January 26, 2024
By Steve Blumenthal
“I hope there are days when your coffee tastes like magic, your playlist makes you dance, strangers make you smile, and the night sky touches your soul. I hope you fall in love with being alive again.”
– Brooke Hampton
I really like the Tampa area. Well, except for the football team and the beatdown they gave my Eagles. I’ve been spending the week here, and the temperature reached 80 degrees both Wednesday and Thursday. Much better than the low teens we saw in the Northeast last week.
Wednesday was a full day of investment presentations. Like me, the attendees were investment managers and due diligence offices, with fund sponsors primarily in the multi-family and single-family housing space. That was timely, considering the subject of last week’s On My Radar: Commercial Real Estate “CRE” – The Next Big Short?
Housing, in general, continues to look favorable to me because of the beneficial supply (low) and demand (high) dynamics. Prices have come down off their highs, as Liz Ann Sonders shared in an X post today (see below). It makes sense, given the period of zero interest rates (a.k.a. free money) we’ve exited. If mortgage rates drop to 5.5%, as I predict they will, the market should find good support. More than a few will be bidding on the same house.
Higher mortgage rates have cooled new buying activity almost everywhere. Some areas are in better shape than others. The commercial office space situation, however, is another story. Today’s subprime-like problem? Possibly. We’ll look deeper into it today.
But first, back to the conference in Tampa.
Four different real estate funds presented. One invests in existing multi-family and student housing. They buy, manage, fix up the units, and increase the rents with the goal of exiting their properties at a higher price. Buy, fix, improve, sell. Two of the funds develop real estate. The fourth fund is creating an entirely new real estate investment category in the vein of professionally managed Airbnb vacation rentals. These properties generate considerably more cash flow than traditional home rentals. Hearing this piqued my interest.
It wasn’t just the subject matter of the presentations that was interesting. The format of the due diligence meeting allowed attendees to pepper the presenters with questions. There were some very smart people in the room, and their questions made for quite a fun, Shark Tank–like atmosphere.
I was mainly interested in understanding the source of each fund’s debt, financing costs, loan timelines, the willingness of their banks to lend, and other potential stress points.
My high-level takeaways are that, at the moment, capital is more difficult to obtain but not impossible. Banks have cut back the amount of money they’re willing to lend. The typical loan-to-value (LTV) ratio is 40– 50%, which is down from 60–75%. That’s a material change. Think of it this way: If you were looking to buy a multi-family apartment building for $1 million a year ago, banks would have lent you up to 75% of the cost, or $750k. Today, they will only lend you 50%, or $500k.
Overall, because interest rates are higher, debt costs are also higher, and while the funds can find additional sources of debt, they come at much higher lending rates. Higher funding costs combined with lower lending ratios logically decrease potential returns. Gone are the hot returns of the zero-interest-rate-policy days, but the market generally looks to be in okay shape. The key to the equation is available liquidity within the banking system, and that’s where the problems in the commercial office space could come into play.
Bad stuff happens when the leverage ratio gets too high while property values decline. That’s the problem in the commercial office market today. Loans are coming due, and since many companies moved to partially or fully remote workforces in the pandemic and, therefore, left office spaces empty, property values have come way down. As you saw in the 60 Minutes video report shared in last week’s post, there’s a massive supply of unrented office space. Rents support a landlord’s ability to stay current on their loans. Refinancing them is an issue for both the landlords and the banks.
Is this impacting banks’ willingness and/or ability to lend? Yes, and we are just in the early innings. And this can spillover to all other areas that require bank financing and to the broader economy.
In last week’s OMR, I raised the question of whether or not this will be “the Next Big Short.” By that, I’m, of course, referring to 2008, when Wall Street guru Michael Burry realized that a number of subprime home loans were in danger of defaulting. Burry bet against the housing market by throwing over $1 billion of his hedge fund money into credit default swaps on subprime mortgage loans. Think of them like put options; you make money when the price drops. He and several others made a fortune from the economic collapse. The crisis put Lehman Brothers out of business and sent then–Treasury Secretary and former Goldman Sachs Chairman and CEO Hank Paulson to legislators begging for a banking bail-out. Great leverage can cause great problems.
So, are we on the doorstep of another Big Short? The answer lies in the banking system and the backstops that legislators and the Fed may or may not provide to the system. The office rental woes are real. The uncertainties are the value of the underlying collateral, the level of bank exposure, and the ability of landlords to refinance their debts. Personally, I don’t believe this is as big of a problem as the subprime junk that avalanched the banking system in 2008, and the Fed and legislators have proven they are willing to be shockingly creative, but the risk to the banking system is not immaterial. We will go deeper into the issue today, concluding next week with a piece that gives us a sense of the size of the exposure within the system.
Grab that coffee and find your favorite chair. I’m going to share some notes from my conversations with a former banker–turned–real estate investor and another developer friend from the Northwest. He’s been sounding the alarm bell for several months and says what we’ll see next is “jingle mail”—like the sound the keys make in the envelope sent from the property owners to their banks.
You’ll find a few telling charts as well, and we’ll look at the cyclical trend in the S&P 500 Index and the 10-year Treasury Yield. Finally, don’t miss this week’s Random Tweets section. Thanks for reading. It’s time to hit the send button… I’m heading home “to let the night sky touch my soul”… alongside my beautiful wife, Susan. Wishing you and your loved ones the very best.
On My Radar:
- Commercial Real Estate – Office Rental Woes, Banking Exposure, Systemic Risk (?)
- Hotter GDP but Cooler Inflation, MBS Highway
- Market Technicals: S&P 500 Index and 10-Year Treasury Yield
- Random Tweet’s
- Personal Note: Snowbird
- Trade Signals: Weekly Update, January 24, 2024
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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Commercial Real Estate – Office Rental Woes, Banking Exposure, Systemic Risk (?)
Lights up on my call with a banking insider:
My friend Dan has been an On My Radar reader for a number of years. He has extensive experience in the CRE world—including with all property types and in all market conditions—having worked on over 800 transactions with a total value exceeding $26.3 billion, spanning development, ownership, repositioning, restructuring, and lending. Commercial Observer recognized him as one of “The Most Important Figures of Commercial Real Estate Finance.”
Dan reached out to me after reading one of my recent newsletters. He believes that with the tumultuous state of the commercial real estate market, investors should seek protected risk-adjusted returns, which can be achieved by proper evaluation and structuring of investments at a lower basis in the Capital Stack.
Below are a few slides Dan gave me permission to share with you. I have included notes from our discussion. The first slide sets the stage. It’s information you know, but it’s always good to review:
The key is the last statement: “This environment encouraged borrowers to pay higher prices for assets, including real estate.”
Inflation followed: “The increase in rates has put incredible pressure on both borrowers and lenders.”
Perhaps the most telling slide in Dan’s presentation is this next slide.
Here are the basics:
- Deals were done where the asset buyer put up 35% of the equity, and the bank financed the remaining 65%. That’s 65% debt to 35% equity.
- At the time of the acquisition, the property generated $4.25 million (net operating income).
- But now, since financing costs have increased so much, the net operating income generated from property rents has decreased. In the case of commercial office space where we have high vacancies, it’s even worse.
- So, the value of the building is now worth less.
- The challenges come when the buyers need to refinance the loans.
- The bar on the right in the graph below assumes the cap rate increases to 6%, which reduces the value of the property from $100 million to $70.8 million.
- Under this scenario, the bank will resize the loan to $46 million, down from $65 million.
- As a result, the property owner will lose $29 million, so they need to find some rescue capital in order for a new loan to be written.
- This assumes the property owner is earning enough in rental income to cover expenses, including the higher interest costs.
- Without rescue capital, the owner turns the keys over to the bank.
- Thus, “jingle mail.”
The cost of borrowing has risen sharply. In the chart below, look at the change from pre-pandemic levels to current ones. Ouch!
Dan also sent me a report from Muddy Waters, a short-selling firm that looks for problems and takes short positions to profit in decline. Muddy Waters estimates that one popular REIT (real estate investment trust) fund needs a 180-bps decline in the Fed Funds rate. Otherwise, they’ll have to eliminate their entire dividend payout. I do not have authorization to share the research report.
See the debt maturity calendar below (squared in dotted red). The tipping point is when the loans mature and need to be refunded. I asked Dan about the 2023 debt; he said the 2023 loans have been pushed to 2024, which, surprisingly, the banking regulators are allowing for now. Pretend and extend, apparently. Everyone is hoping the Fed will cut rates by six times or more.
But there is a short timeline for the ability to avoid the issues; there’s $1.9 trillion due to be refinanced.
Many large owners have already started defaulting on their properties. And several more have happened since Dan created this slide.
For his own part, Dan previously owned 36 properties. He sold them all a few years ago and is waiting to reenter the market to buy at distressed prices. According to him, there’s no reason to go over the top and buy these assets right now because every banker he talks to says they “have no problems,” but the loans paint a different picture. He says he’s made offers, and they go to their board of directors or board and waive all the covenants. But you shouldn’t be able to do that if you’re an SEC-reporting bank and you’ve got to issue GAAP-compliant statements. This tells us that the Feds have softened their regulatory position (for now). If Dan were still Vice Chairman of a bank, they would have made him reappraise and take write-downs on every single asset.
I told Dan I’m concerned that the Fed will create a Bank Term Funding Program number two similar to the BTFP they created on March 12, 2023, in response to the banking crisis (SVB, Signature Bank, etc), except that this time, they’d allow banks to push off their bad commercial real estate loans at par. It pains me even to posit that.
Dan suggested that another possible solution, modeled after something utilized in Europe, that doesn’t involve another government bailout. Europe created a market for synthetic securitizations based on Basil III banking standards that allow you to make what is called a substitution. It involves getting a guarantee from another entity that can issue debt. Think of outside investors putting capital into various pools of different levels of risk-and-reward investment structures. This new capital shifts the risk, allowing the banks to free up capital in their books.
The challenge is that no banking regulator is currently willing to give Dan and his team an opinion on this. They will only give their opinion directly to a bank. I’m pulling for Dan.
Concluding thoughts:
Capital will freeze up in another banking crisis. I believe that the Fed is well aware of the problem, and they’ve certainly shown the will to backstop the system with creative new programs. Dan concluded that we were at the top of the first inning with the first batter at the plate—still early in what is likely to be a big problem unless the Fed takes the Fed Funds rate back down to 3% (my guess) or creates something similar to the Bassel III enabled synthetic market in Europe. However, I really have to learn more about that market. A better solution at face value than putting more junk assets, priced at par, but worth significantly less, onto the backs of the US taxpayers.
We’ll go more into the size of the problem next week.
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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Hotter GDP but Cooler Inflation, Barry Habib – MBS Highway
My good friend Barry Habib has an excellent subscription service called MBS Highway. His clients are mostly real estate professionals and mortgage brokers. With his permission, I’m sharing with you his comments on yesterday’s GDP and Inflation data.
Barry sent me this late this morning. Video link: “It’s Only Rock and Roll But I Like It”
Opinions are Barry’s and subject to change.
(Reminder: This is not a recommendation to buy or sell any security. My views may change at any time. The information is for discussion purposes only.)
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Market Technicals: S&P 500 Index and 10-Year Treasury Yield
I post the following two charts in Trade Signals each week. Free to clients. You can subscribe here.
The S&P 500 Index:
Here’s how to read the chart:
- The first big observation is that stock prices move up and down, and the swings can be large.
- Next, take a look at the lower section of the chart. Plotted is a MACD of two moving average lines (a 12-week and a 26-week). Signals occur when the lines cross. Green arrows signal a rising price trend in the stock market. Red arrows signal a declining price trend.
- Also, take note of the top section in the chart that plots something called RSI. It stands for relative strength index. It is a technical indicator that compares recent price gains against recent price losses. It is used by traders to identify overbought and oversold conditions in the market.
- The top line shows an RSI of 70 (overbought extreme), and the current reading is 70.63.
- The bottom line shows an RSI of 30 (oversold extreme). The oversold extreme was reached in March/April 2020 (COVID). There were few other periods in the last five years. Generally, readings near 40 are good entry points.
- If you are a trader looking to sell the rallies and buy the dips, RSI may be helpful.
- Overall, MACD continues to support the bullish price trend. However, we are late in the move with RSI above 70.
The 10-Year Treasury Yield:
Here’s how to read the chart:
- The first big observation is that yields move up and down, and the swings are large. The tag boxes show various levels, with the most recent high of 4.99% in Q3 2023.
- The yellow highlighted zone estimates a possible target for rates. The high end of the range is 3.75%, and the low end of the range is 2.75%.
- You can see that rates declined from 4.99% to 3.785%, touching the top end of the yellow zone, and closed yesterday, 1-25-24, at 4.13%.
- Next, take a look at the lower section of the chart. Plotted is a MACD of two moving average lines (a 12-week and a 26-week). Signals occur when the lines cross. Green arrows signal rates dropping. Red arrows signal rates rising.
- Bottom line: Technical evidence suggests the intermediate-term direction in interest rates is down. As you can see, signals can last for months.
Conclusion: I believe we are on the back-end of inflation wave #1, and I don’t see how we can avoid a recession. Wall Street economists are predicting six Fed interest-rate cuts this year. The majority are calling for a soft landing, but six cuts will only come if we’re in a recession, so I don’t understand the mismatch. If we have a recession, I expect rates to drop toward the lower end of the yellow zone (see the above chart).
My view hasn’t changed: Expect a rollercoaster ride with big swings up and down in stocks and interest rates over the balance of the decade. I would sing a different song if valuations weren’t so darn high.
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.
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Random Tweet’s
Recession has followed every move above the dotted red line:
US Government Debt topped $34 Trillion.
Debt Spiral is explained here:
“Let that sink in.”
Follow me on X (formerly Twitter) @SBlumenthalCMG.
Not a recommendation to buy or sell any security. For discussion purposes only. Current viewpoints are subject to change.
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Personal Note: Snowbird
As I mentioned at the start of this newsletter, I really enjoyed my trip to Tampa. The excellent weather allowed me to play some golf Thursday morning before racing to the airport to catch my flight back to Phila.
My caddie was a young man in his early 30s, married with two children. He’s a mortgage broker, but business has been difficult recently with the Fed raising interest rates from 0.25% to 5.25% over the past three years. Three years ago, he made nearly $300k in income. Two years ago, it dropped to $175k. By last year, it was just $75k. If you want to get a sense of how rising rates slow the economy, ask a caddie (or plenty of others in the housing ecosystem).
He was clearly a smart person, who’s doing what he needs to do to support his family.
Speaking of family, Snowbird is up next on our calendar for Feb 3–10: Susan, me, and four of our six children. I’m really looking forward to the bonding time together. And praying for some fresh new powder snow.
Wishing you a wonderful week.
Kindest regards,
Steve
Trade Signals: Weekly Update – January 24, 2024
“Extreme patience combined with extreme decisiveness. You may call that our investment process. Yes, it’s that simple.”
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Stephen B. Blumenthal
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