Last May, Starwood Investors placed a limit on the monthly withdrawals from its private commercial real estate funds it manages. It did so to avoid having to sell assets at a loss to meet redemptions. Starwood manages about $10 billion in assets in what is estimated to be a $90 billion industry. The withdrawal limit is 0.33% of an investment per month.

Starwood’s decision had a knock-on effect, as investors in other funds began to question their ability to withdrawal funds. While redemptions have recently slowed, there is still the question of valuing the investments which plague the industry. Most private funds that hold illiquid assets value them once a year, usually employing an outside appraiser. Unlike public funds like REITs, there is no daily valuation of the investment, which is to say there is no easy way to get out of the investment should it be desirable or necessary.

Of all categories of commercial real estate (CRE), the one under the most pressure is office buildings. With the work from home movement started during covid still in effect in some areas, companies need far less office space than previously the case. Automation of office functions, the potential of artificial intelligence (AI) to accelerate this trend, and the declining demographics of the work force all seem to be pointing to a decline in office space needed.

The problem is that most office space cannot easily be repurposed for other uses. Older offices with their air shafts may find a new life as apartments or condominiums. The modern office, with its large floors, does not lend itself to this. To give everyone a window, the redesigned condos would have to be very narrow. The first floor could be converted to retail, but demand for retail space is not much better than office space given the rise in ecommerce. Restaurants are under pressure due to inflation and rising worker costs.

All this would be simply a bad-luck story of an investment type save for one thing: commercial real estate is acquired largely with borrowed funds. Given the mechanics of lending, a lot of the loans are held by banks, with smaller banks as a group holding a rather large share relative to their size. Unlike a residential loan, which lasts for usually 30 years and can be offloaded to third parties with a government guarantee of principal repayment, commercial real estate loans are typically held by the banks. They are amortized for 25 or so years but come due in 5-10 years. This “ballon” payment for the outstanding balance gives the lender a chance to re-calibrate the loan rate. Refinancing also requires the lender to re-appraise the property to see if enough value is there to cover the balance of the loan plus a buffer.

To give an example: suppose a $1 million commercial real estate (CRE) loan is made on a $1.3 million building at 5% for 5 years with a 25-year amortization. As the fifth year comes around, the value of the building has fallen to $700,000 (the building is largel empty). The principal of the loan is, say, $800,000. The new appraised value will not cover the loan to be reissued. A bank can at most lend 80 percent of the appraised value. This would come to $560,000 The balance of the loan is $800,000. The borrower must either come up with $240,000 in additional cash to put into the property, or he or she can hand the keys to the lender and walk away. If the latter occurs, the bank is on the hook for the property and must sell it in a falling market. If it is sold for a loss, the bank’s capital account takes a hit.

Most people would immediately point out that by walking away, the owner gives up the initial $300,000 investment. However, the owner does not have to put an additional $240,000 into a declining asset (assuming the owner has the funds). Incredibly, most lenders never asked for personal guarantees or cross-collateralized their CRE loans. In such cases, the former owner no longer has a problem. The bank has a problem.

How much of a problem is in dispute. Many lenders have responded to declining rents from their customers by extending terms, lowering interest rates, etc. A practice known in the trade as “extend and pretend”. It can work if downturns are temporary. If not, this approach is problematic. Come refinancing time, the third-party appraisal will usually bring these strategies to light. Regulators are not too keen to see such on a bank’s books, as it implies weak assets and correspondingly inflated bank capital.

How large is the problem? According to a paper published by the International Monetary Fund (IMF). About $300 billion in office and retail loans are set to mature in the next 18 months. Defaults would not be spread out evenly across the country but would be more severe in urban areas like San Francisco and Atlanta, and among older CRE buildings rather than newer.

One issue is whether the FDIC can continue to insure deposits more than their $250,000 balances like they did in the case last year of Silicon Valley Bank and the like. The number of loans to be refinanced in 2024 is up 41 percent from 2023. While fortunes might be made by buying CRE at the bottom, fortunes will be lost as well. This decline is secular, not cyclical. This does not put banks of any size in a good situation.

The Economy

The economy continues to expand at a decelerating rate. About a third of the jobs created last month were in government services. On the other hand, both residential and commercial construction is contracting.

At this stage of the economic cycle, capital spending and exports would provide the next leg up. However, outside of chip production and AI-associated efforts, there is little restrained demand in the economy that would justify an increase in capacity. Exports are hamstrung by issues at Boeing, the country’s largest exporter.

Inflation

Inflation seems to be at long last coming down. With an unemployment rate now crossing back above 4%, wage pressures should moderate. A decline in construction is leading to a moderation in the price of materials such as lumber and steel.

Energy is a category that for now seems to be bucking this trend. Natural gas is trending upwards as export demand continues to escalate.

Interest Rates

Interest rates are beginning to see a decline. This is due to the influx of foreign funds into US dollars, reflecting turmoil in other parts of the world.

If the Federal Reserve wants to reduce interest rates without appearing to be overtly political, it will probably need to start soon. As the November elections approach, the perception of a rate cut helping the incumbent administration increases. Republicans have made no bones about wanting to put the Federal Reserve under its domain, removing its historic independence in the process.

The Stock Market

The environment in the stock market seems a bit unreal with a handful of technology names dominating the total valuation and returns of the same. Some people are comparing this to the advent of radio in the 1920s and the corresponding effect it had on the market’s rise and subsequent collapse.

There are several issues that have not participated in this year’s advance. Often, they are in industries that are growing well, such as pharmaceuticals and energy, but have not captured the investor’s imagination like AI.

At some point high-valued stocks will require extraordinary increases in profits just to justify their current valuation. When a stock is reflecting not just the here but also the hereafter, it is time to consider other options. According to FactSet, ten companies (2%) making up 37% of the value of the Standard and Poors 500 stock index, market indexing may not prove to be the best way to diversify.

Warren M. Barnett, CFA
July 10, 2024
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From the desk of Warren Barnett

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