Speaker 1: Hello, and welcome to another episode of the Odd Lots Podcast.
Speaker 1: I'm Joe Wisenthal and I'm Tracy Alway. Tracy, there's two
Speaker 1: things that people well, there's all kinds that thinks people
Speaker 1: are like very attuned to these days. But I would
Speaker 1: say what's going on with regional banks has obviously become
Speaker 1: a huge focus, you know, with the collapse of Silicon
Speaker 1: Valley Bank. And then what is going on with a
Speaker 1: commercial real estate We talked about that recently, and everyone
Speaker 1: knows like the office woes that are hitting major cities
Speaker 1: like New York. Two things that are like top of
Speaker 1: mind for many people. Well, and I think they started
Speaker 1: out sort of separate to each other because there were
Speaker 1: concerns about commercial real estate even before Silicon Valley Bank
Speaker 1: went bust. But since then, and since we've had the
Speaker 1: turmoil in the banking sector, the posit flight, there is
Speaker 1: a concern that that is going to also start affecting
Speaker 1: the CRI outlook. And basically these two things are impacting
Speaker 1: each other and compounding each other at the same time,
Speaker 1: because of course regional banks have quite substantial exposure to
Speaker 1: commercial real estate, right so that was the interesting thing
Speaker 1: about SVB specifically, which is that there seemed to be
Speaker 1: many problems there, but one thing it was not. It
Speaker 1: did not really seem to be about the credit quality
Speaker 1: of the assets. Is a rate story, is a deposit
Speaker 1: concentration story, but it wasn't about like, oh, they have
Speaker 1: some sort of like asset side exposure, just something troubled.
Speaker 1: But then, as you point out correctly in the immediate way,
Speaker 1: a bunch of people like sort of stuck up their
Speaker 1: fingers like, oh, by the way, guys like these regional
Speaker 1: banks you're right about, they also are like sort of
Speaker 1: like disproportionately the funders of Yeah, well this is it.
Speaker 1: So there's two things here. So one, there's concern about
Speaker 1: the commercial real estate loans that some of these smaller
Speaker 1: regional banks hold. Are those actually going to default? Are
Speaker 1: they going to come distressed in some way? Are they
Speaker 1: going to be able to refinance them in the current environment.
Speaker 1: And then secondly, as you get the stress in the
Speaker 1: banking system as you see deposits pulled from smaller banks,
Speaker 1: are they still going to be able to pour money
Speaker 1: into that sector? And those two things are sort of
Speaker 1: impacting each other. They go in both directions. As you
Speaker 1: as you sort of clarify there. And I think the
Speaker 1: other thing too, is like, you know, people like doom.
Speaker 1: I mean I don't, but you know what I'm saying,
Speaker 1: Like people still like this is the exact type of
Speaker 1: thing that gets people going, and people post all these
Speaker 1: charts that most people you know, like don't aren't really
Speaker 1: an equipped to understand, including myself, Like, I don't really know.
Speaker 1: I'm a novice on this stuff, and so I think
Speaker 1: it's kind of important, like let's sort of get real,
Speaker 1: let's put some numbers and like how big of a
Speaker 1: deal is this? Because there is a lot of like, oh,
Speaker 1: you know people, right, and I think people here, this
Speaker 1: is a twenty trillion dollar market and they think, oh,
Speaker 1: this is a very big deal. But of course, as
Speaker 1: we spoke about in a relatively recent episode with Rich Hill,
Speaker 1: it's not a monolithic market and a multi family you know,
Speaker 1: residential development is different to an office building in downtown
Speaker 1: New York that might be empty now. And also, you know,
Speaker 1: a big bank is going to have a different risk
Speaker 1: profile to the sector than a smaller regional bank. So yeah,
Speaker 1: it's important to dive into the details. Yeah, totally. And
Speaker 1: you know there's office which we all know, because you
Speaker 1: could just pull up like a chart of like a
Speaker 1: big office rate like a tornado or something, and then
Speaker 1: there's medical would probably fine, and there's all the different categories.
Speaker 1: So we really need to give in the interest. We
Speaker 1: really need to dive sort of like deeper into like,
Speaker 1: all right, let's talk about some of these exposures, let's
Speaker 1: talk about these relationships. Let's get some real numbers rather
Speaker 1: than just let's get granular, baby, let's get granular. All right, Well,
Speaker 1: we have the perfect guest to speak about this. We're
Speaker 1: going to be speaking to Jim Castillo, chief economist over
Speaker 1: at msci's real Assets team. He was recommended to us
Speaker 1: by our recent guest, Ben Carlos type, and he said,
Speaker 1: this is the guy you wanted to talk about. That
Speaker 1: was a really good episode on New York City Residential.
Speaker 1: So I always love it when the guest recommends another guest,
Speaker 1: so that's usually a good sign. Jim, thank you so
Speaker 1: much for coming on. Odd Lots. Hey, great to be here.
Speaker 1: Let's just start with the sort of like key question
Speaker 1: that I see frequently asserted, which is that regional banks
Speaker 1: have more exposure to commercial real estate as a share
Speaker 1: of their assets than the big banks. Is this just like,
Speaker 1: is this a fact? And what does that mean? The
Speaker 1: thing that people have been highlighting is the fact that
Speaker 1: regional banks are a bigger share of bank lending to
Speaker 1: commercial real estate, and they've been taking that as a
Speaker 1: sign that maybe these regional banks are more of a
Speaker 1: problem for commercial real estate than anything else. The challenges
Speaker 1: People are looking at the FED flow of funds number
Speaker 1: in a funny way, the FED flow of funds date dabase.
Speaker 1: It's a fantastic thing. There's a lot to dig into there,
Speaker 1: but if you're not careful, you can look at the
Speaker 1: wrong figures and people get hung up on the bank lending.
Speaker 1: But banks are not everything in the commercial real estate
Speaker 1: lending world. Banks we have our own approach to getting
Speaker 1: at the lending universe, kind of working from the ground up,
Speaker 1: from every transaction and every building that's sold and figuring
Speaker 1: out who made the loan. From twenty fifteen to twenty nineteen,
Speaker 1: about forty eight percent of all commercial real estate loans
Speaker 1: in the university properties two point five million and greater
Speaker 1: that was in the banking realm, So already forty eight
Speaker 1: percent in the banking realm, and of that maybe sixty
Speaker 1: percent was the local and regional banks. Now there's a
Speaker 1: difference there ten percent and sixty percent and seventy percent.
Speaker 1: There's a ten percent difference. And part of that comes
Speaker 1: into we're only tracking everything two point five million up
Speaker 1: the institutional universe. If you have a former gas station
Speaker 1: and two below Mississippi that's been converted to a barbecue shack,
Speaker 1: we're not tracking that. Okay, no institutional investor is really
Speaker 1: interested in that kind of property. The FED from a
Speaker 1: regulatory standpoint, they have to think about all capital flows,
Speaker 1: so they're looking at everything that goes in there. But
Speaker 1: the key point is you can't just look at the banks.
Speaker 1: You have to look at the life insurance companies. You
Speaker 1: have to look at the debt funds, you have to
Speaker 1: look at the CMBs, market clos everything. Right, So just
Speaker 1: on this point, maybe we can back up a bit
Speaker 1: and talk about what exactly the concern is here, because
Speaker 1: my impression is before the collapse of SVB, a lot
Speaker 1: of it was, well, these commercial real estate loans, you know,
Speaker 1: whether they're unsecured or secured via CMBs, there's a concern
Speaker 1: that they're going to be in trouble. They aren't going
Speaker 1: to be able to refinance, they might default banks. I'd
Speaker 1: take your point about life insurers and other big investors,
Speaker 1: but there are a lot of banks who are heavily
Speaker 1: invested in CMBs. And then at the same time, now
Speaker 1: the concern seems to be that with the recent turmoil
Speaker 1: in deposits its, maybe banks start to tighten their lending standards.
Speaker 1: Maybe that cuts off some financing for commercial real estate.
Speaker 1: And so you have that aspect of it too. But
Speaker 1: what exactly is the worry here? Yeah, and banks have
Speaker 1: been tightening their standards over the last three quarters. You
Speaker 1: look at the Fed's survey of senior loan officers, they're
Speaker 1: all getting more cautious even before the news NSCUB hit.
Speaker 1: And you know, Jay Pal's been saying that with this event,
Speaker 1: maybe they don't need to tighten as much because this
Speaker 1: is this turmoil is creating a little bit more constraint
Speaker 1: in the credit markets. That is helping them to limit
Speaker 1: the kind of exhumert activity that was underway. Banks. We'll
Speaker 1: do it naturally, right, right, But it's a circular issue.
Speaker 1: If and the issue that we faced during the financial
Speaker 1: crisis was that you had cashline assets that couldn't get
Speaker 1: refinanced because lenders were afraid to issue a new loan,
Speaker 1: and so if somebody had to buy it, it was
Speaker 1: now available in a much lower price, which then got
Speaker 1: into the market data, and then the lenders see, oh well,
Speaker 1: prices are falling out want to be even more restrictive.
Speaker 1: And it was a vicious downward spiral until all the
Speaker 1: federal regulators stepped in and put a floor under that
Speaker 1: negative decline. So that was the safety net that to
Speaker 1: put a floor under prices. But this time you have
Speaker 1: that dynamic and play to some degree with pressure on
Speaker 1: prices to fall. They have been falling recently, and it
Speaker 1: lenders becoming more restrictive when they do originate alane. It's
Speaker 1: at lower LTVs than before, at higher interest rates. So
Speaker 1: you're not able to get the same kind of return
Speaker 1: expectation out of investment if you do that, which limits
Speaker 1: deal activity, which pushes volume down. So it is a
Speaker 1: little bit different than the two thousand and eight situation though,
Speaker 1: and this is the key thing every downturn that I've
Speaker 1: been working through. There's this human behavior to always try
Speaker 1: and fight the last war, look at the last bad event,
Speaker 1: and you're looking at it that well, here's what happened.
Speaker 1: So I got to look out for those same things here,
Speaker 1: but conversely not just look out for the same bad things.
Speaker 1: A lot of the the estate people I talked to are
Speaker 1: looking for the best opportunities that come out of it.
Speaker 1: Out of every downturn, everybody's always tried to use the
Speaker 1: playbook of the person who made money in the last downturn,
Speaker 1: and everybody wanted to be sam'zell for a bit, but
Speaker 1: there's only one Sam's Ll everybody wanted. At the beginning
Speaker 1: of the COVID crisis, they thought that we would have
Speaker 1: another downturn, just like the global financial crisis, and so
Speaker 1: buying all the distress debt like before was exactly the
Speaker 1: same way to make money. They were wrong then, too,
Speaker 1: because there was different factors at play this time. There
Speaker 1: are some things at rhyme with the financial crisis, but
Speaker 1: going in we're in a much healthier place. We had
Speaker 1: loans that were being originated at more conservative terms than before.
Speaker 1: You know, it's not like, you know, you have all
Speaker 1: these toxic loans that were being made. The only challenge
Speaker 1: is that rates have gone up so much that things
Speaker 1: we're able to finance before they're going to have to
Speaker 1: do something else when it comes up for refinancing. All right,
Speaker 1: I have a ton of questions, but to start off,
Speaker 1: like when it comes to the financing of commercial real estate,
Speaker 1: and I want to get into like the breadth that
Speaker 1: is commercial real estate and that it's not just like
Speaker 1: office buildings in New York City. But when it comes
Speaker 1: to the financing of commercial real estate generally, is there
Speaker 1: something about the business model of the small slash regional
Speaker 1: banks that makes them more natural sources of financing to
Speaker 1: these projects than some of the you know, the really
Speaker 1: big two big to fail banks. There is regulatory shopping
Speaker 1: in the financial world, Okay. You have groups like the
Speaker 1: debt funds that they're really only regulated at the level
Speaker 1: of the sec when they're raising capital. You know, they're
Speaker 1: making a private loan. There's no state bank regulator, no
Speaker 1: insurance regulator. You know, they're just doing their own thing.
Speaker 1: The local banks they don't have the same kind of
Speaker 1: restrictions placed on them as the large national banks. And
Speaker 1: over time some of the restrictions have been eased a bit. Yeah,
Speaker 1: I know some banks have explicitly tried to keep their
Speaker 1: book a business below a certain levels so they don't
Speaker 1: get that regulatory burden because you know then there's extra
Speaker 1: costs that go into it, and just the administrative cost
Speaker 1: starts to rise at an exponential pace once you get
Speaker 1: above a certain threshold level for those regulatory burdens. And
Speaker 1: really since around twenty fifteen when there were some tightening
Speaker 1: up of those standards and for the larger banks, the
Speaker 1: smaller banks started to gain more share of all the
Speaker 1: bank lending activity. There's a slight I've version, but I
Speaker 1: actually am really curious about those administrative costs. You says
Speaker 1: they rise exponentially, and so I am curious, like what
Speaker 1: happened when a bank flips over to that larger size
Speaker 1: and they all want to avoid it and SVB tried
Speaker 1: to avoid getting these sort of larger designations, etc. But
Speaker 1: like what actually does happen internally in terms of the
Speaker 1: regulatory obligations and how that sort of changes the way
Speaker 1: the bank must operate at that point they have to
Speaker 1: hire a lot more risk management people and do a
Speaker 1: lot more work on scenario planning around what happens to
Speaker 1: different FED scenarios that the FED will publish around the
Speaker 1: economy and potential changes to asset prices, not just in
Speaker 1: real estate, but other sectors, and it's a big administrative burden.
Speaker 1: Some of the bank managers that I talked to, the
Speaker 1: presidents of some of these small local banks, you know,
Speaker 1: they've noted that when they were hiring during the aftermath
Speaker 1: of the financial crisis, they felt bad that they were
Speaker 1: hiring more were administrative workers then loan officers, not the
Speaker 1: folks who are going out and producing money for them.
Speaker 1: And their worry was, if I go above that threshold,
Speaker 1: I'm gonna have to hire a lot more administrative folks
Speaker 1: to do all the CCR testing that they were talking
Speaker 1: about back in the day and run all these different
Speaker 1: scenarios and just more compliance people. Got it. And so
Speaker 1: if you're hiring a third of your people were in
Speaker 1: compliance and not income producing, you're going to try and
Speaker 1: avoid that. Also, if you get really big, I think
Speaker 1: you start to get regulators who are situated on site
Speaker 1: in your bank right just to kind of monitor how
Speaker 1: things are going. You know, I don't know about that.
Speaker 1: I do know I was visiting one client once and
Speaker 1: all of a sudden, regulators came in sort of an
Speaker 1: announcement that morning they were coming in, and the atmosphere
Speaker 1: in the place was suddenly very tense. So just on
Speaker 1: this regulation, no shit, It is true that commercial real
Speaker 1: estate has been on regulators radars collective radars as a
Speaker 1: source of potential risk for some time. What exactly was
Speaker 1: the concern there and can you kind of give us
Speaker 1: a quick synopsis of how that regulation has changed over
Speaker 1: the past few years. Well, in twenty fifteen, that was
Speaker 1: a watershed for certain types of loans. The high volatility
Speaker 1: Commercial real Estate regulations came in HVC, so that the
Speaker 1: loans with shorter terms lenders had to hold more capital
Speaker 1: and reserve. So suddenly it became more expensive to originate
Speaker 1: loans like that. Construction lending was dead center for that
Speaker 1: activity because those are typically short term loans that just
Speaker 1: pay out very quickly once the construction projects done. And
Speaker 1: we saw a distinct move in construction financing there. It
Speaker 1: used to be something like seventy percent of construction financing
Speaker 1: was bank driven, and that really declined to debt funds
Speaker 1: who didn't face any of that kind of regulatory burden.
Speaker 1: They really stepped into that and started originating more construction loans.
Speaker 1: Banks are still the question number too. Yeah, Like so
Speaker 1: it was seventy percent what's it done too, it's my recollection.
Speaker 1: It was like fifty two percent recently, so it's still
Speaker 1: a majority bank financing. But the debt funds really aid
Speaker 1: into that business. And they know. Some of these lenders.
Speaker 1: When I talk with them, they complained about their competitors,
Speaker 1: how they're just so aggressive compared to them. And they
Speaker 1: kind of lifted the market in this period from twenty
Speaker 1: fifteen to twenty nineteen because they were originating loans at
Speaker 1: much higher LTVs, much lower interest rates, and with very
Speaker 1: few covenants out there, because they were underwriting differently than
Speaker 1: banks banks. They underwrite a loan wanting to avoid in
Speaker 1: a foreclosure situation. They want to avoid what you call
Speaker 1: in the industry r EO, not the band, but you
Speaker 1: know r EO the real estate owned situation. They want
Speaker 1: to avoid that because you know, if I'm a big bank,
Speaker 1: what do I know about running an apart building? What
Speaker 1: do I know about managing an office building? I'd rather
Speaker 1: have the experts take care of that and I just
Speaker 1: collect a nice, stable yield. So I want to underwright
Speaker 1: to avoid that. So I'll put covenants in there to
Speaker 1: make sure that if occupancy flow falls below a certain level,
Speaker 1: that there are scrapes of any revenue, so I make
Speaker 1: sure that I'm whole. So they put those kind of
Speaker 1: things in there. The debt funds they didn't do any
Speaker 1: of that because the debt funds a lot of them
Speaker 1: started as equity shops that have their own investments and
Speaker 1: own management in place, and you know, they viewed it
Speaker 1: as an opportunity. It might be a situation where I
Speaker 1: have either any stable yield and I can help my
Speaker 1: investors that way. But if I had the tell situation
Speaker 1: where there's a foreclosure, I have this equity management shop
Speaker 1: on the side. I can just take the property to
Speaker 1: lower basis than before, and I know how to run
Speaker 1: a property and I could probably do it better than
Speaker 1: those people who were coming to me for a loan.
Speaker 1: So I'll put it into that shop and raise some
Speaker 1: capital to stabilize that and I'll be good. So it's
Speaker 1: a different behavior, and it's you know, those were the
Speaker 1: folks who are the most aggressive and did some of
Speaker 1: the larger loans in that period of twenty twenty twenty
Speaker 1: twenty one when interest rates for so low, and typically
Speaker 1: they had short terms as well, So we have a
Speaker 1: wall of maturities coming in twenty twenty three through twenty
Speaker 1: twenty five, and those aggressive loans are the ones that
Speaker 1: I think are going to see the most attention. This
Speaker 1: was exactly what my next question was going to be.
Speaker 1: But talk to us about what the maturity wall actually
Speaker 1: looks like at this point in time, because again, this
Speaker 1: is where a lot of the worry is stemming from,
Speaker 1: this idea that you have the sort of frontloaded wall
Speaker 1: that is coming due in the next year or two.
Speaker 1: And how are banks slash private investors to your point,
Speaker 1: going to actually be able to refinance those loans. The
Speaker 1: originators of loans for them, their ability to refinance, you know,
Speaker 1: they have a certain cost of capital. They'll offer a
Speaker 1: bour Okay, we can refinance a loan, but it's at
Speaker 1: a lower LTV than before. The rate is higher. And
Speaker 1: if somebody bought a property back in twenty thirteen and
Speaker 1: the loan matures in twenty twenty three, you've had a
Speaker 1: tremendous amount of price growth along the way. Even though
Speaker 1: we've had some price declines recently, there's probably still enough
Speaker 1: that they might be able to refinance that at a
Speaker 1: higher rate and keep that alive, assuming that you don't
Speaker 1: have a problem on income. I'm gonna put that to
Speaker 1: the side for the moment because that's another challenge. But
Speaker 1: just dealing with one challenge at a time here. Yeah, So,
Speaker 1: if you had a long term loan you're refinancing, Yeah,
Speaker 1: maybe you're not going to get the same proceeds as before,
Speaker 1: but you might be okay. But if you had a
Speaker 1: loan that was originated in twenty twenty one, when we
Speaker 1: saw a record low interest rate environment and you had
Speaker 1: a very high LTV and a record low interest rate
Speaker 1: thinking that game would continue forever, you may have a
Speaker 1: bad day as you try to get that refinance because
Speaker 1: you're going to go to a lender who will offer
Speaker 1: you money, but it's going to be in a very
Speaker 1: low LTV comparative before and with a mortgage rate closer
Speaker 1: to a seven percent than a three and a half percent,
Speaker 1: and so the numbers may not work for those folks
Speaker 1: and they're gonna have to have You know, there's three
Speaker 1: options for some of these folks. Maybe it could do
Speaker 1: a cash in refinancing where they bring more equity to
Speaker 1: the table themselves in their own pocket, and they might
Speaker 1: want to do that just so they don't end up
Speaker 1: in a default situation if the property, if they still
Speaker 1: have an expectation of price growth ahead or income growth,
Speaker 1: or there's still some fees that make them whole and
Speaker 1: you know, they think of as a brand new investment
Speaker 1: at that point, or maybe they get some outside investor
Speaker 1: to bring that cash in a preferred equity situation and
Speaker 1: that person gets some of the upside of the project
Speaker 1: moving forward, so that you the investor can at least
Speaker 1: still collect some fees on the project. And then another
Speaker 1: opportunity is to literally hand the keys over to the
Speaker 1: lender a jingle mail. I know we're making the point
Speaker 1: about how this might not be two thousand and eight,
Speaker 1: but these are all very oh eight type terms real
Speaker 1: estate owned and jingle Yeah, just in a different context.
Speaker 1: But I wanted to you know, you mentioned setting aside
Speaker 1: the income question because we've been talking about raids, we've
Speaker 1: been talking about price appreciation. Can you break down like
Speaker 1: where is their income stress? Where is there not income
Speaker 1: stress within the commercial real estate world, and how are
Speaker 1: you thinking about that particular aspect of it right now? Yeah,
Speaker 1: the income stress is a bit of a challenge and
Speaker 1: there still is a lot of uncertainty around it. Let's
Speaker 1: start with offices. You're saying earlier, Hey, everything's not Manhattan's offices,
Speaker 1: but let's talk about Manhattan. Okay, yeah, please. It's Wednesday
Speaker 1: today when we happen to be recording walking around the city.
Speaker 1: There's more people out today because it's a Wednesday, that's
Speaker 1: when more people are around. But if you're around on
Speaker 1: a Monday or Friday, it's usually pretty empty. And you know,
Speaker 1: so people see that and they see that, hey, there
Speaker 1: are less people coming in. The subway ridership is at
Speaker 1: like sixty five per sent to the previous peak levels,
Speaker 1: so obviously the space is being utilized less. That said,
Speaker 1: the fiscal side of it, you know, the fiscal occupancy,
Speaker 1: the tenants who are still on the hook for the space.
Speaker 1: There still is some good occupancy in that direction. You know,
Speaker 1: there's a lot of sublet space where firms are signaling
Speaker 1: that they want to get rid of it, but they
Speaker 1: still are pain and so there's a short term challenge
Speaker 1: that everyone knows that there's going to be a reduction
Speaker 1: to demand eventually, but right now there's still some income
Speaker 1: coming in, and so there's that there's a term in
Speaker 1: the industry walt weighted average least term and if you
Speaker 1: have a property that has a very long least term ahead,
Speaker 1: even if people aren't using it as much. If you
Speaker 1: have some high quality tenants who are unlikely to default,
Speaker 1: that might seem like a safe investment. But if I've
Speaker 1: got a tenant who has one year left on the
Speaker 1: lease and I see that the building is half empty
Speaker 1: most days, I'm going to be concerned about what happens
Speaker 1: to income. They're moving forward, so it's a slow motion thing.
Speaker 1: You know, everybody sees the direction it's going. That's one
Speaker 1: of the things about real estate forget about you know,
Speaker 1: I used to work with a bunch of economists in Boston.
Speaker 1: There's a lot of complex math we did, but forget
Speaker 1: about it all that the real estate market, there's all
Speaker 1: these sticky things. You just count the number of cranes
Speaker 1: and you can see whether you're going to have some
Speaker 1: construction challenges ahead. You just look at the number of
Speaker 1: people walking into a building and you can just get
Speaker 1: a sense of what the potential demand is. All those
Speaker 1: kind of rule of thumb measures have been telling people
Speaker 1: that there's going to be some sort of reduction in demand,
Speaker 1: and we know that's coming, but nobody's really been able
Speaker 1: to fully quantify it yet it's something we just have
Speaker 1: to live through over the next few years before we
Speaker 1: see all the leases burn off. All right, but that
Speaker 1: was great. But what about the non Manhattan office? Yeah?
Speaker 1: And two, I guess sort of two interrelated questions. But
Speaker 1: like Ridge Hill, the number he'side was twenty trillion. But
Speaker 1: when we think about that twenty and how much is
Speaker 1: this sort of like prime city office that might not
Speaker 1: ever come back to pre COVID levels. And then can
Speaker 1: you talk a little bit more about like are there
Speaker 1: other these other areas, medical, etc. Are they doing fine
Speaker 1: in terms of like income and income expectations. There's a
Speaker 1: couple of things that are digests there. Yeah, the office market,
Speaker 1: most of the US office market is a suburban market, Okay,
Speaker 1: And that goes back to the nineteen seventies and nineteen
Speaker 1: eighties when we saw a surge in construction in those areas.
Speaker 1: And it's not just suburban New York. A lot of
Speaker 1: it is the development of the sun Belt states and
Speaker 1: as they entered the modern economy in that time and
Speaker 1: became service sector economies as opposed to agriculture and manufacturing,
Speaker 1: those office buildings in those areas they do constitute a
Speaker 1: large part of the office market Manhattan off top of head,
Speaker 1: I think it's about forty percent of all CBD office
Speaker 1: based in the United States. So that's why people like
Speaker 1: to focus someone Happen because it's pretty significant. It's an
Speaker 1: indicator of where the whole c D office market is
Speaker 1: going nationally. But you know, that suburban market is a
Speaker 1: bigger market overall, and it's been bigger in terms of
Speaker 1: the deal vium recently, the last really since twenty fifteen,
Speaker 1: when the Chinese investors pulled back from investing in the
Speaker 1: US deal. Vilume fell off for the CBD locations, and
Speaker 1: the past had always been sort of half and half.
Speaker 1: Half of all investment was in suburbs, half of all
Speaker 1: investment was in CBD locations, and that really started to
Speaker 1: turn a corner then when the prices hit a record low,
Speaker 1: and you know, there was just a very little upside left.
Speaker 1: So there's been a lot less transaction activity than the
Speaker 1: CBD locations even before all the central business essentially yeah sorry, yeah,
Speaker 1: and so there's been a decline ever since. So it's
Speaker 1: it has been important, but it had been priced perfection
Speaker 1: back around twenty fifteen, so there Wasn't you know that
Speaker 1: that same push to continue to invest in it as
Speaker 1: there had been for more suburban locations. I want to
Speaker 1: go back to what you were talking about when it
Speaker 1: comes to income deterioration and waltz, so you know, the
Speaker 1: weighted average lease terms and things like that, is the
Speaker 1: implication that the old extended pretend strategy, which you know,
Speaker 1: another blast from the past from two thousand and eight
Speaker 1: and the years after that, is the implication that that
Speaker 1: just won't work in the current environment, that at some
Speaker 1: point you're not going to be able to refinance, or
Speaker 1: there will be some sort of catalyst on the income
Speaker 1: side that makes it impossible. Yeah, that is a good distinction.
Speaker 1: The extended pretend it worked for a simple reason. Everybody
Speaker 1: understood it was a temporary credit market challenge. You had
Speaker 1: otherwise cash flown properties, and if you know, the credit
Speaker 1: markets simply stabilized. Given that the some high quality cash flow,
Speaker 1: you'd be able to refinance at reasonable rates. In fact,
Speaker 1: the folks who made a lot of money into the
Speaker 1: recovery period where folks who came in took buildings that
Speaker 1: were otherwise cash flowing, just with bad debt situations reposition
Speaker 1: the debt, put an appropriate debt structure in there, and
Speaker 1: then ride the wave of recovery as a debt market stabilized.
Speaker 1: This time through, you don't have that same opportunity of
Speaker 1: healthy cash flowing properties. You see properties that have uncertainty
Speaker 1: around the income moving forward. So it's just not going
Speaker 1: to work out the same way we track distressed asset cells,
Speaker 1: and we don't have a lot of distressed asset cells yet. Again,
Speaker 1: everybody kind of sees this coming, but it's a slow moving,
Speaker 1: sticky market, and everybody knows there's some distress cells coming,
Speaker 1: but it hasn't hit in a meaningful way yet. But
Speaker 1: when we do see some of the distress cells, when
Speaker 1: we disaggregate who was buying, it's a different type of
Speaker 1: buyer of the distress we've seen so far compared to
Speaker 1: the aftermath of the financial crisis. The aftermath of the
Speaker 1: financial crisis, there's a bunch of suits from New York,
Speaker 1: from private equity firms flying out to cities across the
Speaker 1: United States buying up these cash flowing assets, you know,
Speaker 1: repositioning the debt and flying home and just you know,
Speaker 1: collecting a big get. Absolutely, and everybody sees that and thinks, Hey,
Speaker 1: I'm gonna be just like those folks this cycle. But
Speaker 1: the folks who have been buying these properties so far
Speaker 1: are local developer, owner operator types. It's people know how
Speaker 1: to swing a hammer. And that tells me that the
Speaker 1: distress is really more fundamental distress. It's not a cash
Speaker 1: flowing building in Nashville with a high quality credit tenant.
Speaker 1: It's a dead mall outside of Columbus with burnt orange
Speaker 1: tile and brown carpet from the seventies. And you know,
Speaker 1: somebody has to reposition that, and it's going to take
Speaker 1: somebody who has relationships with local regulators. Every zoning board
Speaker 1: wants to get their hands involved in that to be
Speaker 1: able to change the use and bring it into the
Speaker 1: modern economy again. And so that takes a lot of
Speaker 1: elbow grease, both literally from the physical side and then
Speaker 1: figuratively just talking with local zoning boards and getting changes
Speaker 1: and entitlements and land use regulation. There's a cre guy
Speaker 1: I follow on Twitter who goes by the handle repositioning play.
Speaker 1: That's what that means. It just clicked to me that
Speaker 1: that's what that means. That it's like some malls like, oh,
Speaker 1: maybe this could be like residential or maybe this could
Speaker 1: be like a big paintball sort of like thing. But
Speaker 1: that's what that means that you have to identify the
Speaker 1: opportunity to like make it something other than it was. Yeah,
Speaker 1: and with those malls, a lot of malls that are
Speaker 1: positioned well relative to transit opportunities, yeah, for highways, and
Speaker 1: so some of them would be great for logistics and
Speaker 1: local distribution activity. However, that flies in the face of
Speaker 1: local zoning issues where you know, local city leaders feel
Speaker 1: that it's too beneath them. It's not bougie, it's not
Speaker 1: a consumption area. Plus, you know, we're not a low
Speaker 1: class industrial town. We want them all we want, we
Speaker 1: want blooming deals because you know, we're high end. But
Speaker 1: they you know, the reality is the market doesn't believe that,
Speaker 1: and it's going to take a long time to get
Speaker 1: some local city leaders to kind of understand where they
Speaker 1: really sit. But there's another issue that in many states
Speaker 1: we have that those local city leaders want the retail
Speaker 1: because it generates more tax revenue without them having to
Speaker 1: tax residents as much. And so that that's the other
Speaker 1: reason that it's a sticky issue keeping the market from
Speaker 1: converting the space to what it really needs to be.
Speaker 1: So this is really fascinating, just this idea that the
Speaker 1: buyers we're seeing show up in some of these distressed
Speaker 1: is not the people who just know how to like,
Speaker 1: you know, do a spridge. Yeah, that people who actually
Speaker 1: have to under have these sort of are sort of
Speaker 1: like concrete connections. But I want to get back to
Speaker 1: some of the specific bank questions and specifically, like you know,
Speaker 1: let's say we talk about CBD office some of these
Speaker 1: areas that are income stressed, Like of the debt out there,
Speaker 1: how solid are the numbers in terms of like how
Speaker 1: much is bank how much is private credit funds? Like
Speaker 1: how is that broken down? I mean the originations we're
Speaker 1: tracking originations. Okay, we don't have a good measure of
Speaker 1: the stock. We have some estimate some maturities. You know,
Speaker 1: given when we know all the loans were originated and
Speaker 1: the kind of terms that were in place, measures of
Speaker 1: stock gets get they get tricky because some loans, you know,
Speaker 1: it might default and we're not going to hear about that.
Speaker 1: So you know, I can give a perspective on on
Speaker 1: the share of originations. And in the boom period when
Speaker 1: interest rates were so low and everyone was excited about
Speaker 1: the fact that there were some yield on offer and
Speaker 1: commercial real estate. Those debt funds were around thirteen percent
Speaker 1: of originations, and given that they had typically short term
Speaker 1: short terms associated with those loans, you know that's going
Speaker 1: to be a significant component of the maturities in the
Speaker 1: near term. Thirteen percent of the market was high LTV,
Speaker 1: low interest rate and a very few covenants from these
Speaker 1: aggressive lenders. Could be an interesting situation with those with
Speaker 1: those deals. So, just on this topic, how do you
Speaker 1: see banks and private investors actually hedging their CRE exposure
Speaker 1: at this moment in time, if they're doing it at all,
Speaker 1: Because my impression of the space was it was always
Speaker 1: kind of a difficult one to hedge or go short.
Speaker 1: And you do have synthetic instruments like the CMBX, which
Speaker 1: is a derivatives index tied to not that many CMBs properties,
Speaker 1: I think, which makes it, you know, sometimes a not
Speaker 1: perfect one for one hedge for this kind of exposure. Yeah,
Speaker 1: hedging the commercial estate market has been it's been the
Speaker 1: white whale for many folks in the industry over the
Speaker 1: last fifteen years. The firm I'm with now, they bought
Speaker 1: this company, Real Capital Analytics back in twenty twenty one,
Speaker 1: and Real Capital Analytics had been one of the folks
Speaker 1: trying to get a real estate DRIVTIS index going based
Speaker 1: on our commercial Property Price Index. We had licensed it
Speaker 1: out to a third party that was trying to get
Speaker 1: that going. There a few of the folks trying to
Speaker 1: get that going, the trade organization Nate Creef, some folks
Speaker 1: are trying to trade routives on that. So there are
Speaker 1: a lot of folks trying to get that going, but
Speaker 1: it never really took off, and just they couldn't get
Speaker 1: enough buyers and sellers on opposite sides of a transaction
Speaker 1: to make any of that work. Again, the market is
Speaker 1: highly predictable because there's so many sticky elements in the
Speaker 1: performance of the market that you know, if you just
Speaker 1: again forget about econometrics and forecasting, just very simple things
Speaker 1: talking to leasing brokers. Any deal that's going to be
Speaker 1: done in the next six months, they're working on it
Speaker 1: right now, and so you can get a sense of
Speaker 1: just future demand that way. So those kind of challenges.
Speaker 1: Everybody saw that, so it's just been hard to make
Speaker 1: you know, a product like that, Wait, can I just
Speaker 1: press you on that point because since we're this is
Speaker 1: a fun episode for me because it's bringing up a
Speaker 1: lot of two thousand and eight flashbacks. But you know,
Speaker 1: if you wanted to go short residential real estate pre
Speaker 1: two thousand and eight, you use the ABX. Why is
Speaker 1: the commercial real estate market so different from the residential
Speaker 1: market that putting on that big commercial real estate short
Speaker 1: seems to be much more difficult. Yeah, you know, I
Speaker 1: haven't gotten into that as much, the comparison in that direction.
Speaker 1: There are fundamental differences in the two product types. You know,
Speaker 1: there's much more of a subsized finance side on the
Speaker 1: residential market. The residential market is vastly larger than the
Speaker 1: commercial market. There's many more single family homes out there,
Speaker 1: So just more information availability becomes an issue. You can
Speaker 1: do a lot more. You go in the academic literature.
Speaker 1: There's all kinds of folks doing stuff on residential real
Speaker 1: estate because that's where the data is. There's fewer folks
Speaker 1: doing work on commercial estate because it's just harder to
Speaker 1: get information. Interesting, Okay, I've been working in this sector
Speaker 1: since nineteen ninety six trying to help generate more transparency,
Speaker 1: more information, just better data sets for the sector, and
Speaker 1: as much as we've improved since that time. When I
Speaker 1: talk to my public markets colleagues over at MSc EI,
Speaker 1: they're like, well, you guys are doing okay, well, all right,
Speaker 1: So again on this sort of like bank question. Part
Speaker 1: of the reason we're even having this discussion again is
Speaker 1: because in the wake of SVB, people are like, what
Speaker 1: are what are the landmines? I guess maybe that these
Speaker 1: banks could be stepping out or something. What's lurking on
Speaker 1: the asset side of the bank balance sheets? And so
Speaker 1: when we sort of like, and I imagine there's no
Speaker 1: one model bank, obviously they're all going to be different.
Speaker 1: But when it comes to the various things that a
Speaker 1: theoretical bank could have on its balance sheet, you know, treasuries,
Speaker 1: agency mbs, you know, some sort of whatever, it is like,
Speaker 1: how significant is this really in terms of percentage of
Speaker 1: their own exposure to commercial real estate? Or how do
Speaker 1: you think about answering that question, or how do you
Speaker 1: think about trying to dive into where this lives diving
Speaker 1: into that. The FDSC call sheets have a lot of
Speaker 1: information about some of the exposure sort of the stock
Speaker 1: of loans of different entities, and my colleague Tama up
Speaker 1: at Columbia. He did a study I think it was
Speaker 1: released on marks thirteenth of all days, and estimated that
Speaker 1: maybe two hundred banks face some challenges in that direction.
Speaker 1: But what do we mean, like, because that's arrange it
Speaker 1: things right, It's like they're gonna like take losses, They're
Speaker 1: gonna have write down as verses like people are worried
Speaker 1: about like insolvencies, etc. So like, how seriously do you
Speaker 1: view the stress not to the commercial real estate market,
Speaker 1: but to the banking system from the exposure that they have. Sorry,
Speaker 1: can I just tack on to the end of that,
Speaker 1: wouldn loan loss provisions actually look like for CR because
Speaker 1: you would expect that. You know, again, this has been
Speaker 1: sort of on people's radar for some time. Yeah, I'm
Speaker 1: not sure what the loan loss provisions were. I don't
Speaker 1: have insight to that. I just know when they made
Speaker 1: the loan sort of the high the terms there. This
Speaker 1: is a challenge that is out there for the sector.
Speaker 1: You know, as much as we've tried, there are still
Speaker 1: many things that are known unknowns. It's still an opaque sector.
Speaker 1: On performance, I'm in the office every day and part
Speaker 1: of that is every day. I use it as a
Speaker 1: base of operations, and I'm going around the city. You'll
Speaker 1: have a few meetings every week just talking to people
Speaker 1: because you pick up so much information that's not in
Speaker 1: a database, that's not easily accessible. Because you just have
Speaker 1: a conversation with somebody, you get a few observations in
Speaker 1: sort of a sense of direction. Momentum is a challenging
Speaker 1: sector in that direction, and just in terms of like
Speaker 1: the seriousness that a CIRI weakness poses two banks themselves, Like,
Speaker 1: what is your judgment on that. Everybody saw what happened
Speaker 1: with Silicon Valley Bank. You know they had all this
Speaker 1: rmbs on their balance sheet. You know it was a
Speaker 1: it seemed like a safe product. You know it was
Speaker 1: thrown off yield. But in a rising interest rate environment,
Speaker 1: you know, the acid value needs to be written down.
Speaker 1: Other entities have the same kind of thing on their
Speaker 1: balance sheet. The question that I would be digging into
Speaker 1: is how many of them have actually taken those write
Speaker 1: downs so far and have they been able to replace
Speaker 1: that capital in other ways. Before the bank runs started SVB,
Speaker 1: they were trying to bring in other assets. They were
Speaker 1: trying to raise capital to shore up their balance sheet.
Speaker 1: What I'd be looking at is have other banks been
Speaker 1: ahead of the curve there? Have they been able to
Speaker 1: start to step that up, and you know where do
Speaker 1: they stand. That's what I would be looking for, because
Speaker 1: anybody who held those kind of securities realistically, if they're
Speaker 1: marketing it to market, they're not worth what they were
Speaker 1: back when interest rates were so low. And this is
Speaker 1: the challenge of the medicine that the FED has to
Speaker 1: deal with inflation. The last time the FED raised the
Speaker 1: FED funds rate at such a rapid pace was in
Speaker 1: the early nineteen seventies. You know, they's just they had
Speaker 1: to put the pedal to the medal here to fight inflation.
Speaker 1: But it had unintended consequences. You know, back in the seventies,
Speaker 1: you didn't have these complicated structured products like rmbs. It
Speaker 1: just it wasn't something that banks held, and the financial
Speaker 1: environment was largely a bank and a life company market.
Speaker 1: You didn't have debt funds in the United States. They
Speaker 1: had a structure like that in the UK, but not
Speaker 1: here as much, and you didn't have CMBs didn't exist
Speaker 1: at all, So you didn't have complicated products on the
Speaker 1: balance sheet. So when rates were raised, you know, you
Speaker 1: didn't have as much of an immediate shock to the
Speaker 1: banks this time through. I don't know if they were
Speaker 1: thinking about the fact that you have a more complicated
Speaker 1: financial environment today than the early nineteen seventies, with more
Speaker 1: unintended consequences. What are you hearing from the banks themselves?
Speaker 1: I mean, give us some color, because as you pointed
Speaker 1: out multiple times, this is a very opaque market. It
Speaker 1: is difficult to get a handle on whether or not
Speaker 1: people are writing stuff down what the capitulation point actually is.
Speaker 1: That is something that I always like, like I knowed
Speaker 1: walking around the city, just go visit clients, talk to people.
Speaker 1: You pick up a lot that way. Yeah. Since mid March,
Speaker 1: it's been very quiet, no meetings and just no conversations
Speaker 1: with our clients there or with the regulators either, Not
Speaker 1: that I didn't want to talk with them, it's just
Speaker 1: they've been busy elsewhere. Interesting. Yeah, one of my favorite
Speaker 1: forms of cell side research is when they send all
Speaker 1: the analysts to go shopping like a mall. Yeah, but
Speaker 1: now it's going to be when they send analysts to
Speaker 1: just walk around downtown New York and observe how many
Speaker 1: people are going in and out of office buildings, you're like,
Speaker 1: how many people are in line at a Starbucks or
Speaker 1: just like those charts which I would share, like and
Speaker 1: everybody's still monitoring those like MTA usage. I just want
Speaker 1: to go back again, and I think outside of you know,
Speaker 1: this sort of non office, non central business district real estate,
Speaker 1: I guess malls, there's some issues, but by and large,
Speaker 1: is this still more about like a rate pressure than
Speaker 1: it is an income pressure, Like is there income stress
Speaker 1: showing up in other parts? Yeah, the income stress has
Speaker 1: mostly been a story of properties where the previous economic
Speaker 1: justification from is evaporating. Okay, Malls we've been dealing with
Speaker 1: for a long time, right, Like that's a pre COVID
Speaker 1: story for a long time. An office is now are
Speaker 1: kind of where malls used to be, where everybody saw
Speaker 1: there was a change. They weren't sure how long it
Speaker 1: was going to take, but it's going to be there.
Speaker 1: Offices today are in some cases much like the malls
Speaker 1: in the past, But you know, the other property types,
Speaker 1: it's not as extreme on sort of the income and
Speaker 1: certainty some elements of hotels, with some of the convention
Speaker 1: center locations still not where they were in expensive urban
Speaker 1: markets you don't see as much activity and some of
Speaker 1: those although the nature of it has changed much more
Speaker 1: tourism and talking with hotel experts, there's sort of been
Speaker 1: a change in the patterns of daily room rates because
Speaker 1: there's many more folks who are not doing the come
Speaker 1: in the middle of week for a conference or to
Speaker 1: see clients. It's many more tourists, So it's changed in
Speaker 1: nature of some of those hotels, but you know, it's
Speaker 1: largely all about the change in the economic justification of
Speaker 1: some of the some of the assets. Jim Castello, thank
Speaker 1: you so much for coming in. This is like such
Speaker 1: a big topic and this was so helpful in terms
Speaker 1: of sort of understanding the various dynamics out there. So, yeah,
Speaker 1: that was really great. Thanks for coming out, Old One. Yeah,
Speaker 1: great to be here, Tracy, I thought that was really great.
Speaker 1: Obviously a lot there, but this idea that like for
Speaker 1: the most part, and this it speaks to why we
Speaker 1: really need to do a sort of like office to
Speaker 1: Resie episode turn and the challenges there that this is
Speaker 1: not going to be a situation which the money is
Speaker 1: accrued to like people who know how to like read
Speaker 1: a spreadsheet or enter numbers, into a model and sit
Speaker 1: behind a computer in New York. But someone who knows
Speaker 1: about like actual construction and zoning and relationships, I think
Speaker 1: it's like a really interesting Yeah, this is not the
Speaker 1: least absolutely, And also the parallels between where shopping malls
Speaker 1: were in say twenty fifteen, and I mean I remember
Speaker 1: writing those stories from a CMBs perspective of you know,
Speaker 1: what are we going to do with all the shopping
Speaker 1: malls and some of them are going to become like
Speaker 1: multi family living centers and things like that. Yeah, and
Speaker 1: the parallels with the office space now. And the other
Speaker 1: thing I thought was really interesting was this idea and
Speaker 1: I'd never thought of it before, but the idea that
Speaker 1: the local authorities might want to hold out for you know,
Speaker 1: retail because they get higher tax income than for resie.
Speaker 1: That was really interesting to me. And then also just
Speaker 1: the point about why extend and pretend won't work in
Speaker 1: that environment, In an environment where you know, the cash
Speaker 1: flow the income is actually in doubt, it's not just
Speaker 1: a matter of refinancing again, you know, I think obviously
Speaker 1: for understandable reasons, there are these concerns about regional bank
Speaker 1: exposure to this space. But I do think that like
Speaker 1: people need to remember that there is like a diversity
Speaker 1: of what's meant by commercial real estate, and that like
Speaker 1: a lot of like the risky stuff, like the sort
Speaker 1: of like fast money, the riskiest stuff, especially in this
Speaker 1: sort of like low interest rate period with like the
Speaker 1: worst covenants or the sort of like the worst investor protections.
Speaker 1: The fastest time to REFI was by the sort of
Speaker 1: like private debt funds. Was a really interesting point. Yeah,
Speaker 1: and like the older people who have money invested in
Speaker 1: those private debt funds, like they're probably not going to
Speaker 1: do great. I would assume they're gonna like take some heads,
Speaker 1: but like that seems better than like having all those
Speaker 1: like losses be borne by like the banks themselves. I
Speaker 1: have these like sort of like key infrastructure groups. Well,
Speaker 1: I mean the good news is, to some extent, that's
Speaker 1: what a lot of the recent regulation was trying to encourage,
Speaker 1: which was, you know, banks are more conservative on risky CRI,
Speaker 1: and there was a lot of recognition that was an
Speaker 1: area of worry in recent years and that some of
Speaker 1: that risk would be pushed out into non banking entities
Speaker 1: such as large debt funds. But I guess now we
Speaker 1: get to see well whether or not that was a strategy. Yeah,
Speaker 1: and then still the point that like part of the
Speaker 1: reason the regional banks have this exposure is because of
Speaker 1: the Yeah, they're less less burdened than the large banks
Speaker 1: in terms of the types of risks that they can take.
Speaker 1: So clearly still risks out there for multiple parties. I
Speaker 1: do want to do an episode though, on why commercial
Speaker 1: real estate seems to be so difficult to short or
Speaker 1: to hedge, Oh, because this has been a sort of
Speaker 1: it's a little geeky or wonky, but this has been
Speaker 1: a perennial talking point in the industry at various points
Speaker 1: in time. You see people come out with very creative
Speaker 1: ways of going short, but there hasn't been an obvious
Speaker 1: industry standard other than CMBX, which is definitely not a
Speaker 1: perfect hedge for a long time. So we should do
Speaker 1: an episode on that. Yeah, that is interesting because I
Speaker 1: think people just sort of imagine that, like and I
Speaker 1: remember these even go back take two thousand and two
Speaker 1: thousand and nine, like just with like credit default two. Yeah,
Speaker 1: and people like imagine you just like go like log
Speaker 1: into your brokerage, right and like by a CDs or
Speaker 1: like whatever as if like it's like buying a stock.
Speaker 1: It's like, why don't you put on a hedge? It's like, well,
Speaker 1: it was someone willing to sell you a hedge for this, yeah, yo, sided.
Speaker 1: It's sort of this idea that like there is just
Speaker 1: that always a hedge out there that someone could have bought,
Speaker 1: sort of like this sort of naive fantasy about how
Speaker 1: these markets work, right, or the idea that everyone has
Speaker 1: like an ista agreement up there sleeve. Yeah, okay, shall
Speaker 1: we leave it there? Let's leave it there. This has
Speaker 1: been another episode of the Old Thoughts podcast. I'm Tracy Alloway.
Speaker 1: You can follow me on Twitter at Tracy Alloway. And
Speaker 1: I'm Joe Wisenthal. You can follow me on Twitter at
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