Financial Stability Oversight Council Says CRE Is Big Financial Risk

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In its 2023 annual report, the Financial Stability Oversight Council — a legacy of the Dodd-Frank Act that includes a broad array of federal banking regulators and others — pointed to multiple financial risks for the U.S. First on the list, commercial real estate.

At the top of the CRE section, $6 trillion in loans as of 2023 Q2, with half sitting on the balance sheets of banks, because these don’t get sold off to government agencies the way residential mortgages do. CRE loans are also the largest loan category for almost a half of all U.S. banks.

The concentration makes for a systemic weakness, especially as “the CRE market faced a rise in vacancy rates and declines in value for some property types, elevated interest rates, heightened CRE loan maturities, inflation in property operating costs, and an increase in CRE loan delinquencies.”

None of this should be a surprise to anyone who has been monitoring the market.

The agency’s concern is the one many in CRE have expressed.

“High interest rates increase refinancing costs for borrowers and can lead to decreasing property values across CRE sectors,” the report said. “If the decline in property value is significant relative to the time of financing, then the borrower may not be qualified to refinance the loan at maturity without an additional injection of equity. Thus, the loan may need to be restructured or entered into default, causing losses for the lender. As losses from a CRE loan portfolio accumulate, they can spill over into the broader financial system.”

That can cause banks to dump loans and properties, driving down values further and creating a vicious circle and also tightening credit availability. There are already signs of loan distress, with the delinquency rate for banks up 0.74 percent in the second quarter of 2022. CMBS delinquencies are also up.

Another concern is that bank stress could spread through interlinkages among banks, insurance companies, REITs, and private lenders.

The FSOC has some recommendations, that “supervisors, financial institutions, and investors continue to closely monitor CRE exposures and concentrations, and to track market conditions.”

The suggestions include ongoing evaluation of loan portfolios’ “resilience to potential stress, ensure adequate credit loss allowances, assess CRE underwriting standards, and review contingency planning for a possibly protracted period of rising loan delinquencies.”

 

Source:  GlobeSt.

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The Nightmare Scenario for CRE Bank Loans

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A lot of discussion in business and economic circles is around whether 2024 will bring a soft landing or some degree of recession. The optimists have been out in force for some time and are expecting a Federal Reserve rate cut as soon as the first quarter of next year.

But there are still those who think a recession could happen and that victory is far from clear. If that proves to be true, Yale School of Management’s Professor of Finance and Management Andrew Metrick says to prepare for some serious trouble for commercial real estate and the banks that hold the loans.

“Historically, for every one percentage point increase in the policy rate from the Fed, banks take 1% hits to their capital over the next eight quarters,” Metrick said in an interview with Yale Insights. From the zero-interest rate to the current baseline federal funds rate range of 5.25% to 5.50% has been a large and rapid leap. “If banks lose 5% of their capital, there are going to be a lot of banks in trouble.”

“If we manage to avoid a recession and get a soft landing, the banks will recover,” Metrick says. “Past commercial real estate downturns have been slow moving things,” he explained. “We spent 10 years after the global financial crisis working out a whole lot of problems.”

At issue is the deep intertwining of banks and commercial real estate. As Metrick notes, the banking system holds about $3 trillion in CRE loans on their book sheets, $2 trillion of which is held outside the largest 25 financial institutions. To date, the loans have performed because their interest rates have been low. Refinancing is drastically changing that.

If a soft landing skips and slides into a recession, the processing of CRE loans would kick into high gear because banks don’t typically sell them on as they do with residential mortgages. Under a 2016 change in accounting standards called Current Expected Capital Losses (CECL), “banks are supposed to take seriously what they think the probability is of something paying off in the future, even if it’s current,” Metrick says.

His “nightmare scenario” starts with banks as yet having to provision adequately for potential losses. In a recession, banks are even more reluctant to lend into commercial real estate than they have been. Many loans don’t get refinanced, and some bank somewhere becomes the “Silicon Valley Bank of commercial real estate” that suddenly fails. Congress investigates and finds that the bank not only failed to have reserved enough, but also didn’t warn shareholders.

“That next quarter, every accountant in the world is going to tell their banks, ‘I’m not going to be the one blamed if you fail.’ They’re going to get very tough on CECL, and what looked like a slow-moving downturn suddenly crystallizes as an expected value disaster that everybody has to put in their balance sheets at the same time,” Metrick says.

Many banks, maybe hundreds, now become insolvent, creating a wave of closures not seen since the very worst of the Global Financial Crisis.

“Not to leave you super scared, but you should be a little scared because I’m a little scared,” he says.

 

Source:  GlobeSt.

 

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4 Trends That Will Shape Florida Real Estate In 2024

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As commercial real estate markets across the U.S. cope with rising costs and slowing demand, Florida has been a rare bright spot. The Sunshine State has welcomed a record number of people and businesses in recent years, and that activity is driving strength and stability across asset classes.

Florida is home to six of the country’s top 20 most competitive multifamily markets, its tourism sector set a new visitation record in 2022, and office market dynamics from Miami to Tampa are outperforming national averages.

As 2024 approaches, the burning question is whether Florida’s commercial real estate landscape will remain resilient. Bilzin Sumberg, which has one of the largest and most active real estate practices in the state, is tracking the following trends heading into the new year.

1. Lenders will become even more selective

Developers have been grappling with escalating costs on multiple fronts throughout 2023, and this is unlikely to ease as interest rates, inflation, wage growth and insurance costs mount and lenders have been grappling with valuations and pricing. As a result, capital for commercial real estate investments will be increasingly hard to come by, as lenders will be more selective about the deals they choose to finance. The more expenses and interest rates rise while uncertainty prevails, the more difficult it will be to complete deals in 2024. Developers will become even more strategic about the projects they pursue, and more proactive in getting ahead of potential challenges.

The good news for South Florida is that developers are still building, according to Bilzin Sumberg’s real estate practice chair Suzanne Amaducci. The demand for the South Florida lifestyle remains strong from both domestic and international buyers. Condo construction projects financed in part with upfront buyer deposits have obtained financing and are now underway with more projects to start in the near future, Amaducci reports.

“Our team is on track to close at least four condominium construction loans with a combined value of more than $600 million before the end of the year,” Amaducci said. 

2. The Live Local Act will spur development in metro areas

Against the backdrop of a housing affordability crunch and tight financing environment, one Florida law enacted in 2023 is becoming an important vehicle for developers and investors looking to get shovels in the dirt.

The Live Local Act is a statewide housing strategy designed to create affordable and attainable housing opportunities, allowing more of Florida’s workforce to live in the communities they serve. The act offers funding and tax credits, and mandates that local governments administratively authorize multifamily development on certain sites if at least 40% of units will be affordable for people making up to 120% of the local area median income.

The Live Local Act could become a blueprint for other states to follow as cities across the U.S. contend with an affordability crisis.

“This is Florida’s most significant land use policy change in 20 years to address the biggest problem we have had in 100+ years,” said Bilzin Sumberg partner Anthony De Yurre, who is advising on more than 40 projects advancing under the law. “The Live Local Act is crucial for teachers, government employees and other pillars of Florida’s economy, many of whom have been priced out of the best employment centers, resulting in long-distance commutes. It’s also a game changer for developers. In many cases, this law will be the difference between a project getting done or shelved.”

3. Condo redevelopment deals will grow in popularity

Florida is home to 1.5 million condo units, and 925,000 of those are more than 30 years old, according to Bilzin Sumberg real estate partner Joe Hernandez. Nearly 50% of those units are in Miami-Dade and Broward, making South Florida fertile ground for condo terminations that pave the way for redevelopment.

As Florida’s population grows, aging condo buildings emerge as prime targets for buyouts that pave the way for redevelopment. The impetus behind this trend is twofold: the imperative for costly repairs mandated by state regulations enacted in 2022, and escalating construction and insurance costs.

Condo associations at aging properties are dealing with the worst of all worlds, as expensive repairs required under state regulations passed after the collapse of South Florida condominium Champlain Towers in 2021 are colliding with mounting costs. Compounding the problem is Florida’s insurance crisis, which is resulting in fast-rising premiums, decreased coverage amounts, and some insurers becoming insolvent or exiting the state altogether.

“The confluence of factors in Florida creates fertile ground for developers seeking to breathe new life into aging condominiums – and with a surge in population, the demand for housing is more pronounced than ever,” said Bilzin Sumberg’s Joe Hernandez. “Condo terminations represent a strategic move in response to higher maintenance costs, rising insurance premiums and tightening regulations.”

Florida is likely to see even more of these deals in 2024 as condos struggle with higher maintenance and insurance costs, and tighter regulations.

 

4. Initial signs of distress will emerge

For all of Florida’s strengths, there is no escaping the fact that almost $1.5 trillion in commercial real estate debt comes due by the end of 2025. For the time being, distressed properties are hard to come by in Florida, but that may change as pressure mounts on owners whose assets currently benefit from low financing costs.

“The CMBS market is cyclical, and many property owners took advantage of the prolonged period of low capital costs that ended in 2022,” said Karyl Argamasilla, co-head of Bilzin Sumberg’s CMBS and real estate capital markets practice. “We anticipate a wave of loan maturities in 2024 and 2025. In some instances, these loans will not be able to be refinanced or paid off, which could trigger an uptick in workouts.”

 

Source: JD Supra

 

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What CRE Industry Insiders Are Thinking Might Happen In 2024

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Commercial real estate professionals agreed in the Fall of 2022 that 2023 would have a healthy serving of uncertainty, with falling transaction volumes leading to a lack of price discovery and rising interest rates putting pressure on financing.

Still, people thought that by the second quarter of 2023, things would be getting back to normal. No one had a clue how long inflation would hang in, how high interest rates would go, and how much macroeconomic trouble there would be with banks being closed, many lenders pulling back, falling valuations, the ongoing impact of higher interest rates, major strikes by unions, political division, and more.

CRE pros are being much more careful and circumspect now.

As Jeff Klotz, founder and CEO of The Klotz Group of Companies, says, “The only certainty we’ve added is that it’s more uncertain.”

Welcome to the future. Here’s what industry insiders are thinking might happen this year in key areas.

PRICE DISCOVERY AND VALUATIONS

With all other problems, discovery of many types is maybe the biggest, because it holds important answers, if only that discovery gets to happen.

“For the next 12 months, the theme will be a discovery of the result of all the mistakes made over the last several years,” Klotz says. On the transaction level, he thinks that “the divide between buyer and seller is larger and wider today,” and “it hasn’t shrunk as we had expected at this time last year,” Klotz says. His company buys, sells, owns, operates, consults, borrows, lends, and develops with 12 different wholly owned subsidiaries.

Klotz gets excited over the potential for buying “some discounted and cheap real estate.” His big worry is his own portfolio.

“Let’s face it, I can’t control the market. I can’t control what it’s worth because the market does that.”

PRIVATE MARKETS HAVE YET TO PRICE IN CHANGES

Going hand-in-hand with a lack of price discovery is the opacity and potential over-valuation of private real estate values.

“The public REIT markets have already priced in the impact of higher debt caps and are trading at the 6% cap rate,” says Uma Moriarity, senior investment strategist and global ESG lead for CenterSquare. “For core private real estate funds, we look at the NCREIF ODCE Index. The valuation across those funds is still close to a 4.2% cap rate. If you don’t have transactions, you don’t have comps and you don’t have the right data feed appraisers need. In terms of the 4.2 cap rate, those ODCE funds are doing transactions in the 5% cap range. We think the public REITs are on the slightly cheap side of fair because the private market is still overpriced.”

According to research from CenterSquare Investment Management, REITs historically outperform private real estate and equities in the periods of time after rate hiking cycles end. If the Fed does stop the upward march of its rate hiking cycle, 2024 could see REIT outperformance.

INTEREST RATES

If there is any single number that is a meaningful metric for the industry, it’s the federal funds rate, the benchmark interest set by the Federal Reserve, with its enormous impact on financing costs.

“I think you could argue very convincingly that the 30-year bull run is over,” Nancy Lashine, managing partner of Park Madison Partners, says. “I don’t think I’m ever going to see a 2% Treasury rate again. I don’t think we’ll ever see a 3% or 4% mortgage rate again. You could argue there’s no good deal. There’s plenty of capital but no good deal.”

 

“I would say we’ve enjoyed cheap money for a very long time, but it’s led us to a lot of pricing perhaps that was reliant on that cheap financing,” says Tess Gruenstein, senior vice president, acquisitions and portfolio management, real estate at Bailard. “When it goes away, things shift. We’re back to a more normalized environment and people won’t do deals because they’re optimized for leverage.”

That means a lot of real estate — and not just office — is going to be underwater.

“We have a lot of groups coming to us because we raise private equity capital. The best thing anybody can say to us is we have no legacy assets,” says Lashine. “If you were in this business over the last 15 years and you heard someone say, ‘I sold everything in 2005, 2006, and 2007,’ not only is he a good operator, but he has good timing. That was the best story anyone could tell and you’re going to hear those stories again.”

LENDERS PULL BACK

“This is kind of a doom and gloom moment,” says Stephen Bittel, chairman and CEO of Terranova Corporation. “The real challenge is that, whether they admit it or not, most banks are pretty much out of the lending business. There are a handful that will continue to dip their toes in the water for best customers with good equity and balance sheets.”

Many banks are worried about depositors seeing some assets, whether long-term Treasuries and mortgage-backed securities, or CRE-backed loans, as suspect, as happened with bank closings in 2023. Depositors pulled their money. For the first time, bank deposits contracted, by 4.8%, in the first half of 2023. Banks are worried that CRE loan values could drop in the face of falling property valuations, cutting asset values and making it harder to cover further worried withdrawals.

“If the small and mid-sized banks stop lending, which they effectively have — they’re pushing deals with high rates — businesses will shrink and cause a recession,” Bittel adds. “Banks are nervous about the future because it’s uncertain.”

 

Adam Fishkind, a member of law firm Dykema Gossett, says his “loan origination practice has definitely fallen off a cliff” — not just with banks, but other sources. “When I do borrower representation, I don’t see a lot of CMBS deals coming through these days.

“A lot of that has been replaced by private equity lending” with “the overall loan transaction is more akin to hard money lending.” Rates are higher and generally include points on the front and back ends, with larger spreads, shorter terms, and higher interest rate floors.

 

“Our expectations is that we’re not going to see an early improvement in 2024,” says David Cocanougher, president of multifamily at Leon Multifamily, part of Leon Capital Group. “I think there’s a tendency to want to be optimistic, but the longer this continues, the more down to earth everybody becomes.”

OFFICE SPECIAL SERVICING AND DEFAULTS

Ongoing data from multiple sources have shown that defaults, workouts, and special servicing are all on the rise, especially for office.

“We’re seeing some large office product defaults in the CMBS special servicing stuff that I do,” says Fishkind. “A lot of these buildings, they have a couple of major tenants that have left. If you have an A property and a great location, you probably still have a pretty good asset. But if you have suburban office or older office, you might have trouble again. It’s one of those opportunities where people are probably reducing space and putting the money in their pocket because they’re nervous about the possible recession, or they’re reducing space and going to a better environment.”

 

DISTRESS

“There are more distressed situations and transactions happening because of the way projects were structured because of floating rate debt or even pressure from equity partners to get a faster exit,” Cocanougher says.

 

“A lot of people say things because they want to move the market,” Jason Aster, vice president at KBA Lease Services, says. “The truth of the matter is my business exclusively relies on tenants taking office, but other than highly liquid companies poised to take advantage of distress, I don’t see anyone jumping in to invest in office assets, or any commercial assets.”

GlobeSt.com has previously reported signs of a secret distress market — increased bank CRE charge-offs and higher levels of distressed CRE loans — largely being handled privately and that has not broken out into a fully obvious run on distressed properties.

“What you’re seeing in leases is a focus on how a landlord or owner could apportion reinvestment,” Cocanougher adds. “What you’re seeing in leases are ways for the landlord to take back space originally designed for tenants, but then” charge back the costs or possibly even the lost rents. “While super high quality, trophy office assets will be fully booked and retain their value, landlords will hand the keys of distressed assets back to the lenders at a greater frequency in 2024. This will be particularly prevalent in the older Class A and Class B office product in dense cities like NYC and San Francisco.”

Klotz refers to the current distressed market as “private” and “embarrassing.” No one wants to talk about it publicly because they don’t want to draw attention to having made a mistake and losing money. Or, on the other hand, they don’t want others to realize that they bought some distressed properties and got a good deal. And the data lags because these events are in real time.

But it’s also attractive. “If you’re a core buyer, you can look around and say, ‘Would I take a 7% interest rate on a core investment?’ I think so,” Gruenstein says. “If you have a long-term perspective and patient capital, it’s very easy to make a case that now is the time to be out in the market, picking up some of these great pieces of real estate.”

Many with capital in their back pockets may still be waiting, though.

“I think there’s possibly a lot of equity being kept out,” says Tere Blanca, chairman and CEO of Blanca Commercial Real Estate. “It’s eroding if you had any, with values being hit as much as they have been. You wake up to higher interest rates and to much higher costs of operating your property and values are getting impacted. It’s a difficult time to navigate.”

 

“We’re still being patient, for sure, especially when it comes to investing in hard assets,” says Matt Windisch, executive vice president at Kennedy Wilson, which bought PacWest’s CRE loan portfolio for $2.4 billion back in June. “We continue to think that the construction lending space is extremely interesting. We have committed capital partners to fund an expansion.”

CONSUMERS PULL BACK

While consumer spending has appeared to continue strongly, it may not be all it seems. When the Census Bureau reports on consumer spending, it doesn’t take price differences into account. In other words, these are nominal and not real changes in spending behavior. To top it, the changes in spending are to only a 90% confidence interval that generally includes zero, so there is no way to tell if there’s been an actual change.

“I think part of why the pickup in transaction volumes didn’t happen this year is the Fed kept raising rates,” says Moriarty.

The translation from monetary strategy to the rest of the economy isn’t working as it has in the past.

Moriarty says she’s seen a rolling recession across the economy, but that it hasn’t hit the consumer. “That lasted a lot longer than any of us anticipated,” she says. “If you listen to what we saw from a lot of the consumer-oriented earnings this past earnings season, listening to what the hospitality REITs were telling you or the apartment REITs were telling you, you were seeing a pullback from the consumers.”

Credit card debt is at an all-time high and credit card and auto loan delinquencies are on the rise.

“The other new big thing to watch relates to student debt payments coming back online,” she adds “It seems difficult with the lack of credit availability overall to see that level of tightening without an impact.”

Consumers had built-up liquidity from Covid, but estimates, including from the Federal Reserve Bank of San Francisco, suggest that is likely gone. Not what you want to see when you’re hoping to avoid a recession, but consumer spending is 68% of GDP.

 

Source:  GlobeSt.

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Local Commercial Real Estate Foreclosures Tick Up In 2023

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This year, South Florida saw an increase in the number of significant business foreclosure cases filed.

Seventeen foreclosure lawsuits totaling at least $2 million on commercial real estate were filed for the 12-month period ending on October 30 and are still pending, according to the Business Journal. A year earlier, there were 15 lawsuits of this type at the same time.

The Business Journal reported in 2023 on four commercial foreclosure lawsuits that have since been settled out of court.

Rising building costs and high borrowing rates are posing problems for many developers, making it more difficult to sell their properties or refinance. Eight of the seventeen cases on the list are related to large-scale construction or remodeling projects.

Only one foreclosure involved an office that was leased to tenants, despite worries about the state of the office market across the country. But there were three cases concerning lodging establishments.

 

Source:  SFBJ

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Is A Sale-Leaseback Strategy A Viable Alternative For Your Business?

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By Ron Osborne, Managing Director, Sperry Commercial Global Affiliates | RJ Realty

 

As a financing method, a sale-leaseback holds more advantages for businesses compared to leveraging their balance sheets. With today’s escalated interest rates, a scenario has emerged where the sale-leaseback option outweighs borrowing avenues for companies. If a business’s borrowing rate for a leaseback (or cap rate) is significantly lower than its corporate borrowing rate, redirecting equity tied up in a building becomes a viable alternative, particularly for business expansion.

Often, businesses encounter opportunities to broaden their reach or enhance their current facilities. Capitalizing on these prospects sometimes demands more funds than readily available. In such cases, selling the property, unlocking the tied-up equity, and reinvesting it into business expansion or improvements becomes a more cost-effective solution than traditional borrowing options.

Consider this: if the borrowing rate stands at 9% to 10%, but the business can sell and lease back the property at 6% to 7%, there exists a substantial 200 to 300 basis point spread. Undoubtedly, this presents a far more advantageous financing route than leveraging the balance sheet.

This strategy empowers the company to retain control over the asset by becoming a tenant for a specified duration—a 5-year, 10-year, 15-year term, or as outlined in the agreement.  Sometime the buyer will give the ownership the First Right of Refusal or Option to buy back the property at some future time and price.

Sale-leasebacks have served companies, regardless of their size, for numerous years, facilitating business expansion, debt reduction, or other alternative uses made possible by the equity in their properties. They’re  an excellent method for companies to unlock dormant equity and channel it toward paying off debts, acting as a debt substitute, or funding crucial business-related upgrades.

Given the recent substantial rise in interest rates over the past couple of years, businesses eyeing property purchases or refinancing endeavors to expand could view a sale-leaseback as a viable alternative to an SBA loan.

 

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Distressed CRE Reaches Ten-Year High

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Distress has been the buzzy question making the rounds of commercial real estate for more than a year now. When will it really start? When will the falling prices finally bring in the large mounds of capital that have been waiting on the sidelines?

When will the gift wrapping get shredded? The boxes surrounding presents of cheap properties ripped open? The prices turning into big profits when interest rates eventually fall and values finally climbing back up?

GlobeSt.com has previously reported that a secret round of distress might be behind a lot of CRE market performance. MSCI released its U.S. distress tracker and it’s helping to put some surface on the bare bones of distress.

“The balance of distress in the U.S. commercial real estate market climbed for a fifth consecutive quarter to total $79.7b at the end of September,” they wrote. “This figure, which includes both financially troubled and bank owned assets, has not swelled to such a level since 2013, when the fallout from the Global Financial Crisis was working its way through property markets. Still, the current distress level remains less than half that reached during the height of the GFC.”

The actual outstanding distress through the third quarter of 2023 has reached $79.7 billion, though not evenly distributed by property type. As anyone in the industry might guess, the largest single source of distress right now is office, at about $32.5 billion, or almost 40.8% of the total. Retail is in the number two spot: $21.2 billion, or 26.6% of the total. Then comes hotel, 17.9% of all the distress at about $14.3 billion.

The bottom three categories are apartment/multifamily ($7.5 billion, 9.4%), other that includes sectors like self-storage and manufactured housing ($2.5 billion, 3.1%), and industrial ($1.7 billion, 2.1%).

However, the real concern for investors, developers, and owners should be what might come. “Potential distress is indicative of financial stress that, if not reconciled, has the potential to become full-blown financial trouble,” MSCI wrote. But the biggest danger isn’t office but multifamily, at $65.7 billion, or 30.4% of the $215.7 billion total.

But the possible exposure of office is still enormous, at $50.3 billion or 23.3%. Hotel’s $31.1 billion/14.4% comes next, after which are retail ($30.7 billion, 14.2%), industrial ($26.7 billion, 12.4%), and other ($11.3 billion, 5.2%).

“The composition of ownership for distressed assets shows that one-third of the balance of distress is tied to assets owned by private capital, while another third is associated with institutional investors,” they wrote. “Rather than by value, which skews towards institutional ownership, a look at the ownership composition by the number of assets indicates that private investors own 50% of the assets currently classified as distressed.”

 

Source:  GlobeSt.

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Commercial Real Estate Valuations Are So Hard-Hit That CBRE Warns Could Fall ‘Another 10%,’ After Saying Earlier They ‘May Come Down 15%, 20%’

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Workers will likely spend 20% to 25% less time in the office than before the pandemic, according to the head of real estate brokerage CBRE Group.

Chief Executive Officer Bob Sulentic said companies such as CBRE are seeking to balance in-person work with the recognition that people don’t want to spend hours in traffic.

The rise in remote work since the pandemic has had far-reaching implications for the real estate industry, including property owners that Sulentic’s company counts as clients. Office landlords have been confronting declining tenant demand as more companies adopted remote-work policies. That’s pushed the office vacancy rate in the US up to 18.4% in the third quarter, according to CBRE.

Landlords have also been pressured by the rise in borrowing costs, which has contributed to a nearly 21% decline in office prices in the 12 months through October, according to real estate analytics firm Green Street. Investors including Brookfield Asset Management Ltd. have defaulted on debt and walked away from buildings.

Sulentic said higher borrowing costs have dented commercial real estate valuations more than his firm originally forecast.

“We thought values may come down 15%, 20%. We now think that may be another 10%,” Sulentic said.

He noted price declines were “most acute” for office buildings.

 

Source:  Fortune

 

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CRE Transactions Expected to Fall 5% Next Year Amid Rising Treasury Yields

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To understand where interest rates might go, watching the actions of the Federal Reserve is important, of course, but so is monitoring yields of Treasury instruments. Whether bonds, notes, or bills, depending on the term, they have great sway.

Treasurys are considered safe investments, and so are one of those practical baselines for calculating risk adjusted returns. As the yields rise, so do interest rates.

But as is true with anything, trying to track every movement can become confusing.

For example, CBRE noted on Thursday, November 3 that the “recent bond market sell off has lifted the 10-year Treasury yield to nearly 5% and further dampened investor sentiment for commercial real estate.”

 

“Rather than inflation, a mix of short- and medium-term economic and political pressures is driving up bond yields,” they continued. “These include a stronger-than-expected economy with robust consumer spending, increasing term premiums, the surging government deficit and reductions in the Fed’s balance sheet (quantitative tightening).”

Based on such data and their analysis, CBRE said that it lowered growth expectations for CRE investment rate volumes in 2024. The projection had been +15%; now they are -5%.

“Our econometric models indicate that the rise in the 10-year Treasury yield to 5% or more, if sustained, will raise cap rates and lower capital values for commercial real estate,” they wrote.

And if they were correct that the 10-year would continue a strong upward pace, maybe the impact of higher interest rates would have such an impact. They might even be correct.

But this is where following short-term data flows can drive people to potentially make mistakes.

On Wednesday November 1, the 10-year dropped from the previous day’s 4.88% yield to 4.77%. Then on Thursday, it hit to 4.67%, and Friday closed out at 4.57%. Similarly, the 2-year yield went from 5.07% on Tuesday to 4.83% on Friday.

Econometric models can be wrong. Then again, they could be correct, look further out, and maybe yields will rebound in the long run.

But then, CBRE wrote that other than office, the “relative health” of CRE property types “makes forward internal rates of return (IRRs) increasingly attractive.”

“If the economy manages a soft landing and long-term bond rates ease, investment activity may surprise on the upside,” they wrote.

This is why solid hedging strategies make a great deal of sense.

 

Source:  GlobeSt.

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The Odds Are Stacked Against Maturities Refinancing

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Almost any problem can be solved if there’s a realistic plan and the necessary materials are at hand. But miss what you need for the repair and there’s only so far that you can go. That’s a problem facing commercial real estate right now.

There is an “historic volume of mortgage maturities,” as a recent Trepp analysis of Federal Reserve Flow of Funds data showed: $2.78 trillion in commercial loans coming due by 2027.

But will there be enough money to keep the bulk out of trouble? Up until Wednesday, the 10-year yields were moving tentatively toward 5% and have been at levels not seen since 2007. The higher Treasury yields go, the harder it is to argue for riskier investments without a lot of extra return. Shorter-term Treasury yields are even higher.

Even with a slight retreat of the 10-year yield with the Fed’s hold on interest rates and Treasury slowing expansion of planned new bond issuance, there is still abundant safety at respectable returns that becomes difficult to compete with. CRE property valuations have plummeted, with the Fed saying that after the reductions they were still elevated beyond where they should be.

Too many of the maturing loans were granted under easy money conditions and bigger amounts of leverage than are typically available at the present. Deals that need refinancing often make no financial sense because of the amount of capital needed to get new financing is prohibitive.

That is why the news on reduced funding for CRE is worrisome. Third quarter private real estate fundraising of $18.2 billion plummeted by 71% compared to the $63.4 billion of Q2, according to Preqin dataquoted by Bloomberg. Global property transactions fell from $31.9 billion in the second quarter to $26.9 billion in the third.

As the Wall Street Journal noted, CRE lending is at “historically low levels.”

“There is liquidity available,” James Muhlfeld, managing director at Eastdil Secured, told the Journal. “But it’s likely going to be more expensive, with lower leverage and with a different lender.”

All this raises the question of which projects will be able to afford refinancing — and if they can’t, who will be left holding the bag for the mortgages on those properties.

 

Source:  GlobeSt.

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