It is a precarious time for commercial real estate investors. It’s not clear if the worst of the fallout from the failures of Silicon Valley and Signature banks has passed. Some market observers warn that hundreds of additional regional banks might be facing as similar imbalance between the assets and liabilities on their books. The Federal Reserve recently raised its key interest rate by another 25 basis points, making debt more expensive for property owners who might need refinancing in the coming months.
To make matters worse, media outlets across the spectrum are publishing stories about how commercial real estate might Is th “the next shoe to drop” for U.S. banks after crypto and tech start-ups.
But are these assessments accurate? We spoke to Jim Costello, chief economist at data firm MSCI Real Assets, and Alexis Maltin, vice president, real assets research, Americas, with the firm, about how concerned investors ought to be about what’s happening in the banking sector, how difficult it might be to refinance their debt and whether the current environment offers any opportunities for savvy market players.
This Q&A has been edited for length, style and clarity.
WMRE: The failures of SVB and Signature Banks have obviously been one of the biggest news stories for the industry in the past few weeks. How worried are you right now about potential further contagion in the regional bank sector?
Jim Costello: We haven’t done a comprehensive study of that topic ourselves. I have seen though work that was done by a colleague at Columbia that came up with an estimate that close to 200 banks may be failing due to the same issues that took down Silicon Valley Bank. You might have an asset/liability issue there and some of them may not make it. But 200 banks across the scope of things is not the same as what we’ve seen in the middle of the Great Financial Crisis.
WMRE: So, it sounds like you feel some more trouble might be coming in the regional bank sector, but it won’t be as bad as the last time around. What would happen if more regional banks failed?
Jim Costello: If you have a number of banks that go under, it’s going to throw an additional sense of caution into the banking sector and make the bankers who are there much more cautious, and that tends to constrain credit availability. It might be harder for folks who have loans maturing in the next few years to replace their existing loans. They might have some capital available, but at higher cost, at lower LTVs. The question for them then is—how do I fill out the capital stack? There may be need for additional capital. Some buildings may not be able to, at any cost, fill the gap in that capital stack. The question for the owners becomes—do I put more of my own equity in, do I walk away? And we’ve been watching the distress situation, that’s the kind of thing I’ve been looking for.
WMRE: Some media outlets are promoting the idea that commercial real estate might itself become the next source of trouble for regional banks. Would you agree with that assessment?
Jim Costello: It is the case that asset prices are falling for commercial real estate. And the signs have been there for some time that there should be a decline in prices. The public markets have been signaling that everything was overvalued for more than a year now. If you look at REIT indices, the price component has been falling for a year. And that’s an issue that’s just started to be realized in the private world. And the banks—that collateral might have been written down a little bit. [For them] it’s—do we face an issue where we are now too risky relative to the assets we have on our books? It’s about how quickly the appraisals will be moving for the collateral that the banks lent against. It’s something that has been moving for the public markets. The private market—the dots are just starting to catch up to that.
WMRE: There have also been stories floating around that Signature Bank’s real estate portfolio was not included in its takeover by New York Community Bankcorp because of supposedly “toxic” loans on rent-controlled New York apartment buildings. Would you agree with that assessment? Or is there a different story around why the real estate portfolio was not picked up?
Jim Costello: I just don’t know. I’ve heard similar things, I’ve seen similar stuff on Twitter, but we don’t have anything specific on that. You search for Signature on real estate Twitter and there’s been a lot of [unflattering] talk about them, about the types of loans they’ve been doing. If you look it up on Twitter, some doozies come up.
WMRE: But aren’t apartment buildings in New York City generally seen as a safe investment, something that would not be described as inherently toxic?
Jim Costello: A rent-controlled building in New York can be viewed as a safe asset because if you buy it at the right price, you know people will never leave, they have stable rents. For some investors, it makes sense for their portfolios. But with the changes in interest rates, it depends on how you finance that investment. If you don’t have tremendous rent growth in the asset and interest rates go up, you might have a problem with your debt. Even a conservative loan, if you don’t have income growth, it can become a problem. If you had some debt on it and now you have to replace it with a lot more expensive debt, that’s where someone could run into trouble.
WMRE: How worried should we be about upcoming loan maturities in 2023?
Alexis Maltin: What we’ve seen, at least in the next two years, most of the maturities are in the CMBS world. And if you look back at 2013-2014, CMBS lenders were providing at least a quarter of all real estate loans at that time. And what we’ve seen after that is private equity lenders coming in. That is something to watch going into 2026-2027. But, certainly, there’s a nice wave [of maturities] coming. And one of the things that we did notice there as well is that a significant portion of the loans coming due are on offices. And it isn’t to say these aren’t class-A [office buildings], but certainly there are high capex costs, there certainly could be some issues there.
WMRE: So, these CMBS loans that are coming due this year and the next, were they originated at terms that are less likely to lead to distress now than those provided by some of the other lenders?
Alexis Maltin: [We don’t have complete visibility into the loan terms]. Generally, what I can say and what our data shows is that CMBS lenders tend to lend with more conservative terms, which gives them a lower risk of default. The underlying assumption is that the investor-driven lenders or debt fund lenders are lending generally, on shorter terms, a lot of times these are floating-rate loans, which are inherently more risky.
WMRE: This may come across as a question with an obvious answer, but where would you say we are in the current real estate cycle?
Jim Costello: I hate that question. Because the suggestion that [you can tell exactly] where you are on the clock implies that tomorrow moves in a certain way and it doesn’t. Think about the difference in the public and private markets in terms of how they were valuing assets. In the public markets, prices were dropping rapidly a year ago, and in the private markets, they were still going up. And it is clear, in how appraisals are coming in, that investors have been holding some assets on their books and now they have to write them down. And in terms of the momentum, it has been toward the decline recently.
WMRE: Based on the numbers in MSCI’s most recent report, investment sales volumes were down significantly in February, continuing a trend that’s been going on for about 12 months. Do you expect that trend to continue for a significant period of time? Or do you feel we might see an upward momentum relatively soon?
Jim Costello: I would change that question to “what would it take for yield buying to start growing again?” Right now, buyers and sellers have different expectations on asset prices. If I am a buyer, I might be willing to spend some money, but I want to underwrite every worst-case scenario assumption on an asset because I am very risk-averse right now. If I am an owner, and I am an institutional investor, who don’t carry a lot of debt, they are not worried and they don’t want to sell at a lower price than they would a couple of years ago because they are not forced to sell. On the other hand, the current owners, if the debt is coming due, maybe they will have a “come to Jesus” moment with their lender. And the buyers too—they might think “I’ve got some cash, I’ve got to put it into something, maybe I don’t have to be so risk-averse.” But one of those two groups would have to move before you get deal volume growing again.
WMRE: For the past several years, investors tended to favor industrial and multifamily properties because they had a stronger performance outlook than the rest of the core commercial real estate asset classes. But those were also sectors that saw the highest price growth. Do you expect that trend to continue or might we see a shift to some other property types?
Jim Costello: Think back before the pandemic, before we even knew what COVID was, at every conference that fall of 2019 investors were talking about reallocating from office and retail toward industrial and multifamily. Simply because of the view that we have been in a low interest rate environment too long [and rates were due to come up]. COVID kind of delayed that. What a higher interest rate environment does to offices and retail is make their capex more expensive. And in a higher interest rate environment, from even today, it’s hard to see how that equation changes. The assets that are still low capex are going to look attractive to investors for some time. I am not sure whether it has been fully priced in yet. But office, in particular, with major cities effecting climate change regulations—there are definitely risks to climate change, but to spend money on those risks is expensive and people want to figure out what kind of return they are going to get out of it.
WMRE: So, it sounds like the movement away from investment in office buildings is not entirely tied to people returning or not returning to offices full-time on a scale that was expected, but to some of these other factors?
Jim Costello: That’s the thing—not everything is about the pandemic. There were some fundamental challenges in the economy that were there before the pandemic.
WMRE: MSCI’s recent report also mentioned that even though more distress is beginning to show in the market, it may not garner nearly as much interest from potential investors that distressed assets did after the Great Financial Crisis. What’s your sense of how the distress situation in today’s environment might play out?
Jim Costello: I have a lot of thoughts on that. One of the key things to look at, talk to Alexis a bit about the maturities coming up. We haven’t really seen much distress come in, and what we have seen has been fundamental distress, it wasn’t debt. But you have this wave of maturities the next two years.
Alexis Maltin: We haven’t seen too much in the way of distress yet, but that doesn’t mean that investors aren’t interested in distress. To the extent, there certainly is likely a lot of interest and just capital sitting there waiting for it.
WMRE: What kinds of entities might be able to capitalize on today’s market conditions?
Alexis Maltin: What we saw the end of 2022, we saw well-funded investors had an easier time acting quickly. Institutional investors, while they pulled back to some extent, were a significant part of the market. But the largest part of the market were private investors, private investors can deploy equity where they can take advantage of the situation. And those companies who did fundraise are more than happy to sit and wait for an opportunity. And to some degree, we have seen delinquencies. But it just hasn’t manifested itself in full-blown distress.