Wednesday’s Consumer Price Index numbers were higher than expected, sending Wall Street into a swoon about what it could mean.
For starters, it’s just about a given that, following this latest evidence that prices are not declining as fast as had been expected, the Fed will delay implementing its promised rate cuts. But some prominent voices are wondering about a worse case scenario: that the Fed might actually start raising rates. If this were to come to pass, simply put it would raise havoc in commercial real estate. GlobeSt.com has heard repeatedly over the last few months that transactions were resuming in part because the market believed that the Fed was done raising rates, introducing some much-needed certainty into forecasts.
Former Treasury Secretary Lawrence Summers is one of these voices.
“You have to take seriously the possibility that the next rate move will be upwards rather than downwards,” Summers said on Bloomberg Television. He said such a likelihood is somewhere in the 15% to 25% range.
The odds still do favor a Fed rate cut this year, “but not as much as is priced into markets,” he said.
Also, Federal Reserve Governor Michelle Bowman said earlier this month that it’s possible interest rates may have to move higher to control inflation.
“While it is not my baseline outlook, I continue to see the risk that at a future meeting we may need to increase the policy rate further should progress on inflation stall or even reverse,” she said in a recent speech to the Shadow Open Market Committee in New York. “Reducing our policy rate too soon or too quickly could result in a rebound in inflation, requiring further future policy rate increases to return inflation to 2 percent over the longer run.”
Bowman is a permanent voting member of the Federal Open Market Committee.
JPMorgan Chase CEO Jamie Dimon has also floated the possibility that rates could increase in his letter to shareholders. The investment bank is preparing “for a very broad range of interest rates, from 2% to 8% or even more,” he wrote.
These voices, though, are in the minority. Right now, most analysts have coalesced around the theory that rate cuts will be delayed this year.
Less than 24 hours after the CPI was released, Wall Street economists began revising their outlooks. Goldman Sachs and UBS now see two cuts starting in July and September, respectively, while analysts at Barclays anticipate just one reduction, in September, according to the Wall Street Journal.
Others are even more pessimistic about the timing.
“The lack of moderation in inflation will undermine Fed officials’ confidence that inflation is on a sustainable course back to 2% and likely delays rate cuts to September at the earliest and could push off rate reductions to next year,” Kathy Bostjancic, chief economist at Nationwide, said in a research note that was reported by The Associated Press.
Right now the Fed’s official expectation is that inflation continues to move down albeit in an uneven trajectory. If this is true, then rate cuts are still likely this year.
However, Wall Street worries that inflation has stalled at a level closer to 3% and if the evidence bears this out in future reports, it is conceivable that the Fed could scrap cuts altogether.
One indicator that does not bode well for rate cuts this year is the so-called supercore inflation reading, which besides excluding the volatile food and energy prices that the core CPI does, also strips out shelter and rent costs from its services reading.
Supercore accelerated to a 4.8% pace year over year in March, the highest in 11 months, according to CNBC.
Tom Fitzpatrick, managing director of global market insights at R.J. O’Brien & Associates, told the publication that if you take the readings of the last three months and annualize them, the supercore inflation rate is more than 8%.
All this said, the Fed has promised it would cut rates three times this year and that is a hard promise to unwind. The upheaval a rate hike would cause would give the institution a black eye even worse than its promises a few years ago that the creeping inflation in the economy was transitory.
Source: GlobeSt.
Treasurys Get Harder To Sell And That’s Not Good For CRE
In the latter half of last week, yields on Treasury 10-years jumped, hitting 4.55% on Wednesday, moving to 4.56% on Thursday, and dropping down to 4.50% on Friday. By the end of Monday, it was 4.63%
If you ignore 2023 when rising interest rates had a heavy impact on Treasury yields, the last time the 10-year was in this range was in the fall of 2007, as the initial rumblings of what would become the Global Financial Crisis.
Markets are not seeing the trembling of an out-of-control housing market and the derivatives built on top of it. But the current shakings might be worse.
The worry among investors is that if inflation doesn’t continue to sink, the Federal Reserve will keep interest rates where they are now rather than start cutting as investors have wanted. Or maybe increase rates if they decide it’s necessary to break the back of rising prices.
May will bring another $386 billion in bond sales, and, as the Journal notes, this will continue no matter who is elected president in November. The first quarter of 2024 saw the Treasury sell $7.2 trillion in debt. Last year, the government issued $23 trillion in Treasurys, “which raised $2.4 trillion of cash, after accounting for maturing bonds.” But a number of Treasury auctions did more poorly than expected. The Treasury Department decided to push short-term instruments as the Fed encouraged the idea that eventually they would cut interest rates. That would make higher-rate Treasurys more valuable in a presumed near term.
With inflation started to strengthen again, that strategy becomes less appealing to buyers. Also, the Fed has said it will slow quantitative tightening, which is how it reduces its balance sheet holdings of Treasury instruments. Tightening expects that investors would buy more debt. As the Fed reduces tightening, the government might lower its expectations of how much investors needed to buy.
From a CRE perspective, the more debt on sale, the greater degree that circumstances invoke the law of supply and demand. Prices will likely drop to get enough investor purchases, which would send yields up as the two aspects move inversely. The 10-year yield is one of the standard baseline rates used in CRE lending. The other, the Secured Overnight Financing Rate, or SOFR, is strongly correlated to the 10-year, though often with a timing gap.
If baseline rates go up, so do borrowing costs, which is the big problem faced by many with maturing loans and who need refinancing but who based their business case on low interest rates and high leverage that are no longer available.
And then there is the psychological factor. All investors, whether individuals, organizations, or sovereign states, are under the thumb of human emotion. The more risk they perceive, the more skittish they are as buyers, which could push down Treasury prices even more, driving up expected yield and negatively affecting CRE.
Source: GlobeSt.
Banks Have Another Reason To Scale Back CRE Lending
The pressure that banks are feeling from CRE loans has become a regular observation by the Federal Reserve, Department of the Treasury, Federal Deposit Insurance Corporation, other regulators, economics, financial analysis, investors … pretty much everyone paying attention.
But there’s an odd twist according to a new analysis by economist and economic policy advisor Miguel Faria e Castro and senior research associate Samuel Jordan-Wood at the Federal Reserve Bank of St. Louis.
The analysis started with an examination of the relationship between commercial real estate exposure as a share of total assets on one hand and total assets in billions of dollars, on a natural logarithm scale. Something immediately obvious is that the largest banks have a relatively small exposure in CRE loans as they represent 10% or less of their assets. But smaller to medium banks had high exposures, in some cases topping 60%.
They found that those banks with high exposure to CRE loans tended to have “relatively fewer liquid assets on their balance sheets, lower capital ratios (that is, more leverage), a larger share of their liabilities in the form of deposits, and a larger share of their assets in the form of loans.”
They then moved beyond a correlation analysis and used regression to look at the connection between CRE exposure and bank returns.
So, it seems to be another way banks are currently feeling negative effects from CRE exposure. Not just in concern over asset values and regulatory pressures, but in actual earnings.
Source: GlobeSt.
Some Experts Float the Possibility That the Fed Could Raise Rates Again
Wednesday’s Consumer Price Index numbers were higher than expected, sending Wall Street into a swoon about what it could mean.
For starters, it’s just about a given that, following this latest evidence that prices are not declining as fast as had been expected, the Fed will delay implementing its promised rate cuts. But some prominent voices are wondering about a worse case scenario: that the Fed might actually start raising rates. If this were to come to pass, simply put it would raise havoc in commercial real estate. GlobeSt.com has heard repeatedly over the last few months that transactions were resuming in part because the market believed that the Fed was done raising rates, introducing some much-needed certainty into forecasts.
Former Treasury Secretary Lawrence Summers is one of these voices.
The odds still do favor a Fed rate cut this year, “but not as much as is priced into markets,” he said.
Also, Federal Reserve Governor Michelle Bowman said earlier this month that it’s possible interest rates may have to move higher to control inflation.
Bowman is a permanent voting member of the Federal Open Market Committee.
JPMorgan Chase CEO Jamie Dimon has also floated the possibility that rates could increase in his letter to shareholders. The investment bank is preparing “for a very broad range of interest rates, from 2% to 8% or even more,” he wrote.
These voices, though, are in the minority. Right now, most analysts have coalesced around the theory that rate cuts will be delayed this year.
Less than 24 hours after the CPI was released, Wall Street economists began revising their outlooks. Goldman Sachs and UBS now see two cuts starting in July and September, respectively, while analysts at Barclays anticipate just one reduction, in September, according to the Wall Street Journal.
Others are even more pessimistic about the timing.
Right now the Fed’s official expectation is that inflation continues to move down albeit in an uneven trajectory. If this is true, then rate cuts are still likely this year.
However, Wall Street worries that inflation has stalled at a level closer to 3% and if the evidence bears this out in future reports, it is conceivable that the Fed could scrap cuts altogether.
One indicator that does not bode well for rate cuts this year is the so-called supercore inflation reading, which besides excluding the volatile food and energy prices that the core CPI does, also strips out shelter and rent costs from its services reading.
Supercore accelerated to a 4.8% pace year over year in March, the highest in 11 months, according to CNBC.
Tom Fitzpatrick, managing director of global market insights at R.J. O’Brien & Associates, told the publication that if you take the readings of the last three months and annualize them, the supercore inflation rate is more than 8%.
All this said, the Fed has promised it would cut rates three times this year and that is a hard promise to unwind. The upheaval a rate hike would cause would give the institution a black eye even worse than its promises a few years ago that the creeping inflation in the economy was transitory.
Source: GlobeSt.
Just How Big is the Wall of Maturities?
According to Newmark, there is now a $2 trillion maturity wall of CRE loans facing banks over the next three years. A dizzying sum.
But the statement raises a question. When the size of the oncoming wall — or wave or lava flow, or whatever to call the coming flood — is mentioned, is anyone really sure of the size?
CRED iQ’s database at middle of December 2023 showed “approximately $210 billion in commercial mortgages that are scheduled to mature in 2024, with an additional $111 billion of CRE debt maturing in 2025. In total, CRED iQ has aggregated and organized a total of $320 billion of commercial mortgages slated to mature within the next 24 months.”
In February 2024, the Mortgage Bankers Association said that 20% of commercial and multifamily mortgage balances were to mature this year.
Even discussions can be misleading. Take the Financial Times article. The headline is, “Banks face $2tn of maturing US property debt over next 3 years.” The immediate question becomes how much of banks’ portfolios are coming due? But to get there, it’s critical to see what the total holdings are.
According to the Federal Reserve’s “Assets and Liabilities of Commercial Banks in the United States,” also known as H.8, thetotal of commercial real estate loans, including multifamily, held by banks was $2,985.5 billion during the week of March 20, 2024. Given the timelines of loans, most frequently five-year cycles, a 20% turnover annually is a realistic estimate. But a $2 trillion count would be two-thirds of all bank loans, which doesn’t seem plausible.
GlobeSt.com contacted Newmark for some clarity. The firm responded with information from David Bitner, Newmark’s executive managing director and global head of research. Here are his points:
So, the pool of loans is much larger than those held only by banks. Even with the “extend and pretend” treatment lenders seeking to keep losses off their balance sheets, eventually reality sets in. In one sense, it won’t matter who holds the loans. As accounting standards eventually force lenders to write off clear losses, the result would be a large exercise in mark-to-market, lowering the value of many if not all CRE loans.
That would hurt the total asset values of many banks, which is the condition that led to the closures of Silicon Valley Bank, First Republic Bank, and Signature Bank last year. As Gosin told the FT, such a result would force some banks “to liquidate their loans or find other ways to reduce their weight in real estate,” whether by finding ways to increase capital, offload the risk, or further reduce the amount of CRE lending they do.
Source: GlobeSt.
Loan Modifications More Than Doubled Last Year
The move for lenders to find ways to avoid action on troubled CRE loans has been called “extend and pretend,” though “delay and pray” might be even more apt.
While an institution can avoid significant and final decisions, it can put off the day when it takes a hit to its balance sheet, hoping that find another solution in the meantime. Who wants to take possession of a property along with the responsibility of disposing of it?
But how much of this activity has been going on and how long could it be sustained? CRED iQ has analyzed loan modifications during this period of significantly elevated interest rates.
In office, 26% of $35.8 billion in CMBS loans that matured last year were paid in full. Borrowers either couldn’t get refinancing (which likely would have meant a heft injection of equity into projects) or couldn’t sell for a price that allowed them to gracefully exit the stage.
Since February 2022, so two years, 593 office loans transferred to special servicing. Out of them, 13.7% were modified, 14.0% returned to the master servicer as corrected, 8.4% were paid off, and the remaining 63.9% are still with the special servicer.
CRED iQ gave two examples of the largest loan modifications to date — 1.6 million square feet One Market Place in San Francisco and 249,063 square foot mixed use in the Chelsea submarket of New York City. Well enough, but how long can this go on without investors, regulators, or others demanding a permanent ending?
Source: GlobeSt.
Spread Between Corporate Debt and CRE Mortgages Hits 24-Year High
In its recent look at U.S. capital trends, using the most recent data through 2023, MSCI look at what it called debt snapshots — a handful of considerations that help explain how troublesome CRE debt markets are at the moment.
The first was the spread between corporate debt and CRE debt and how it has risen to a high at least when looking at figures from the last 24 years. It was more relatively costly to finance a commercial property through a direct mortgage.
After the Great Financial Crisis, the gap between corporate and CRE mortgage debt averaged only about 9 basis points between Moody’s Baa corporate bond yield and 7-year and 10-year commercial mortgage rates.
Connected to the cost is the perception of risk. According to Moody’s, the definition of Baa credit is, “Obligations rated Baa are judged to be medium-grade and subject to moderate credit risk and as such may possess certain speculative characteristics.” The added spread for CRE mortgage rates suggests that commercial mortgages are even riskier. Given market jitters and concerns about default, that shouldn’t be surprising.
And when interest rates are higher than returns on investments, debt becomes dilutive. MSCI estimates that interest rates on outstanding debt went from 3.4% in June 2022 to 4.5% by December 2023. Property returns for the year were -8.3%.
So far, bank loan delinquency rates have been “rising, not surging.” However, as GlobeSt.com has separately reported, there have been questions of whether lenders have been indulging in “extend and pretend.” Stretching renewal dates means not having to take immediate hits on balance sheets. That can work for a while, but only so long.
Source: GlobeSt.
How Sale-Leasebacks Help PE Raise Capital In A Tight Market
Funding for growth, refinancing corporate debt, and merger and acquisition activities are top priorities for many private equity firms. A recent PwC report noted that 60% of CEOs plan to make at least one acquisition in the next three years. The report further explains that lower levels of M&A activity during 2023 created “pent-up buyer demand” moving into the current year. However, tapping into capital isn’t always easy when it is locked in assets.
Understanding sale-leasebacks and their advantages can help private equity firms strategically manage growth funding, debt maturities and other capital needs.
The Advantages of Sale-Leasebacks
With traditional financing strategies such as mortgages, terms are often shorter and exposed to higher market volatility. Accessing capital can also be time-consuming, a challenge for firms that need to move quickly for acquisition deals. That’s not the case with sale-leasebacks, notes Swann.
He explains that capital uses also have very few restrictions, with the most common purposes being acquisition financing, dividend payments, and refinancing maturing debt.
Misconceptions About Sale-Leasebacks
As private equity firms consider sale-leasebacks, questions often linger regarding who qualifies for this type of financing. Many believe that because their real estate is in a secondary or tertiary market, or their asset doesn’t have a huge value, they won’t qualify. But according to Swann, that’s not necessarily true.
As the market progresses through 2024, Swann expects sale-leaseback activity to continue upward, partly due to M&A activity and its flexibility to tap into capital quickly.
Source: GlobeSt.
How One Net Lease Giant Plans to Deal With Debt Maturities
Debt maturities are a big consideration in all areas of commercial real estate, including net lease. The topic came up in most recent earnings call for Global Net Lease (GNL), one of the largest public REITs focused on net lease.
The reason for a focus on debt maturities and the connected topic of interest rates is because they put pressure on all CRE businesses. The stock price reflects concerns about macroeconomics and finance. There was a sharp plummet starting late February 2020, which makes sense given pandemic-related shutdowns of retail businesses. With the advent of successful vaccines, the price regained ground to within a couple of dollars by June 2022, and then came the Federal Reserve’s reaction to inflation — a series of sharp and quick rate hikes. And the stock started falling again, from $19.90 to $7.56 as of March 18, 2024.
The expected wave of CRE loan debt maturities is a problem across CRE. That includes net lease properties.
He further said that assets targeted for disposition include both non-core and those that have near-term debt maturities or implied-term lease expirations. The latter is important because the company focuses on investment-grade or near-investment-grade tenants, with 58% of their tenants in that category. Single-tenant retail represents two-thirds of the investment-grade or implied investment-grade tenants. If a significant portion of the lease expirations are among these tenants, turnover would put more financial pressure on the company.
The largest segment of their portfolio is industrial and distribution, and that segment has been seeing pressures of late that had once seemed to pass the category by.
Source: GlobeSt.
Law Firm Office-Leasing Activity Hit Milestone In 2023
The legal industry leased more office space last year than it has since the Covid-19 pandemic.
In 2023, U.S. law firms leased a collective 16.9 million square feet, according to Cushman & Wakefield. That’s not only more office space leased by the sector since the Covid-19 pandemic, but exceeds the amount leased nationally by law firms in 2017, 2018 and 2019, as tracked by Cushman.
The legal industry has bucked the broader trend of office-market leasing since the pandemic upended norms around office-space usage. While law firms, like other industries, have taken a hard look at their office real estate, they on the whole are using the office more regularly than other industries. Therefore, they’ve occupied a more robust segment of the leasing market while other industries have slowed their deal activity, put spaces on the sublease market or exited big chunks of space.
For those in commercial real estate who work with law firms on their office-space needs or otherwise track the industry, the legal sector’s recent leasing activity is indicative of its new normal.
Many law firms that saw their leases expire in 2020 or 2021 inked a short-term extension because of the uncertainty during the height of the pandemic. But in the past two years, law firms have gone back to the office more frequently and overall feel more confident making longer-term decisions about their space, said John McWilliams, senior research analyst at Cushman.
The biggest relocation signed by a law firm since the pandemic, according to Savills, was Paul, Weiss, Rifkind, Wharton & Garrison LLP’s deal inked late last year. The international law firm agreed to take 765,931 square feet at 1345 Avenue of the Americas in Manhattan. Not only was it the largest law office relocation since the pandemic, it was also the largest office lease signed across all industries and the U.S. last year.
What Law Firm Leasing Activity Says About The U.S. Office Market
Although it’s only one sector — and legal tenants only made up 8.8% of the national leasing market in 2023, according to Savills — how this industry is making office-space decisions is somewhat indicative of broader trends affecting the U.S. office market.
For example, like many professional-services tenants, law firms are largely seeking to be in the top 10% of office buildings in the markets they’re in, McWilliams said. Many law firms that have made leasing decisions in the past couple of years have departed office buildings that, while not necessarily Class B or C space, are no longer considered the top-tier towers in town.
Notably, a growing share of legal-industry tenants have decided to renew their leases in their current buildings rather than relocate, which may be indicative of the shrinking amount of top-tier office space available in a given market. That’s especially true of office tenants that require 100,000 square feet or more.
Data from Savills found, in 2023, 56% of leases signed within the legal sector were stay in place, compared to 33.9% in 2022.
And as office space at the high end of the office market is leased, and buildout construction costs are growing, a greater number of legal tenants are considering higher-quality sublease space on the market, experts say.
Source: SFBJ
A New Financing Risk Emerges
Goldman Sachs Group put together a mortgage-backed bond deal in 2021. Nothing unusual about that. The money went to a group purchasing 61 multifamily properties with a total of 1,719 rent-controlled units in San Francisco. The floating-rate, interest-only, first lien mortgage loan had an initial balance of $674.8 million.
By the end of 2022, the borrowers defaulted, as Mortgage Professional America noted. The loan was sold off at a deep discount, according to Bloomberg. Then came the rest of the bad news. Special servicer Midland Loan Services told the investors of a holdback of $164 million.
Holdbacks happen on occasion in CMBS financing, but this was big. As Bloomberg noted, it exposed multiple classes that had been rated as investment grade by Kroll Bond Rating Agency to potential loss and has raised fears among some investors that servicers will make surprise decisions that affect their returns in deals.
In February 2023, Fitch Ratings gave the overall package, GSMS 2021-RENT, a AAA investment-grade rating, with an explanation of key rating drivers.
The collapse of a highly-rated mortgage-backed bond might bring up memories of the Global Financial Crisis in which many bonds backed by residential mortgages with strong ratings were found to be less than what they appeared.
This has reportedly spooked Wall Street and investors. They already see a big downturn in markets, as GlobeSt.com has extensively reported. The prospect of special servicers holding back payments adds to the risk. Some of the investors in the deal reportedly were Angelo Gordon, LibreMax, and Lord Abbett.
He also said that there may have been a good explanation of the action, and that it was likely the biggest such action in that type of security.
Source: GlobeSt.