Do you feel it in the air? Is summer out of reach?
Many of us came of age, or thought we did, the first time we heard Don Henley’s mega-hit The Boys of Summer, released in October 1984. But can a song be reincarnated to mean even more? Can one brush with destiny change everything? This week more than any other, it’s right and true to look back and answer that question in the affirmative.
For those of us in New York 16 years ago, September 12th and 13th stretched on for many more than the 24 hours the clock conveyed. It wasn’t until the early morning hours of the 14th, when Dick Grasso announced the New York Stock Exchange would remain closed through the weekend, that many of us were released, on many levels. Walking the beach that weekend, looking for signs in the sand, Henley’s mournful song stopped me in my tracks. “Those days are gone forever” forever took on new meaning.
An old friend dropped me a line recently. His none-too-subtle message reminded me yet again of Henley’s song, but in yet a different way. It would appear the innocent boys of summer have departed the investing world as well, leaving in their stead conditions in which only “big boys” should engage, his words. Though this market veteran has been around long enough to know most asset classes are vulnerable, the article he shared spoke specifically to tail risks building in ccommercial real estate (CRE), which we’ll get to in relatively short order.
Longtime readers of these weeklies know the two asset classes I foresee investors will grapple with the most in the next recession are high grade corporate bonds and apartments. The math and logic backing this warning are simple as they most resemble that which supported the explosion of subprime mortgage issuance during its heyday. Accept credit quality as a given, so long as it brandishes an investment grade rating, and green light record levels of issuance at just about any price. No, this will not end well.
But what about other CRE subsectors? After all, rent declines throughout the three most recent recessions were the deepest in office and industrial markets. Multifamily, meanwhile, was the least distressed sector. Retail is a unique case in point: rent declines were near nonexistent during the 2001 recession, but worse than office and on par with industrials during the Great Recession thanks to pricing pressures accelerating the rise of ecommerce.
Since then, things have gotten mighty interesting in what has, by all accounts, been the lesser manipulated of the two types of domestic real estate markets. Hint: it isn’t housing. The Federal Reserve’s misguided policies and interest rate suppression tactics are manifest in residential real estate, where Morgan Stanley figures prices have recovered 90 percent of their peak-to-trough values (‘Peak’ is defined as 2007-2008 highs, while ‘trough’ reflects 2009-2010 lows).
As for CRE, it’s recouped nearly double that of residential – peak-to-trough prices are up 168 percent. Critically, these are the ‘headline’ figures that catalyze concerns among the superficialists. But it’s the subsectors that serve up the real smokin’ hot spice factor. A quick perusal of the nearby table highlights how haywire things have become in multifamily, which we already know, and about which you should consider yourself amply forewarned.
But look just beneath manic multifamily and you see that in any other world, what’s happened in major market and central business district (CBD) office properties would be garnering plenty of angst if not for apartments hogging the overvaluation limelight. And that’s purely through the prism of price behavior.
Factor in what’s driven those price gains and you really start to get worried. We’re talking the zero interest rate policy that the Fed has facilitated. At the extreme, we’re talking about $60 billion in 2015 CRE sales…in Manhattan alone, a record high and 14 percent above 2007’s prior peak.
Lending standards, of course, played their part and dutifully tanked, hitting their most lenient laxity in mid-2015. Foreign investors, in this cycle more than any predecessor, clocked record transaction volumes, which topped out at 18 percent in late 2015.
This highly favorable dynamic was most visible in capitalization, or cap rates, which is the net operating income of any given property divided by its price. The less in the way of income a buyer is willing to accept for a given price, the lower the cap rate. In 2015, cap rates sank to lower levels than they did at their 2007 lows. Valuations were, in other words, at unprecedented peaks, with the key word being ‘were.’
Since peaking, quarterly transaction volumes have slumped to around $100 billion from late 2015’s briskest pace, when sales hit $160 billion. In the meantime, standards have tightened for eight consecutive quarters and foreign investors’ share of transaction volumes has declined to 13 percent. And finally, as has been broadcast widely, the Fed has been in a tightening mode.
What happens when the favorable dynamic that drove cap rates into the ground reverses? The only answer is rents will have to increase to justify keeping cap rates down.
Some caveats to the caveats. Financial conditions are actually easing as sabre rattling, DC stagnation and Mother Nature collude to suppress interest rates. And while sales volumes are well off their peaks, they did recover somewhat in the second quarter and are down just five percent over 2016 levels.
It should be added that Chinese investors would rather have their cash escape to our fair shores; they just can’t get past the state-imposed controls put in place to staunch capital flight. The Saudis and other crude-export-dependent countries would also prefer to have the resources to keep investing were it not for that sticking point of the lowly price of that sticky fluid they pump out of the ground. In all, Middle Eastern investment is down 73 percent over last year; Saudi investment in particular has crashed by 96 percent.
And so, you have sellers thinking their still- nosebleed prices could be validated and buyers thinking recent trends will deteriorate further and thus refusing to budge. That brings us to where we are today – a virtual standoff.
To bring the extreme back into the picture to prove a point, CRE volumes in Manhattan are expected to end the year at $19.8 billion, matching levels last seen in the dark year of 2008. Not surprisingly, expectations for commercial leasing and the future rental market in New York both hit four year-lows in the second quarter.
The good news is the froth coming out of the market should reintroduce rationale among owners. Let’s just say that’s not exactly how the outcome appears to be evolving, which brings us to that article referenced at the outset, the one that disturbed and inspired at the same time.
The Bloomberg article is easy enough to Google, which you should: “NYC Landlords That Can’t Find Buyers Turn to Borrowing Instead.”
The gist of it speaks to the intersection of easy financial conditions not being reflective of the Fed being in a tightening mode, which actually speaks to the disconnect plaguing many asset classes. As it pertains specifically to CRE, think in terms of how cash-out refinancings increased investor losses in securities backed by subprime mortgages way back when.
Recall it wasn’t until John Thain attached a price tag of 22-cents-on-the-dollar to Mother Merrill’s subprime book that anyone truly knew the Street value of the toxic waste. Though things are certainly not nearly so bad, it is the spirit of owners’ behavior that resonates.
This from Bloomberg, per CBRE: “In a building where building sales are few and far between, it can be challenging to find a comparable transaction to get a reading on prices for an appraisal. There are other ways to calculate a property’s value, but it’s impossible to account for changes on a real-time basis.” (Let their painfully diplomatic wording plant its own seed next time you’re contemplating going long or short CRE on a macro level.)
Pardon the digression. Back to the matter at hand of what exactly entrapped owners should do? Why not seek out buyers for your property and simultaneously take out a mortgage on the property. That way you’re effectively refinancing at an inflated value, what my old friend who’d just as well stay in the private domain for, like, ever, terms the “perfect crime in CRE,” assuming you’ve cordoned said property into its own little LLC.
“If things go well, the property value goes up, no harm, no foul,” he observed. “If the market tanks, you hand the keys to the lender, but you still have the cash from the recapitalization.”
Let’s be clear, we’re not talking traditional lenders here. Indeed, second quarter originations fell two percent for life insurers and a steep 21 percent for commercial banks. The flip side is they rose by 26 percent for government sponsored enterprises and an eye-watering 126 percent for commercial mortgage backed securities.
For the record, retail was the only sector to see a decline in quarterly originations, so that’s something. As for multifamily, Morgan Stanley warns that, “investors are more willing to purchase and lenders more willing to finance, resulting in less deleveraging.” Cue the understatement considering the Bloomberg story referred specifically to apartment landlords though the cash-out contagion is sure to spread to other overvalued sectors by yesterday.
Notably, the Morgan Stanley data did not elaborate on the behavior of the most go-go cowboys in the land of lending, that is, private equity (PE). Disregard for a moment, as difficult as it is, the near trillion-dollar pile of dry powder PE sits atop. Ruminate rather on the quarter of that pile earmarked for real estate, some $255 billion, a record if there ever was one.
The beat looks set to go on and on. According to Canaccord Genuity’s Brian Reynolds, in the five-week period through mid-August, pensions directed an incremental $9 billion into some form of private equity fund. A few tasty offerings illustrate a particular penchant for that hard asset which, by the way, has become one of retirees’ most crowded trades, as you, but not they, can see:
- Boca Raton Police and Fire Pension allocated $10 million into distressed real estate fund
- Vermont state pension $30 million into value-added real estate fund
- Illinois Municipal Pension put $75 million into a value-added real estate fund
- Wisconsin state pension sank $395 million into real estate funds
- Kansas Public Employees’ Pension allocated $50 million to a real estate fund
And that’s just pensions. All manner of investors continue to herd into the divine diversification on offer with PE funds. As for the founders of PE funds, they’re taking buyouts and getting the heck out, at least according to the Wall Street Journal. Lovely.
“A majority of aggressive CRE recap deals are with real estate funds chasing yield,” my friend further added. “Banks can’t touch their rate and terms, so big boy rules apply.” Lovelier.
In the event you think some egregious omission has taken place, safe assured, the $300 billion in hurricane damages will indeed make a different kind of impact. But no one is sure how prominent that role will be just yet.
What can be said of Houston in particular is nearly a fifth of office space in the city stood vacant as of June while 11 million square feet were free for sublease pre-Harvey, the most since at least 1998. Oh, and the vintage of loans with the greatest exposure? That would be 2015. For any of you vultures out there, can you please get back to me with a stronger word than ‘emptor’ to put after ‘Caveat ______” before you go off half-cocked?
In the meantime, this chart from Hoya Capital Real Estate highlights office real estate investment trusts (REITs) that have largely been given a pass vis-à-vis their brethren in the battered retail (mall) and massed multifamily spaces. You’ll note one REIT found its niche in low quality properties in Houston.
Don Henley’s song reminds us that we can never look back. Perhaps it’s best to then look forward, knowing that time as we know it often compresses and that any summer can come to an abrupt end. With any luck, unforeseen events make us stronger in the end. As investors, the best we can do is be positioned for the likely and unlikely outcomes, those that arrive after even the big boys of summer have gone.