CHART OF THE WEEK: In a leverage-dependent industry such as commercial real estate, the cost of money goes beyond the reference interest rate. Mortgage availability is crucial to returns and it appears unlikely that mortgages will suddenly become easier to get if/when the Fed pivots. Tight lending standards - due largely to weakening demand and oversupply (specifically in apartments and logistics) - suggest values will have to fall back to sustainable levels. Rate cuts will help - eventually - but not until the market fundamentals begin working back into balance.
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CHARTS OF THE WEEK: CRE investor worries appear to be extending to apartments. Sales volume over the last 4 quarters is the lowest since 2014, while the number of transactions is at a 13 year low. As cap rates rise, so too are delinquencies. The rise in delinquencies is even more pronounced in the CRE CLO market, which have jumped 10X since mid 2022. According to Trepp, 16% of the CLO market are backed by new apartment construction. We believe this stress is still in the early innings and will worsen as construction loans come due. The CRE CLO delinquencies may be the canary in the coal mine...
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s Inflation Really Beaten? Despite the latest CPI print showing inflation does not appear to be moderating, the driving force behind major component - Shelter - will continue to fall throughout 2024. Rents, which are imputed in the Owner's Equivalent Rent (OER) are weakening and beginning to turn negative. The 18 month lag suggests that by YE 2024, the YoY % change in the Shelter component could be near 0%. Given the heavy weighting of Shelter, the annual headline CPI rate could easily be lower than 1%, leading to deflationary fears. Unfortunately, even when the Fed pivots on the Fed Funds rate, the same lag applies, meaning measured Fed actions will not likely provide a quick fix to the deflationary forces behind OER. It may require something that seems unthinkable right now - sharp cuts to the Fed Funds rate.
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Charts of the Week: While everyone is aware of the deep trouble in the Office market, comparatively little attention has been paid to the coming danger in Multifamily. But a deluge of deliveries is already overwhelming demand, and the worst is yet to come. Assuming organic demand from job growth remains at roughly the historic mean of ~1.5% annually, the number of units YET to be delivered represent a 4+ year supply. Vacancy rates, which are already at the GFC level, will continue to spike due to the massive amount of near-term supply - even with positive absorption.
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Chart of the Week: As much as many in the CRE industry hope that a falling 10Y UST or SOFR will come to the rescue, the value trends are working against that happening. Cap rates for every major CRE sector are rising, because of both weakening fundamentals and lack of liquidity. These risks are only just starting to reflect in values...and unfortunately, we are still in the early innings of this cycle.
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RCS Chart of the Week: With housing affordability at near all-time lows, much of the industry focus has been on the need for lower mortgage rates. No doubt, that will help, but soaring housing prices since 2020 are well above trend. Even at a 5% mortgage rate, affordability remains historically low - a continuing headwind for demand. Without buyers, the implication is a further decline in house prices, possibly into 2025.
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The story that isn't being well covered...banks with heavy exposure to construction loans, especially in multifamily. Many of the outstanding loans were underwritten to values and rent increases that simply aren't going to happen. As apartment supply overwhelms demand, those values will fall, forcing many developers and sponsors short of capital needed to pay off those loans. By YE 2024, the problem will become glaringly obvious. #multifamily #constructionlending #multifamilyinvestor #rescuecapital
Large Bank's Total Exposure to Commercial Real Estate (Updated with 2023-Q3 Data) Many astute commentators about the banking industry have been warning about future losses on commercial mortgages as hundreds of billions reprice in the current high-rate environment. In addition to CRE mortgages, there are two other major bank exposures to commercial real estate--CRE construction loans and unused commitments to fund CRE mortgages & CRE construction loans. For some banks, these other exposures exceed their direct exposure through CRE mortgages. Consequently, I have calculated the total CRE exposure (CRE mortgages plus CRE construction loans plus unused CRE commitments) as a percentage of total equity as a broad measure of bank exposure to commercial real estate. This ratio is used by banking regulators to assess CRE exposures; any ratio over 300% is viewed as excessive exposure to CRE. Below is a list of the total CRE exposure of the 51 banks with greater than $10 billion in assets where their exposure exceeds 300% of total equity capital. (51 out of 156 large banks, 4,669 banks of any size.) Data are as of Sep. 30, 2023. Three have exposures greater than 500% of equity, and additional ten have exposures greater than 400% of equity. This does not include exposure to multifamily mortgages, which only increases these percentages. Most prominent are Comerica Bank and Zions Bancorp. Comerica has $85.8 billion in assets, $10.7 billion in CRE mortgages, $4.5 billion in CRE construction loans, and $4.6 billion in unused CRE commitments, for a total CRE exposure of $19.9 billion, but has only $4.2 billion in total equity. Total CRE exposure is 476% of total equity. Zion has $87.3 billion in assets, $16.4 billion in CRE mortgages, $2.6 billion in CRE construction loans, and $3.7 billion in unused CRE commitments, for a total CRE exposure of $22.7 billion, but has only $5.3 billion in total equity. Total CRE exposure is 428% of total equity. Among banks of any size, 1,728 have total CRE exposures greater than 300%, 975 have exposures greater than 400%, 484 have exposures greater than 500%, and 236 have exposures greater than 600%. For comparison, the aggregate industry total CRE exposure is 116% of total equity ($2.61 trillion vs. $2.25 trillion). This did not end well back during the Global Financial Crisis. These statistics are based upon my calculations using publicly available Call report data downloaded from the FFIEC's Central Data Repository.
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RCS Chart of the Week: Risk Premium for Apartments is now as underpriced as just prior to the GFC. Small wonder that transaction volumes are at 10-year lows. As the bulge of new projects overwhelms demand, look for cap rates to expand quickly, even if the 10-Year UST falls, as risk is repriced to reflect market fundamentals.
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As described in the attached Wall Street Journal article, our projections for the apartment market are coming to pass, as the slug of new construction begins overwhelming demand and values fall. The buying opportunity is coming, but it's still too soon. CEO Marcel Arsenault's quote, “You don’t want to catch a falling guillotine,” sums it up. But once the values fall, RCS is ready to buy. https://lnkd.in/g8gN6diK
