Putting recent commercial real estate debt headlines into perspective

Putting recent commercial real estate debt headlines into perspective

17 minute read

February 2024

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We believe the developments at New York Community Bancorp are not indicative of a systemic CRE debt problem or broader systemic stress across regional banks, but they do deserve some further explanation.

KEY TAKEAWAYS

  • We do not believe New York Community Bancorp’s surprise fourth quarter loss, as it built reserves for commercial real estate (CRE) debt losses, signals a systemic problem in CRE debt or broader stress among regional banks.
  • Our outlook for preferred securities remains optimistic due to the expected end of the rate-hiking cycle, strong issuer fundamentals, attractive valuations, and discounts to par. We have avoided banks we view as having large CRE exposure and weaker capital.
  • Listed REITs are well positioned to withstand volatility in the CRE mortgage market, while expected declines in valuations in private real estate create a historic opportunity for deploying fresh capital.

New York Community Bank (NYCB) posted a surprise fourth-quarter loss as it built reserves for commercial real estate (CRE) debt losses, and it cut its dividend by more than 70%, resulting in the greatest-ever-day-over-day decline for the stock (–38%). The regional bank had significant exposure to commercial real estate as of 4Q23 at approximately 60% of total loans, with multifamily loans at 45%. NYCB aimed to bolster its liquidity and capital to comply with bank regulations and better align with peers. The dividend cut reflected that effort.

These headlines prompted renewed questions about the health of the U.S. CRE markets, while also creating concerns about broader regional banks. We believe the developments at NYCB are not indicative of a systemic CRE debt problem or broader systemic stress across all regional banks, but they do deserve some further explanation.

To start, the headlines surrounding NYCB are somewhat unique to the bank. Last year, the bank surpassed $100 billion in assets on the back of two acquisitions. That triggered new liquidity and capital requirements for NYCB. The bulk of NYCB’s charge-offs also came from just two loans – a New York City residential co-op and an office loan. NYCB was under-reserved on office loans at roughly 2% compared to more than 8% for larger bank peers. NYCB played catch-up and increased its reserves for office losses to 8%.

We do anticipate that more banks will report CRE loan losses because there is now greater transparency on how much property valuations have declined. Further, distress is increasing as delinquency rates climb and a greater volume of loans mature. Banks have been proactively building reserves for future loan losses.

But reserve adequacy can vary across banks. Among the more than 4,600 banks across the U.S., some banks are naturally more conservative—and other banks less so. A number of large banks have recently expressed confidence in their reserve levels as default trends appeared no worse than expected. NYCB, on the other hand, had to add to its reserves.

The developments at NYCB do not alter our conviction that the current market environment will be favorable for performance in preferred securities, listed REITs, and private real estate with fresh capital.

Our outlook for preferred securities remains positive given the likely end of the rate-hiking cycle, issuers’ strong fundamentals, the securities’ attractive valuations and deep discounts to par.

As it relates to banks, which are the largest issuers of preferred securities, there are of course positive and negative outliers. As we actively manage our preferred investments, we are focusing on banks with strong capital and earnings power. In our analysis, we consider banks’ CRE exposures relative to capital, reserve adequacy, and earnings power in estimating their ability to absorb potential losses. We have avoided banks we view as having large CRE exposure and weaker capital.

Banks also don’t hold as large a share of total CRE loans as the headlines would lead people to believe. Specifically, banks hold less than 40% of income-producing CRE loans and around 45% of all CRE mortgages (Exhibit 1). Exposures vary greatly across the banks, with the largest banks far less exposed to CRE than their smaller peers.

The 25 largest banks by total assets hold 14% of all CRE mortgages, and their exposure as a percentage of total assets is small at approximately 4%. Regional and community banks hold 31.5% of all CRE mortgages, and their exposure is much higher at 20% of total assets. Smaller banks have been an important source of lending to the US CRE market, but they are hardly the only lender. You can find further analysis in our March 2023 report entitled The commercial real estate debt market: Separating fact from fiction.

EXHIBIT 1
Parsing bank exposure
Parsing bank exposure

Our outlook for listed and private real estate also stands.

First, we maintain that listed REITs are well positioned to withstand volatility in the CRE mortgage market given their strong balance sheets, diversified sources of capital and only 3% exposure to the office market.

Second, the current declines in valuations in private real estate were expected. In fact, listed REITs are a leading indicator for private CRE in both downturns as well as recoveries.

Listed REIT total returns were down more than 33% at their trough in October 2023 with price returns closer to -40%. They have since rebounded 20% from their lows last year (Exhibit 2). We are subsequently witnessing the standard one-year delay in private real estate value adjustments. The Federal Reserve’s job of hiking interest rates to slow inflation may be done, but the private real estate pricing mechanism will require more time to reflect the structurally higher rates that persist.

EXHIBIT 2
Private real estate values will likely fall further in 2024–2025 if listed REITs are an indicator
Private real estate values will likely fall further in 2024–2025 if listed REITs are an indicator

Despite the constant drumbeat of negative headlines about CRE, the debt markets have been resilient over the past 12 months. Lending standards have tightened, and origination volumes have declined. But delinquencies across lender types have not risen as much as feared and distressed sales as a percentage of total transaction volumes are muted.

We expect this will change. Rising distress is key to the bottoming of the CRE market. Unlevered private CRE valuations are down approximately 18.5% from their peak in the third quarter of 2022. We expect this repricing is at least two-thirds complete and will likely continue into late 2024 and potentially early 2025.

The catalyst for rising distress is the nearly $1.6 trillion of commercial mortgages that are expected to mature across all lender types over the next three years (Exhibit 3). This represents more than 40% of total outstanding commercial mortgages.

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EXHIBIT 3
High number of CRE loans are set to mature by 2026
A high number of CRE loans are set to mature by 2026

We maintain that CRE mortgages as a group are underleveraged. This is because loan-to-values of 50-60% help mitigate the risk of declining property valuations, especially as property valuations have increased more than 30% since the beginning of 2012 even after considering recent pullbacks from peaks of approximately 20%.

However, there are risks in office loans and shorter-term loans originated over the past several years, especially if they are floating rate. Multifamily, despite solid fundamentals over the medium to long term, will likely not be immune given the wave of financing that occurred over the past several years. If borrowers fail to secure new financing or extend existing loans, they are likely to find themselves in default or be forced to either inject fresh equity into their properties or sell properties to fulfill repayment or restructuring obligations. The result could be a historic opportunity for deploying fresh capital in private real estate.

With private real estate poised to drop a further 5–10 percentage points, we believe 2024–2025 will offer the best entry points into the asset class since the global financial crisis. We believe committing capital at this stage is the right strategy.

History shows the best vintage returns have been generated in the aftermath of markets such as today’s environment, with post-2008 vintages a prime example. We expect returns for 2015–2020 vintages to meaningfully decline as capitalization rates reset higher and valuations decline in the coming years (Exhibit 4). This is good for new capital, but not for currently invested capital.

You can read more in our recently published insight, Private real estate set up for attractive early cycle returns.

EXHIBIT 4
Post-2008 vintages have historically generated attractive returns

Average of the median internal rates of return (IRR) by vintage for closed-end funds(1)

Post-2008 vintages have historically generated attractive returns

As these investment opportunities reveal themselves, this downturn will look vastly different than what we have seen for the last decade. It will create winners and losers.

On the losing end, we believe, will be many legacy private funds that purchased properties at or near peak valuations, particularly in 2022, when private funds were the only net acquirers of assets. Those funds have been slow to mark down existing asset prices given a lack of transactions that would otherwise provide pricing transparency. Redemption queues for these funds have been building. The result is that legacy funds may not have sufficient capital flexibility to reposition themselves for the new cycle as they will be more likely to face calls for redemptions from investors.

On the winning side, in our view, will be new strategies with fresh capital as the property types that worked last cycle, will face increasing difficulties this cycle. Notably, most private funds, especially those heavily weighted to industrial and office, are starting to underperform as capitalization rates reset higher. A meaningful rotation in property types and sector leadership is now underway.

We also maintain that listed REITs offer attractive value and are well positioned to withstand volatility in the CRE mortgage market for three primary reasons.

First, they have solid balance sheets with loan-to-values of approximately 36%, and 89% of their debt is fixed (with a weighted average maturity of nearly six years).

Second, office is a very small percentage of listed REITs’ market cap at only 3%.

Third, listed REITs have diversified sources of capital, and this has been important as banks have reduced their lending. For instance, listed REITs have been active issuers of senior unsecured bonds in 2023, with 47 deals totaling almost $29.5 billion and nearly $12 billion of equity. Senior unsecured bond issuance has been robust in the first month of 2024 as listed REITs tapped the market given a decline in nominal interest rates as well as a spread tightening of nearly 50 to 121bps on average. They also have established revolving lines of credit that they can draw down upon if necessary. Finally, while banks may be pulling back, other lenders like life insurance companies are more active.

With listed REITs now trading at premiums to net asset values, the market may finally give them the “green light” to (on net) acquire assets for the first time since 2015. Indeed, it’s important to remember that the public markets force discipline on listed REITs by selling assets when the private market appears expensive and buying assets when they start to become attractive. This is similar to the scenarios that played out from 2000 to 2004 and again from 2010 to 2014.

FURTHER READING

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