point at least for high-quality offices. Investors thinking of buying here are still bottom fishing.

Real estate came in 10th out of 13 sectors in the S&P 500 last year, with only the three technology-related sectors worse.

This year, the three tech-dominated sectors rebounded to first, second and third places—but real estate remains in eighth place, with stock prices flat.

Cedrik Lachance, director of research at advisory firm Green Street, reckons that the plunge in REIT shares in the past year anticipated a drop of 50% to 55% in office prices from last year’s peak. The 245 Park deal shifted that to a decline of 45% to 50%, not much of an improvement.

For comparison, the Federal Reserve’s bank stress test released this week assumed a worst-case scenario where commercial real-estate prices drop 40%, with falls concentrated in office and retail. REIT investors think that for offices, and to a lesser extent retail, the stress is already here.

The rest of commercial real estate is doing OK, with real strength in some parts such as data centers and cold storage. But all types of property—even apartment complexes—face a single overriding problem: rising interest rates.

“The reason why values have to inexorably come down across the board is the cost of debt,” says Eric Adler, CEO of PGIM Real Estate. “There’s no way around it.”

Prices for buildings are taking much longer to adjust than in the financial crisis, the last major downturn, probably because so far there has been relatively little distressed selling or bank seizures.

A handful of high-profile cases, several in downtown San Francisco, in which owners walked away from buildings worth less than their debt obscure the fact that overall loan defaults and delinquencies remain low—for now.

Regulators seem to be trying to defer problems, on Thursday telling banks to give troubled commercial real-estate borrowers some slack to try to fix their finances.

Green Street estimates that the true value of commercial real estate, which includes industrial, retail and others as well as offices, has come down about 15% so far, which is roughly what ought to happen from higher rates.

But there could be a further financing blow from the troubles of the midsize lenders in the wake of the bank runs in the spring.

Banks are less willing to lend, and because they make up about 40% of all commercial real-estate lending, other lenders are unlikely to be able to fill the gap. Less lending means higher rates, more distress and lower prices.

So far, we haven’t had any sort of doom loop. Prices are down thanks to higher interest rates—as is normal—combined with the twin problems of work from home hitting office demand and online shopping hitting retail.

If recession leads to a big rise in layoffs, expect far worse as firms cut back on the cubicles the newly unemployed used to occupy.

The deal for 245 Park shows faith in the idea that the very best buildings will be exempted from this general gloom. The building is in a tiptop location directly off New York’s main commuter station, so if any workers are going back to the office, this is one of the offices they want to go to.

What 245 Park doesn’t tell us is anything about the broader economy. It is the sort of building that can attract top-end tenants, top-end financing and global buyers. If commercial property troubles are going to hit banks and the wider economy, they are much more likely to start in the sort of offices you wouldn’t want to work in, let alone own.

Updated: 6-10-2023

Musk Adds To Goldman Sachs’ Commercial Loan Troubles, FT Says

Elon Musk’s refusal to pay Twitter’s rent contributed to the surge in commercial real estate loan delinquencies that Goldman Sachs Group Inc. faced in the first quarter, the Financial Times reported.

Twitter stopped paying its rent in November and Musk, the world’s richest man, told employees he doesn’t intend to restart payments or cover those past due, the FT said, citing lawsuits. Columbia Property, which is suing Twitter over the missed payments, defaulted on the loan in February.

The value of Goldman loans to commercial real estate borrowers behind on repayments climbed 612% in the first quarter to $840 million, the FT said, citing filings. That compares with a 30% increase to more than $12 billion for the entire US banking industry, the newspaper said.

Columbia Property declined to comment to the FT, which was unable to reach Twitter for comment.

Updated: 6-16-2023

Top US Regulators Flag Increasing Commercial Real Estate Risks

* Delinquencies Are Low, But Vacancies Are Rising, FSOC Says
* Watchdogs Are Emphasizing Risk Management In Oversight

The top US financial regulators say they are stepping up scrutiny of how exposed banks are to commercial real estate, as vacancy rates increase.

The Financial Stability Oversight Council said in a statement Friday that delinquency rates are low, but empty offices are on the rise.

The group, which was set up after the global financial crisis, includes the heads of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission.

“Regulators are taking steps to emphasize risk management and examine exposures to CRE loans at their regulated institutions,” the group said.

After several wild months in finance during which three midsize banks failed, Washington’s watchdogs are under pressure to get in front of any looming issues.

During their Friday meeting, the regulators discussed “the ability of market participants to manage their interest-rate risk and liquidity risk in the current economic environment,” the group said.

Overall, the group, which is known as FSOC, said that the banking system was “well capitalized.”

The Fed and the Federal Deposit Insurance Corp. have been peppering lenders with questions related to interest-rate risks and commercial real estate exposure, Bloomberg News reported last month.

Federal Chair Jerome Powell on Wednesday said “we do expect that there will be losses” in commercial real estate, and banks that have concentrations in that area will experience bigger losses.

Updated: 6-21-2023

Why A Crisis Is Looming In Commercial Real Estate

From the US to Europe and Hong Kong, commercial real estate has become the focus for investors trying to predict the next crisis after a decade of cheap borrowing came to an abrupt end. A cocktail of challenges has emerged for the world’s biggest asset class.

The problems vary from region to region and encompass office buildings and shopping malls. The risk is that these simultaneous troubles lead to a bigger shakeout that jolts the industry’s lenders and leaves city centers pockmarked with empty buildings.

1. What Are The Signs Of Trouble?

Sharp share price falls for publicly traded property firms are a foretaste of what may be in store for the industry. Most commercial real estate is privately held and valuations can take months or even years to respond to shifts in interest rates and changes in supply and demand. The MSCI World Real Estate Index is down 28% since the start of 2022.

* In the UK, asset values suffered their fastest ever declines, with one index of commercial real estate compiled by MSCI down 16.1% in the year through March, after the government sparked a bond market crisis and yields soared.

* US offices, plagued by high vacancy rates, have seen even larger declines, prompting landlords including Brookfield Corp. and Pimco to hand some properties now worth less than the debt secured against them to their lenders.

* Across continental Europe, real estate-backed bonds were trading at distressed levels in June amid concern that landlords can’t raise enough from asset sales to cover the $165 billion of debt that’s coming due across the region by the end of 2026. In Sweden, which is at the forefront of the crisis because of its reliance on shorter-term debt, landlord SBB was downgraded to junk, ousted its CEO and put itself up for sale.

* In Hong Kong, a record 13 million square feet of office space sat empty in June and 15% of the most valuable space was vacant. Western banks have been shrinking their presence and mainland Chinese firms haven’t picked up the slack as their own economy sputters, putting more pressure on rents and prices.

2. What’s Driving All This?

Culprit number-one is the cost of borrowing. Rapid interest rate hikes by central banks have increased the returns on risk-free government bonds. So commercial real estate investors demand more yield to justify holding such an illiquid asset. Rising rents can offset some of the impact on valuations. But the sheer scale of the yield spike triggered by the sudden end of near-zero rates has overwhelmed whatever rent increases landlords can achieve. It’s a particular problem in countries like Germany, where real estate yields had reached record lows and many landlords entered the crisis carrying higher debt loads relative to their peers in places like the UK.

3. Why Are Falling Valuations A Problem?

Because they can hamper a property firm’s ability to borrow. As the value of its assets falls, its relative indebtedness — the all-important loan-to-value ratio — increases. To avoid breaching the terms of its debt, the firm may need to inject more equity or take on more borrowing, albeit at higher rates and only if there’s enough rent to service it. If there isn’t, the company may have to sell into an uncertain and falling market in which buyers will demand deep discounts. Discounted sales in turn create evidence for valuers to then mark down valuations even more, creating a vicious feedback loop. Asset values take time to correct, and it’s landlords with maturing loans that feel the pinch first as banks reduce the amount of fresh financing they are prepared to offer.

4. Are There Any Workarounds?

Selling assets at significant discounts creates transactional evidence that forces valuers to mark down the rest of their assets. So some landlords are finding ways to structure asset sales in ways that disguise the true discount-to-book value. That’s what Germany’s Vonovia SE did in a €1 billion ($1.1 billion) property sale to Apollo Global Management Inc. in May.

5. What Are The Differences Across Regions?

The hit from higher rates is being felt most in Europe. That’s because, while the Federal Reserve jacked up rates faster — and to higher levels — than the European Central Bank, rates before the coronavirus pandemic were higher in the US than across the Atlantic. For that reason, US real estate yields, known locally as cap rates, were not as low as those in Europe before the cycle of monetary tightening began. It’s a key point, as the hit to valuations from higher rates is far larger if the starting yield is lower.

6. Why Is That?

It’s all about how much investors are willing to pay for a yield-bearing asset. Take, for example, a building generating $10 million a year in rent. When yields are 5% — meaning buyers are willing to pay 20 times its annual rent — the building is valued at $200 million. If yields move up to 5.5% the value falls to $182 million. Now take the same building with $10 million of rent and put it in a market where yields reached 2% — a 50 times multiple of the annual rent. That building would be worth $500 million. When yields move to 2.5%, the same 0.5 percentage point shift, the valuation falls to $400 million, a far greater hit.

7. So The Situation In The Us Is Better Than In Europe?

No. Actually, US valuations have fallen further than in Europe as the US had more supply of new and empty buildings and more Americans are still working from home. More than a fifth of office space lies empty in several major US cities, where urban sprawl resulted in far more workspace per head of population than on the other side of the Atlantic. In Europe, tighter planning laws and a slower pace of construction since the 2008 financial crisis kept a lid on supply. That’s kept vacancy rates lower, supporting rents.

8. What’s The Situation With Malls And Warehouses?

Shopping malls are cushioned by the fact that their valuations already took a big hit from the rise of ecommerce, so they were starting from a lower base when rates began to rise. While the pandemic killed off a lot of mall retailers, those that are left generally have better business models and now face less competition, meaning retail rents in many places are finding a floor. As for warehouse properties, demand for space remains reasonably strong in most places and far outstrips supply in others. So rents are rising, helping partially offset the impact of higher yields.

9. What Can You Do With An Empty Office?

One option is to convert it for residential use, if the local planning authority allows it and apartment values are high enough to justify the cost of converting. Another is to modernize and adapt the building to reflect today’s more flexible working practices in a bid to attract a tenant. But older buildings are expensive to upgrade and the improvements in energy efficiency now demanded by policymakers, consumers and corporations only add to the cost. In many cases, the economics of these investments don’t stack up at current prices. The alternative is a wave of foreclosures as landlords give buildings they can’t profitably invest in back to their lenders.

10. What Is All This Doing To The Market?

It’s tearing the office market in two, with a growing divide between the best and the rest. The small proportion of buildings with top green credentials and modern, exciting space can still command top rents. Others will require billions in capital spending to bring them up to standard — money that banks are increasingly unwilling to lend as the volume of impaired loans on their books grows. Even knocking buildings down is becoming more challenging, with policymakers focused increasingly on the embodied carbon in buildings from energy-intensive materials such as concrete, steel and glass. That means in many places they are determined to see properties refurbished, rather than redeveloped.

11. Are There Any Winners From All Of This?

Anyone able to raise new funds has a potential opportunity to exploit the crisis by snapping up properties from distressed sellers and waiting for rates to fall and prices to rise. Some investors are turning to real estate debt, exploiting the pull-back by banks to charge high interest for filling the financing gap that’s opened up. Those developers that have the skills to turn older “brown” properties into trendy green ones also stand to benefit from the crisis, provided they started with sufficiently low borrowing to weather the initial storm.

Updated: 8-28-2023

What To Do With A 45-Story Skyscraper And No Tenants

HSBC’s plan to leave its Canary Wharf tower for a smaller site shows the global challenges ahead in repurposing unwanted office space for a post-pandemic world.

Two bronze lions, each sitting atop eight lucky coins, flank the entrance to the HSBC Tower in London’s Canary Wharf, meant to bring prosperity and good luck to the bank and roughly 8,000 workers inside its global headquarters.

But the building’s fortunes are changing — much for the worse — with the bank relocating in 2027 after more than two decades in the Norman Foster-designed tower. Its new home will be a space roughly half the size in the City of London.

Without its tenant, the landlord at Qatar’s sovereign wealth fund may struggle to find an employer needing so much space. But it’s not alone, and many property investors are facing a similar dilemma.

In a post-pandemic world, the 45-story tower may become a 200-meter-tall conundrum representing the challenges ahead in cities worldwide as companies downsize for hybrid work.

The outlook for these buildings has gotten so bad that some investors are snapping up these empty carcasses for demolition, betting the land they sit on is now worth more than the structure itself.

That newly vacant plot could then be redeveloped for high-rise housing, much needed in developed and emerging cities.

New York City recently rolled out a plan to change zoning rules for Midtown Manhattan to allow more offices to be converted to apartments.

The most logical outcome could be a conversion — with the tower turned into accommodation for students or others, rather than torn down.

That might seem to be a convenient solution to three urban problems. First, long-term demand for office space has been decimated by the pandemic, with London estimated to have the equivalent of 60 Gherkins of empty office space last year.

Secondly, because the UK’s housing crisis totals some 4.3 million units, according to the Centre for Cities, the average house in England costs more than 10 times the average salary.

Lastly, landlords are being urged to reuse or recycle buildings rather than demolish, due to the heavy carbon footprint of the construction industry.

Success stories include Parker Tower, a 1960s concrete office block in London’s Covent Garden, which after thorough renovation and a new façade, has now been converted into homes.

Another example is Leon House in Croydon, a 20-story Brutalist office block that was turned into 263 flats.

But it’s not always possible, said Robert Sloss, chief executive of HUB, a developer that is reworking a £30 million ($39 million)_1950s office block in the City of London into flats. The budget for the conversion hasn’t been determined.

“Not every building can convert to residential — it’s not a panacea for every defunct office,” he said.

The viability of an office-to-residential conversion depends on the building itself. Chief among issues is the “floor depth”: the distance from the windows to the midpoint of its floor plate.

Buildings constructed as offices can be much deeper than those built to be homes, given open-plan office layouts allow natural light to filter to the center.

The sheer scale of the HSBC tower makes it an unlikely candidate for housing, said Ben Clifford, an associate professor of at the Bartlett School of Planning, University College London.

“It would be incredibly challenging to convert,” he said. “The scale makes it more difficult: not necessarily the height. There are some very tall residential buildings.”

But “what will you do with the middle?” he asked.

HSBC’s landlord, the Qatar Investment Authority, didn’t respond to requests for comment.

The façades of office buildings can be an issue, too. Skyscrapers with all-glass exteriors might seem modern, but these designs have been around for over 100 years, heralded by Modernists like Ludwig Mies van der Rohe who built the Seagram Building in midtown Manhattan and the Federal Center in Chicago. The glass skin can create a summer greenhouse inside.

The solution then is to add areas of solid mass, said Tim Gledstone, partner at Squire and Partners, whose firm added an extra façade in the office-to-residential conversion of Parker Tower. “When it’s all glass it overheats.”

Conversions must consider ventilation, too. Many office buildings have windows that are sealed shut. Instead, fresh air circulates via a central ventilation system, which would likely need to be redeveloped to supply separate units instead of one large floor.

Location can also hold back office-to-residential conversions. The most successful sites are in city centers that already have a mix of residential and office spaces, said Gledstone.

This works against the HSBC tower, located in an area that is predominantly offices — and within a borough that has seen falling house prices.

It would be “more straightforward” to convert the building into laboratory space, said Clifford, which would fit in with Canary Wharf’s aims to turn the area into a life-sciences hub.

A multi-purpose layout might work too, he said, with “some residential, some lab space, some hotel space, even some office space, but a smaller amount.”

Gledstone said it may well be possible to convert the HSBC tower into flats, although its architectural quirks would have to become design features.

One precedent is New York’s 24-story 1929 art deco Walker Tower, a former telephone building that reopened in 2013 after conversion into apartments fetching some $2 million to more than $50 million.

Architects worked around its high ceilings, originally to house large telephone equipment, and big windows, needed for ventilation, to create loft-like homes.

“It’s the classic New York style — big brick office buildings,” said Geldstone. “Nice high ceilings, generous corridor with studies or music rooms off there, big living rooms.”

Similar treatment at a deep-set building like HSBC at 8 Canada Square could mean enormous warehouse-like apartments, given each upper floor has a 3,136 square-meter floor plate (33,756 square feet). Even 12-meter deep apartments are “huge,” said Geldstone, let alone ones that are around twice that.

To avoid the feeling of industrial depots, internal spaces could be shrunk by recessing the flats away from the windows, and making the outer edge into “winter gardens”: balconies that are partially or entirely covered in glass, allowing for use in colder weather. That may not be possible depending on the floor slabs, Geldstone said.

Another way of solving the issue of a deep floor plate is to add a lightwell, said Sloss. “A lot of these conversions with deep floor plates will have to have atriums put in,” he said.

Although Clifford said this would be only a “possibility” for a building of this scale: “It would be hugely expensive to do something like that,” he said.

Updated: 8-30-2023

How To Play The Property Meltdown In Five Charts

Savvy buyers made a fortune after the 2008 crash, picking up real estate at distressed prices. Investors hoping to spot bargains in the latest slump can watch these trends.

Is the pain over yet for U.S. commercial real estate? The answer might be yes for stocks but no for the assets they own.

A record $205.5 billion of cash is earmarked for investment in U.S. commercial real estate, according to dry-powder data from Preqin. But good deals may not be available for another six to 12 months. Here are some trends investors can watch for signs of when it is the right time to buy.

How Much Are Values Down Already?

U.S. commercial property prices have fallen 16% on average since their peaks in March 2022, according to real-estate research firm Green Street. Unlike the 2008 crisis, when a lack of credit hurt the value of all real estate, today’s downturn has hit some types of properties much harder than others.

Unsurprisingly given remote working, offices are the worst performers, having lost 31% of their value since the Fed first began raising interest rates.

The discount isn’t as enticing as it sounds, as troubled buildings need heavy investment to bring them up to a standard that will attract tenants, or to be redeveloped for new uses.

Meanwhile, prospects for snapping up America’s e-commerce warehouses at knockdown prices look slim. Warehouse values are down just 8% from peaks to reflect higher financing costs, and top industrial stocks like Prologis
don’t look cheap either, trading close to net asset value.

Apartments might be a better bet for those hunting for distressed assets. Prices for multifamily apartment buildings have fallen by a fifth since March 2022.

Some owners who paid top dollar for properties during the pandemic using short-term, floating-rate debt may be forced to sell if mortgage repayments become unmanageable when their interest rate hedges expire.

Property Sellers Are Still Demanding Yesterday’s Prices

Sellers are holding out for prices that are no longer realistic. MSCI’s bid-ask spread reflects the difference between what U.S. property owners are asking for and what buyers are willing to pay.

As of July, the gap for multifamily apartments was 11%, the widest it has been since early 2012, when the property market was still recovering from the 2008 crash. The gap for office and retail is a bit narrower at around 8%.

Price expectations are closest for industrial warehouses, where sellers want just 2% more than buyers are willing to pay.

The market will be sluggish until one side caves. In the second quarter of 2023, investment in U.S. commercial real estate was down 64% compared with a year earlier, according to data from CBRE.

As the bid-ask gap narrows, it will signal that valuations are approaching more sustainable levels. But this will take some time. It was five years after the 2008 crash before buyers and sellers saw eye to eye on prices on the hardest-hit assets like apartments—although the adjustment should be much faster this time.

What Could Force Sellers To Slash Prices?

The number of properties that slip into distress will be key for bargain-hunters.

So far, there haven’t been many forced sales. Only 2.8% of all office deals in the U.S. in the second quarter were distressed, according to MSCI.

This may be because loans haven’t matured yet. “Owners don’t want to take a loss but once there are refinancing issues, they will have that come-to-Jesus moment with lenders,” says Jim Costello, chief economist at MSCI Real Assets.

Even if forced sales are still rare, the value of U.S. property in distress—in default or special servicing—is rising. In the second quarter, an additional $8 billion of assets got into distress, bringing the total to $71.8 billion, according to MSCI.

Including properties that look at risk, the pool of potentially troubled assets is more than double this amount.

Investment-grade corporate bond yields suggest that property prices have further to fall

Owning commercial property is a bit like owning a corporate bond, only slightly riskier: You bet on the solvency of a tenant, with more uncertainty about the value of the capital you’ll get back.

For at least the past 20 years, investors in U.S. real estate have required a return premium of 1.9 percentage points over the yield on investment-grade corporate debt, according to Green Street’s director of research, Cedrik Lachance.

Right now, real estate only offers a 1.3 percentage point premium. For the relationship to return to normal and make property attractive again, U.S. real-estate prices need to fall a further 10% to 15%.

The Share Prices Of Listed Property Companies Also Point To Further Falls

Publicly traded real-estate stocks provide a live read of sentiment toward property markets. In the U.S., listed property companies currently trade at a 10% discount to gross asset values, based on Green Street data. This is a good proxy for the size of the price falls that investors still expect in private real-estate values.

Investors can also keep an eye on property stocks for signs of improvement. “Listed real estate is a leading indicator for private in downturns and also recoveries,” says Rich Hill, head of real estate strategy and research at Cohen & Steers, who points out that there are already green shoots.

At the end of June, REITs had risen in value for three consecutive quarters and were 13% above their lowest point in the third quarter of last year. Based on how long it usually takes for a recovery to feed through to the private market, property values could hit the bottom within six to 12 months.

All this suggests the best strategy is to buy property stocks but to wait to purchase physical real estate. “If you want to bottom fish in real estate now, do it in the public markets,” says Green Street’s Lachance.

Germany’s Property Market Is Looking Very Sickly

Add construction and real estate to the nation’s long list of economic problems.

If Germany is once again the sick man of Europe, its ailing property and construction industries are unlikely to provide an antidote.

Following a decade-long property boom fueled by cheap financing, new construction and mortgage demand are collapsing while residential and office project developers are filing for insolvency in droves.

The bleak outlook risks dragging Germany back into recession, while worsening an already acute housing shortage. And the three-party coalition government appears at odds about how to help.

Property Depression

German construction companies haven’t been this downbeat since the Great Recession.

Europe’s biggest economy is challenged on several fronts. Demand for German manufacturing exports is sagging, and its energy-intensive industries are having to adapt to life without cheap Russian gas; meanwhile, China has become a much more forceful competitor, especially in autos.

Contributing around 15% of national valued added, construction and real estate activities were until recently a thriving economic counterweight, but these too are now starting to flail.

New construction starts slumped by half in the first six months of 2023, and building permits for new dwellings fell by more than one-quarter.

A toxic mixture of higher financing expenses, building-cost inflation, weak demand and policy uncertainty has resulted in projects being delayed or canceled. With interest rates set to remain higher for longer due to sticky inflation, the situation may get worse before it gets better.

Several developers have filed for insolvency in recent weeks, potentially leaving investors, homebuyers and contractors out of pocket.

Project Pain

Munich property developer Euroboden’s recent insolvency caused the price of its bonds to collapse.

Having set a target of building 400,000 new homes a year to ease pressure on the rental market, Germany will be lucky if it builds half that next year.

Listed property giant Vonovia SE has halted all new construction; it lost €2 billion ($2.2 billion) in the second quarter having written down the value of its properties.

“Building indicators in Germany are particularly weak,” the boss of Swiss sanitary systems supplier Geberit AG told investors earlier this month.

As elsewhere, rising rates are creating winners and losers. Many German homebuyers locked in 1% mortgage rates for a decade or more, thereby shielding borrowers and the banking sector from forced selling.

Yet, fewer than half of Germans own their own homes – the lowest share in the European Union, and far less than the roughly two-thirds of Americans who own their property.

Most Germans didn’t therefore benefit from the property boom. While residential prices have fallen 6.4% from the peak in June 2022 (during which time overall consumer prices increased 7%), transaction volumes have plunged. The upshot is even more people turning to the rental market where costs are rising.

What Goes Up Can Come Down

After rising almost continuously since 2009, German house prices have declined 6% in the past year

Tenants who signed leases years ago are still doing OK; their low rents may not have increased much, and they have no incentive to move.

In contrast, new tenants are often forced to live in apartments that aren’t subject to rent control — owners of furnished apartments with short-term leases have more freedom to adjust rents. In Berlin, furnished apartments now account for the majority of those advertised.

New tenants are also more likely to have rents indexed to inflation. New rents in seven of Germany’s biggest cities rose 6% year over year in the second quarter, according to data provider vdpResearch.

Berlin Is No Longer Cheap

Landlords have circumvented rent controls by offering more furnished apartments with short-term leases.

“It’s more or less impossible for an average or even high-income household to find an appropriate rental apartment for their needs” Ronald Slabke, the boss of real estate tech company Hypoport SE told investors this month.

“If you want to have a nice home in Germany in the next five to 10 years, you need to acquire it. You will not be able to rent it anymore.”

The far right Alternative for Germany party – who around one-fifth of Germans now say they would vote for if there were an election now – hopes to make political capital from the issue.

They blame Germany’s welcome of migrants – almost 1 million Ukrainian war refugees arrived last year — for exacerbating a shortage of homes.

Property developers who made fat profits in the boom years and overpaid for land aren’t necessarily worthy recipients of aid, but Germany can afford to stop a property downturn turning into a meltdown.

This week the government unveiled a 10-point plan to boost the economy, which included enhanced tax deductions for new home construction. The coalition is expected to unveil further housing measures at a summit in late September.

However, the coalition’s attempt to move on from protracted infighting was undermined when Chancellor Olaf Scholz’s Social Democrat party said stricter rent controls are needed.

(Currently landlords are only allowed to increase rents by a maximum of 15% in three years in areas with acute housing shortages. The SPD proposal would reduce this cap to 6%.)

While I’m sympathetic to renters’ plight – landlords often ignore the existing rules — further interventions risk discouraging housing investment.

The debate is symptomatic of a broader problem with policy uncertainty and excessive bureaucracy in Germany.

Earlier this year, the government announced plans to all-but outlaw fossil fuel boilers, only to water down the proposals following an outcry from conservative media over the costs. Applications for heat-pump subsidies subsequently slumped.

Net direct investment in Germany plunged last year to the lowest level on record; some very heavily subsidized semiconductor factory announcements haven’t altered the impression that businesses see better opportunities and conditions elsewhere.

Just as at the turn of the century, it may require a protracted economic malaise to spur Germany to take decisive action. There’s certainly the makings of such a crisis in real estate.

Updated: 8-31-2023

China Evergrande Unable To Pay Wealth Products Due To Cash Crunch

China Evergrande Group’s money management arm said it couldn’t make payments for investment products this month due to a liquidity crunch.

The developer said that it’s been disposing assets to raise money for the payments, but due to setbacks it didn’t receive proceeds and is unable to make the payments, the company said on its official WeChat account on Thursday.

Evergrande, the poster child for China’s property crisis, is among a number of real estate firms that defaulted amid a housing meltdown over the last few years.

Its protracted process to finalize one of the country’s biggest restructurings ever remains in limbo as key votes on its offshore-debt restructuring plan was delayed again this week.

The company missed payments on 40 billion yuan ($5.6 billion) of wealth management products in 2021, sparking nationwide demonstrations and putting pressure on Beijing to find a solution to avoid further unrest.

At the time, more than 70,000 people bought the products, including many Evergrande employees, as the cash-strapped developer tapped them for funding.

Country Garden Downgraded By Moody’s As Default Pressure Mounts

* Moody’s Downgrades Distressed Chinese Developer To Ca

* Developer’s Liquidity Crises Shakes China’s Financial Markets

Moody’s Investors Service downgraded embattled Chinese developer Country Garden Holdings three notches to Ca, piling on more pressure on the distressed company whose liquidity crisis has shaken the nation’s financial markets.

The rating agency’s outlook on the developer remains negative, as it estimates that the company doesn’t have sufficient internal cash sources to address its upcoming offshore bond maturity, given its weakening sales and sizable maturing debt over the next 12 to 18 months, it said in a statement. Country Garden’s long-term corporate family rating was downgraded by Moody’s to Ca from Caa1.

“The rating downgrades with negative outlook reflect Country Garden’s tight liquidity and heightened default risk, as well as the likely weak recovery prospects for the company’s bondholders,” Moody’s said.

The rating agency also pointed to its high debt leverage and the large amount of financing at the operating subsidiary level, it said.

Moody’s also downgraded the developer’s senior unsecured rating to C from Caa2. While Country Garden could service its debt through asset disposals or other fundraising, such activities carry high uncertainties, Moody’s said.

Investors who say they collectively hold 10.5% of a yuan bond effectively due Sept. 4 have proposed the note be declared in default because of a recent downgrade, according to a filing to the Shanghai Stock Exchange’s private disclosure platform that was seen by Bloomberg News.

Country Garden reported late Wednesday an unprecedented net loss of 48.9 billion yuan in the first half of the year and warned of possible default.

The builder’s distress has deepened after it missed $22.5 million of dollar-bond coupons earlier this month, dragging the broader Chinese junk dollar debt market to its lowest levels this year. It must repay within a separate grace period that ends next week to avoid default.

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