Bloomberg Audio Studios, podcasts, radio news. You know, one of the things that kind of surprised me is there was all that concern about commercial real estate and specifically office buildings, and instead we've seen it feels like we've seen more stress in the multifamily space.
Yeah, that's a good point. I don't know, Like I'm still worried because I still see these numbers, at least an aggregate of vacancies not improving. And I sort of thought, you know, about six months ago there was another rash of headlines about companies calling workers back to the office. But I'm not sure if there's improvement. Like I'm still anxious. I'm not comfortable saying coast is clear yet.
But what do I know? You're caveating yourself caveat I feel like that's what you're doing.
I did a deadlift one.
Okay, barges.
This isn't after school special, except.
I've decided I'm in a base my entire personality going forward on campaigning for a strategic pork reserve in the US.
Where's the best with imposta?
These are the important question? Is that robots taking over the world.
No, I think that, like in a couple of years, the AI will do a really good job of making the Odd Lonch podcast and people today, I don't really need to listen to Joe and Tracy anymore.
We do have touching. You're listening to lots more where we catch up with friends about what's going on right now, because.
Even when the Odd Lots is over, there's always lots more.
And we really do have the perfect guest. So Rich, we had you on basically a year ago talking about where stress is in the massive market for commercial real estate. What have we seen since then?
Yeah, well, first of all, it sort of feels like dejean vous all over again. For me. There was a bunch of three bank failures this time last year. Right fast forward a year we didn't have any, and then suddenly we have another bank failure or another bank stress test, if you will, So look, maybe I'll start with office. I think I'm certainly tired of talking about office. I think most people understand that office valuations are down rather significantly.
We think office valuations generically are down around thirty five percent or so, and peak to trough that'll probably be down closer to fifty percent. So I think most people understand that at this point, I do think there's still a little bit of debate and a little bit of misunderstandings about well, not all office is bad. New clean and green office even in New York city's doing exceptionally well.
And then maybe some of the Sunbell office properties where you're seeing strong demographic shifts, those are working working as well. But are people willing to step their toes in? Probably not. I think they share share your views.
They share Joe's tendency towards self cavitation. That's a word that I just came up with. We're speaking with Rich Hill. He is the head of real estate strategy and Research over at Cohen and Steers, formerly of Morgan Stanley, which is how I met you and read your research for a number of years. One thing I wanted to get your sense on. We have seen a rally in broad cre since sort of November December. How much of that
is just echoing the expectation for rate cuts? And I feel like I feel like I should add a caveat here, which is that we're recording this on March twentieth, the day of the Fed interest rate decision, so who knows what will happen, but the expectation is still for cuts, So how much of that is feeding into the rally?
Yeah, so maybe just a level set. The trough in listed rates listed real estate was October twenty fifth of twenty twenty three. Since that time, listed reads are up more than twenty percent. November was one of the best months ever. December was pretty strong as well, top ten month ever. So you bring up a good question how much of this is just driven by rate cuts? So let me let me unpack that a little bit for you. And I think I'm going to be a little bit
wonky here, but I think that's probably that's great. That's what we like. First and foremost listed reads do really well in the aftermath of the FED stopping hiking interest rates. Usually on the next twelve month basis, they put up double digit returns. So what we've seen happen is consistent with what we've seen happen with history. But I also think there's a few other things that are maybe not as well understood, where I would say this is not all about rate cuts, and I'll come back to that
in a second. October twenty fifth marked the high for the tenure Treasury rate. It peaked a little bit above five percent. At that point in time, people were really concerned that the tenure Treasury rate was probably going to be closer to six percent than four percent. Fast forward, in the tenure treasury is now closer to four percent than six percent. So I think that took a lot
of fear off the table. The second thing that we've seen is we've actually seen lending conditions not begin to loosen, because linding conditions are still tightening, but they're not tightening as much as they used to, and so that basically means linding conditions, the worst for lending conditions are behind us. The second erouder has started to improve. The third point I would make to you is that guess what in AY growth net operating income growth for real estate is
holding up really, really well. It's actually one of the few sectors of the S and P five hundred where you're seeing revisions higher not lower. That's interesting, and there's a couple of reasons for that. But I think what I would ultimately say here is listed reads are leaning indicator in downturns and recoveries, and what I think we're starting to see is maybe some of the fear that was in the market was it was turning out to be not as bad as feared, and that's led to a rally.
So it always helps, even if things are bad, if they're going to be less bad because that's helped.
The direction of travel is good.
Yeah, the direction of travel is good, better than expectations all the worst not being priced in. One of the things that's come up in our past CRI episodes just this gap between where people think the market might be and where the market actually is, which we have a hard time knowing because there is just not a lot of transaction period. So you can have these models and you can have expectations or maybe price something off the
one building that did move. Are we seeing on the non listed side, on the private side, are we seeing any sort of pickup in transaction activity.
Yeah, it's a super fascinating conversation that we're having right now, and I think it's the very most important question that people can be asking right now. Let me explain how the transition mechanism usually works in fire cycles, transaction volumes fall, they trough because when they're falling, there's a big spread between where sellers want to sell and our buyers want
to buy. There's no transaction activity. Then as transaction volumes trough and begin to rise, property valuations begin to fall. Transaction property valuations begin to fall, and then about twelve months later, appraisal valuations follow. What we're seeing this cycle is dramatically different than that it's actually flipping on its head. Appraisals are actually leading transaction volumes significantly right now. You're right, transactions,
there's very little transparency in the transaction market. I just got some updated numbers for February of twenty twenty four, and the number of transactions that sold it looks like it's back to COVID lows. So there is still a pretty big bid asque spread. But appraisals, appraisal valueuas we think are down generically around twenty percent right now peak to trough. We think they'll be down twenty five to thirty once everything goes through. But why are appraisal valuations
leading right now? What has everything to do with higher interest rates and higher discount rates, and appraiser has no choice but to deal with that. So this cycle is a little bit different where transactions are just now beginning to catch up to where appraisals are so.
We're talking about sales transactions. But the other thing that's happened in the market is you've had a lot of new financing. So call it what you will extend and pretend or amend and extend. There's different names, different pseudonyms for this activity, but that feels like it's one of the things that has really given the market a little bit of breathing room. So it's odd lots tradition to talk about the looming maturity wall, but the looming maturity
wall is not so looming anymore. It's more of a three foot privacy shrub. I think I've joked before.
Yeah, if you guys can see me on the podcast, I have a big smile on my face because this is one of my favorite topics. First of all, look, I push back on the idea of a maturity wall. Earlier in my career, I always talked about maturity walls because it gets a lot of clicks. But let's be clear.
Commercial mortgages have a seven year wall that means fifteen percent of loans come due on average every single year, which means over a three year time period, you should expect forty five percent of loans to come due guess what, forty two percent of loans are coming due over the next three years. Not shocking at all, that's just sort of math. Is it great that they're coming due right now at this point of distress in the commercial real
estate market. No, but that was inevitably going to happen at some point in the cycle. So that's point number one. Point number two is a statistic that's getting a ton of headlines right now that there's almost a trillion dollars of loans coming due in twenty twenty four. That is factually true. But this time last year there was only a little bit more than six hundred billion dollars of loans coming due in twenty twenty four. Like, you don't
just make up four hundred billion dollars of loans. Why did that increase? Well, loan Behold, a lot of loans that were maturing in twenty twenty three were amenda and extended into twenty twenty four and beyond. Now, we actually think that same strategy is going to play out in twenty twenty four as well. But what you're starting to see is this prisoner's limb are being solved. Borrowers are not in a good position lenders are not in a good position. They're sort of forced to work with each
other right now. And I think your point about you know, call it what you will, modifications and extensions, what it's doing is that it's providing a little bit of a safety net for commercial real estate valuations, where whereby we think valuations are going to be down twenty five to thirty percent instead of like thirty five to forty like we saw during the GFC. And it's because this is a little bit more orderly process than what people feared a year ago.
By the way, I just want to say Tracy that I'm really glad and thank you rich for saying that when you're on the cell side and getting clicks, because I've always had this intuition that journalists in cell side analysts are basically in the same job, and we sort of compete with each other for people's scarce attention. It's
not that different. In fact, I would say, as I progressed in my journalism career, I felt I learned a lot from reading cell side research, both in terms of content but also in like, yeah, your job is, you know, people have a million emails and you want them to open yours instead of the next guys.
So I feel no one will know your research is good if they don't read it.
If they don't read it, yes, you got a in a northern around time is spent on titles, and oh yeah.
I know they're getting really they've got they've gotten so good. If I own a building and it's one of these not on a B tier offices in New York City and I still have a bunch of empty units and the people who were my tenants aren't bringing their employees back, wish do I want? Do I want them to bring their employees back? Or do I want right cuts?
You want rate cuts first and foremost, first and foremost. We had this debate internally at Colin Steers relatively recently. What are we rooting for? And I think everyone in there in the room said rate cuts. And so let's maybe explain what that means. Commercial real estates inherently elevered asset class. Yeah, very few people buy commercial real estate building and don't put debt on it, so the cost
of financing actually really matters. I would much prefer right now a hard landing scenario, believe it or not, where real rates interest rates go much lower and grow slows and credit spreads widen than a no landing scenario, whereby rates sort of stay where they are in growth and credit spreads are just eh. I know, that's weird to get your arms.
Rud No, I believe it, but it still blows my mind.
It's inherently a level asset class. What matters more than anything else is the cost of financing.
Wait, so, on that note, I want to go back to what we were talking about, the refinancing, the amend and extend dynamic that we've seen in the market. Who is refinancing? Is it the existing finance years Because as you mentioned, they basically don't want to take the marks on their portfolio or they don't want to have a catalyst that causes them to record that loss. Who's actually doing it?
Yeah, So let me first of all give you a stat that's I think really remarkable. If you looked at commercial mortgage backed securities, the loans that we're maturing in twenty twenty three, eighty percent of them paid off at or before their maturity date. Eighty percent. Now, some of them obviously paid off before their maturity date. You'll hear much lower statistic for loans that were still outstanding at their maturity date. But those loans still outstanding have inherent
negative selection. If you didn't pay off your loan prior to the maturity date, there's probably something wrong with it. So let me answer your question directly though, and I'm going to focus on banks first and foremost. Why would a bank want to extend a loan, well, particularly.
After March's banking drama and the expectation that there was going to be more pressure in terms of regulation.
There's two reasons, well three reasons. First of all, they're not in the interest of owning properties. That's one number two. They actually don't want to sell a distress property into a distress market. But there's an even more important point here that I don't think people are focusing on the capital charges for modifying a loan at a new ninety percent LTV or actually lower than owning that property on
your balance sheet. Oh, they're incentivized, assuming that they have appropriate reserves and the borrower has a plan, they're incentivized right now to actually extend that loan. I come back to the point I made previously. This is like classic prisoner's dilemma stuff. The barrower is not in a good spot, the lender doesn't want the property back. They're actually coming together and finding a solution. And I don't think this is necessarily to kick the can down the road like
we've seen in the past. They're getting some pretty decent paydowns. They're actually not increasing their rate too much. It is a prisoner's dilemma.
One thing I've come to realize in my own career as a financial journalist is that kicking the can down the road has all these terrible connotations, especially since two thousand and eight, but actually it kind of worked right. We had a bunch of home loan modifications after two thousand and eight, and you know, real estate recovered.
I have come to the conclusion that all of human history is just a big hand ticket. We need to destigmatize that concept forever. We're just going to be kicking the can for thousands of years to come. Put it off to the next generation and they'll do the same. Your point about there's something wrong if you don't prepay your loan like this is because real estate investors are
allergic to building up equity. The moment they have a little bit of equity in the building, they want to pull it out and buy the next building.
That's that's that's not wrong. Yeah, it's constantly refinancing. And now some of this is because we've been a secular decline in ten your treasure eight since nineteen eighty. You could always refinance into a lower and lower and lower interest rate month after month after month.
So someone I was talking to was explain to me, like some of the banking issues that we've seen with some of the community banks. Part of it, I mean, we hit did an episode on Newyor Community Bank and the issues that they've had in like the rent regulated multifamily area. But the part of it is that a lot of these banks just made a bunch of money
on prepayment penalties. I don't know if they're called penalties, but those prepayment fees, and then the moment rates shot up shoot up for the first time in forty years, you just get that big slow down in Yeah.
I mean, well, it's probably fairly nuanced, but when you prepay a fixed rate loan, you have a prepayment penalty which basically compensates the lender for the interest cost that they otherwise would have received over the life of the loan. So there's a lot of different. There's a lot of different reasons. I mean, I think the real issue that the market's dealing with is a return to the old normal. I get asked all the time, what do you think
about this new normal environment? It's not new normal environment. What was weird was the last ten years where interest rates were historically low, inflation was historically low. That created a lot of weird dynamics for the commercial real estate market. All the markets dealing with is a return to the old normal and what that does for valuations. Valuations being
down twenty five to thirty percent. That's huge on a headline basis, but if you actually think about what it means in terms of how much valuations have increased over the past ten years, it's really nothing. This is just a deflating of the balloon that should occur from time to time.
Yeah, And this is where I have to say, like, even before the twenty twenty pandemic, there was talk about underwriting standards slipping in CRE and CMBs specifically, I wanted to ask you one more thing. So one of the themes that comes up on all these cre episodes is this is not a monolithic asset class. So you obviously have office, multifamily retail. So you have that segmentation. But
then even within those categories there's additional segmentation. So Joe mentioned the idea of a Class B office, you would also have fancy offices that are Class A. You might have a really nice shopping mall and then a zombie
one that's going out of business. I wanted to ask in retail on shopping malls we heard recently in an episode we did with Tom McGee from the International Council of Shopping Centers, he would I was talking about there's sort of a revival of demand for shopping centers and that there's a structural lack of supply in certain types of shopping centers. Is that something that you've seen as well.
Yeah, Look, we really like open air shopping centers, and we like them for a couple different reasons. First of all, we think institutional investors in private real estate are under index to them.
Is that a result of like the shopping mall fears of the time.
Yeah, they're just redline. I mean, no one wanted to buy a retail property from twenty ten until twenty twenty because it was going through clickbait so called retail apocalypse. That's not a great environment. So you've actually seen institutional ownership of retail go down, while institutional ownership of multifamily industrial has risen significantly. But there's actually something really interesting
that's happening. Two things in particular, no one was really dumb enough to buy to build a new retail property host the Great Financial Crisis because there was this big shakeout coming, so there's been no new supply of shopping centers. At the same time, you had this great Darwinistic event that happened in COVID where maybe I'm going to use to bold of retirement, but it killed all the stuff
that wasn't you know, it was cuspy. So now you actually have an environment that's right size from a supply standpoint at a time that retailers e commerce companies have actually realized that they can do micro fulfillment through the retail stores. Consumer likes it. So you're actually seeing vacancies for things like neighborhood centers, community centers, power centers actually
near historical lows. We haven't seen an environment like this before, so it's actually a really strong asset class that people aren't paying enough attention to.
So I take this key point that Okay, there's been part of this story is that there's been this game theory cooperation from lenders and borrowers to avoid pain. I take this point that there are some in New York City even that there are prime offices that are doing very well, and that not you know, CIRI and even
office is not a monolith. On the other hand, it does seem as though in many cities that there is still just a lot of empty square footage within buildings, and I don't think people know what is going to happen with it, or whether it's you know, where that's going. And there's still you know, obviously there are some fancy buildings in New York City, but there's a lot that's just done between every block where it's just old and shabby and you just see clearly not a lot of activity.
What is happening with that? And of course in some cities, you know, there's this fear of the urban death spiral, which would be a very good headline for a research piece or for a clickbait piece. But I guess the retail apocalypse of the twenty tens has been replaced by the urban death spiral that you have people are coming back to work, that you have dropped the tax base, that the restaurants closed down and people don't want to
come back to work, et cetera. And then you just have this sort of you know, like something out of a horror movie or a zombie movie. What are people saying about that these days?
Yeah, Well, the first point I would make is the professor I think. I think he went to a professor from NYU that coined the death spiral for New York City actually came back relatively recently and said, I was wrong. That's not playing out like the way I thought it was. Okay, So look, the cliche answer is you take all these dead dead, take all these underutilized office buildings and confront them a multifamily. Guess what, guys, That's easier said than
done for a lot of different reasons. So I think the real answer is people don't know, and that's one of the reasons that people are unwilling to step into the office sector right now, even though valuations have come down a lot. What do I think. I actually think this is a once in a generation opportunity, once in a lifetime opportunity for public and private stakeholders. To come
together and rethink how these cities should work. So it probably requires a master plan where you actually redevelop all of these into I hate to say work, live, play, but there's a real opportunity to do that. And so could you imagine like walking down New York City where it used to be all these Class B office buildings that no one really wanted to work in, and now suddenly it's like vibrant parks, it's restaurants. Well, I think that's going to solve the world's problems apparently.
Cos I think New York should let us redesign the city.
I'm done. By the way, Tracy, the NYU professor the Rich mentioned, I'm pretty sure Arbat Gupta, who who has been to our odd lotch trivia event, we really need to have him on the show because he was talking about the urban doom loop. So there's a message to us basically that we really got to book the ARPIT episode.
Yeah, let's do it.
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