The State of Commercial Real Estate

Equity Research Analyst Michael Beckerman joins the podcast to discuss the Commercial Real Estate market. We discuss the state of "return to office" and what it means for office real estate and the banks that carry real estate loans on their balance sheets.

Important Disclosures:

For institutional investors only. TD Global Investment Solutions represents TD Asset Management Inc. ("TDAM") and Epoch Investment Partners, Inc. ("TD Epoch"). TDAM and TD Epoch are affiliates and wholly owned subsidiaries of The Toronto-Dominion Bank. ®The TD logo and other TD trademarks are the property of The Toronto-Dominion Bank or its subsidiaries. The information contained herein is distributed for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information is distributed with the understanding that the recipient has sufficient knowledge and experience to be able to understand and make their own evaluation of the proposals and services described herein as well as any risks associated with such proposal or services. Nothing in this presentation constitutes legal, tax, or accounting advice. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Certain information provided herein is based on third-party sources, and although believed to be accurate, has not been independently verified. Except as otherwise specified herein, TD Epoch is the source of all information contained in this document. TD Epoch assumes no liability for errors and omissions in the information contained herein. TD Epoch believes the information contained herein is accurate as of the date produce...

Transcript

Steve Bleiberg 

Hello, and welcome to Actively Speaking. I'm your host, Steve Bleiberg. Join us each episode as we discuss current issues concerning capital markets and portfolio management from the perspective of an active manager. Welcome Back to another episode of Actively Speaking. I'm Steve Bleiberg, and my guest today is Michael Beckerman, who's an analyst on Epoch's shareholder yield team. Welcome Michael.

Michael Beckerman

Thank you.

Steve Bleiberg 

I thought this would be a good opportunity to talk about commercial real estate because it's been about 18 months now since there was a bit of a crisis in, in that area prompted by when the Fed started raising rates back at the beginning of last year. And we had some issues with some regional banks. Some of it had to do with just the drop in the value of the treasuries they had on their balance sheets as, as rates were going up. And that prompted people to take a look at what was going on at some other regional banks that have a lot of exposure through lending to commercial real estate developments and developers. And because the rise in rates was also raising issues about the valuation of those properties, and hence the loans, the, the quality of the loans to those, those properties. So but that issue seems to have kind of faded, you know, people, it was, it was on everybody's mind for a while, and then things kind of went quiet again, and we haven't really heard much about it in the news, so I thought this would be a good time to revisit it. And so that's what Michael's here to talk about. So, Michael, let's start off with some definitions. Commercial real estate is a pretty broad term. What does that encompass? 

Michael Beckerman

So what is commercial real estate otherwise called CRE which what it is, it defines any property that is owned or occupied by businesses. And it includes multifamily housing apartment buildings, in other words, warehouses, strip malls, medical facilities, hotels, and office buildings. And just go a level further. CRE can be one of two types. It can be either owner occupied or non-owner occupied. So in an owner occupied CRE a company buys or builds an office, a distribution center, a factory, et cetera, for its own use. So these, when it does this, these purchases goes on the company's balance sheet. It's typically financed by a bank via a commercial mortgage loan. And in addition to the collateral value of the property, that loan is supported by the cash flows and credit worthiness of the business, similar to any other commercial loan. So that's pretty non-controversial. And that, however, is not the type of CRE that that has caused controversy. That's the other type, which is non-owner occupied, CRE. And what this is, is property that is owned by an investor and rented for profit. And these are loans that are collateralized by the underlying property value itself, but the debt service really depends on the rental cash flows of the property. So that is, that is the CRE that we're talking about in a nutshell, non-owner occupied commercial real estate.

Steve Bleiberg 

Okay. So now let's, let's talk about why it's, why it's become a problem, right? So, why is this controversial for some banks? Yes. Why is it controversial?

Michael Beckerman

So as you alluded to, rising interest rates have increased the financing costs, and that same rising interest rate is also negative for property values. And the reason that is so is because there is a what's known in real estate as the capitalization rate or cap rate which is the discount rate used to value a building's rental cash flows, and that rate has gone up. So just the present value math means that, that the principle would've gone down. So at the same time, this is happening. We've had inflation that has been unseen in several generations, but that level of inflation has made the operating and maintenance costs of owning a property go up at the same time. So these are, these are the negatives, and the question is, do rents increase to offset these negatives.

And we find in most areas the answer is yes. That the lease contracts for things like multifamily reprice annually and for longer term leases and things like retail and industrial they generally have rent escalators built into the contracts. So the rents are able to rise to offset costs, and as long as there's demand to occupy the space, the market will absorb the higher rents. But there is one place where we find that this does not hold true, and that is in office CRE, right? And this is the real focus of controversy for the banking industry and the, and the, the broader real estate market where we could be looking at a permanent change in demand,

Steve Bleiberg 

Right? Well, that, and that's, to be honest, sort of one of the things that prompted this topic for this podcast was that we recently here at Epoch announced that we were going start coming back to the office four days a week instead of three. I mean, we all, we, worked from home for over two years, from March of 2020 through June of 2022. You know, there were, there were a few attempts to come back to the office during that stretch, but then there would be some new variant of COVID, and then we would, we would abandon that attempt. But, so we started coming back to the office in June of 22, 3 days a week. And that's been our policy since then. But we recently said, well, now we're going to start coming back to the office four days a week. And that got me thinking about what's going on in general with the return to office around, because I know there are still some, some industries where people are, are working from home a lot more than we are. There are some that people are working in the office more than we are, but I just sort of thought this would be a good chance to catch up on where, where does that stand?

Michael Beckerman

Yeah. The, the genesis of this for the world is the pattern hasn't been that much different than what we experienced. So offices, as we all know, shut down during COVID, and the world had discovered work from home as a concept. It's really never been tested before. But we discovered this on a mass scale for the first time during COVID, and found, I think generally it was pretty effective, and the technology was there to facilitate it. And then as the COVID restrictions lifted, we went from work from home to return to office. So WFH to RTO there's a lot of acronyms, but it really there are some companies that never came back to the office, and they discovered they can save on occupancy costs, and it was very effective for them to not occupy office space.

And others like us, we adopted a hybrid model so employees could work several days in the office and a few days remotely. And we found that made people happy and was effective. But there are industries where there's, there's value to being there in person, and there is a push to be back to that level. And the question is, will it ever be at the level where we started from pre COVID, and there are, there are, if I get into it, a few metrics that we track. And one of them is office building card swipes.. So there's a company called Castle Systems that produces building ID cards, and they publish an index that tracks card swipe data. This is just really a measure of utilization, right?

And this utilization measure says that we started about a hundred percent at the end of 2019, as you'd expect. And it fell to quickly to 15% by April of 2020 during the, the sort of you know, high period of, of COVID uncertainty. And slowly people began returning to the office, and that number grew to 40% utilization at the end of 2021, and then grew further to 48% of the end of 2022. And what I find interesting is that the, the current number as of third quarter of 2024 is that we're still, we're around 51%. So we sort of flattened out around that 50% level and stayed there for two years. And that suggests some combination of hybrid work and remote work could be here to stay. And the new normal could be a less than full office building, right?

So that's return to office that tells you about utilization. The second and maybe scarier statistic is just occupancy. And occupancy is sort of a slower moving metric because it only changes upon lease renewal. So that number was 93% at the end of 2019, when office utilization when occupancy was at its peak, and it declined to 89% at the end of 2023, and it continues to fall. So it was 86% by the middle of 2024. And we're waiting to see what the published result is toward the end of 2024. But all the expectations are that it'll continue to decline. So occupancy declining suggests there's a supply demand imbalance,

Steve Bleiberg

Right? I mean, it's so like for us, we, you know, we come in three days a week, soon to be four, and everybody still has their assigned desk to, to sit at and so forth. But so, but other people may, who, who, you know, if you're coming in two days a week or three days a week, and, and a lot of firms will have decided there's no need to have a desk sitting there empty half, or more of the time for you. So we're going to share desks. We'll have the, so-called hoteling desk scheme, where you just go to an open desk when you come in. And, but that of course means you don't need as much space. You know, we still use as much space as we used to, because everybody still has their assigned desk, but it sounds like many firms are able now to reduce their office footprint. And that would, even though you know, the, so those numbers, like the 50% what was the number utilization, but occupancy might go down even at that point because you just don't need as much space.

Michael Beckerman

Yeah, I think that's a good point. And it it remains to be seen sort of what the future model will be in terms of how much space you have to pay for versus how much space you use, right? So you think about if everyone is in the office together on Tuesday, Wednesday, Thursday, Monday you'd need you need all of the space to, to, yes, to have to, to for them to use on those days. So it's a bit of a utilization might be a permanently lower number while occupancy could be in theory a little bit higher. So it's, it'll be, it'll be interesting to see, see how these play out in the future. But there is a third measure that I think sort of brings together the, the where, where supply and demand meet, and that is building transaction values, which is another sort of data point. And this is really going to be a function of the, the end of the day underlying rental cash flows that a building produces and the cap rates in the market. And you find building transaction values compared to 2019, these are down 10 to 15% which sounds bad, but if you dig a little bit deeper, you can see there's a real demand shift from the central business districts to the suburbs. So the central business district buildings are the large downtown office towers that are, you know, common in, in New York and San Francisco and Chicago. These on average transaction values of, of per square foot are down 50% from pre COVID levels, and, which sounds scary. And then in the suburbs it's much less scary. Those values are down only around 5%. So there is a sort of recognition by the market that, you know, the, the, the present value of the cash flows from these assets, these buildings will not return to what they were. And that will also have implications for the for the CRE office loans that have been made by the banks.

Steve Bleiberg

Okay. So let's turn to the impact on banks from this

Michael Beckerman

Right. So yeah, the, the, I think first it's important to just understand a little about the structure of the CRE lending market, where the, and the nature of A CRE loan. So the, the market has about $6 trillion of CRE debt out there in the world. And banks have about half of this on their balance sheets. And as you look down to from the largest banks to the smaller banks, you see that CRE is heavily concentrated among the smaller banks, whereas just as a percentage of balance sheet the banks that are less than 10 billion in assets. They have roughly a third of their balance sheets a third of their loan portfolios dedicated to CRE. And for the larger banks, the, greater than 10 billion, that number is more on the order of 10%. So there's just a disproportionate level of exposure to CRE from the from the smaller from the smaller banks. As you as you look further into just sort of the terms of these loans, they're generally five to 10 year loans, and roughly 40% of them are scheduled to mature over the next five years. And for some portion of these, you know, as we've established, the cash flows have declined and the appraisal values of the buildings have declined. So what do you do when the when the loan matures and what banks are doing about it are, are sort of there, there are multiple levels to it, but the first is the to that, that their underwriting standards give them some level of protection. So when you originate a when you originate a CRE office loan, they generally have a loan to value ratio of about 50% at origination. So a hundred million dollars building can only have a $50 million mortgage supporting it. And they're also underwritten to have debt service coverage so that the, the principal and interest are covered by the rental cash is at a ratio of two x, two times debt service coverage ratio. So that's the first thing that it gives you some cushion against both a decline in the rental role and a decline in the market value of the building. But if you're looking at the, the worst affected buildings, which are down 50% from peak, they're certainly going to go through that loan. Once you add up the cost of remediating a bad loan, and how you have to hold, how is it on your balance sheet, then market it and sell it to recover the, the collateral there are going to be real losses.

So the second step is that a bank can restructure a loan around its lower cash flows and try to extend out the maturity. And what this generally means is the, the bank can negotiate with the property owner to add more equity, and this often comes in the form of pledging other properties they own where the loan to value ratios are, much more favorable and pledge those properties to better collateralize the, the loan renewal and boost the loan to value ratio. The third thing that they can do is to pray that it gets better with time <laugh>. And there is some value to this in that lower interest rates do help with building values because that gives you a little bit lower cap rate, so it values, the cash flows higher.

And the second dynamic is that if you wait long enough, and there is some base level of growing underlying demand for office space that just comes in the form of growing population employment, new company formation that new office construction has fallen to a to a very low level that since 2019, I think that the 2024 new office construction level shows it's about 20% the level of 2019. And what this means is to play it forward for a few years, the new supply deliveries of office space will be pretty minimal by 2026. So if you can wait long enough a lot of the excess unused space will get absorbed theoretically. But the, base assumption here is that there will be losses, and they will be significant in the, in, you know, particularly in the commercial business district office space.

But we don't think those losses are likely to be systemic. It turns out that the banks with the exposures to the, to the very worst office buildings are often also the ones who are best equipped to absorb those losses. So the large regional banks and money center banks are really where you found most of the lending to these large downtown office towers. And for them these exposures make up about 2 to 3% of the total loan portfolio. Okay. And it's already it's, it's already been recognized to a large degree through reserving, right? So there's a, there's a 10 to 12% sort of reserve ratio against these portfolios. And in theory there'll be a lot of pain to be absorbed, but it'll be taken by the people who can, who can sort of best roll with the punches. Right.

Steve Bleiberg

Now, I think you said the beginning of all this, that about half of that debt was held by banks. So who holds the other half? Is it things like pension funds private equity firms? Who else might be at risk?

Michael Beckerman

So insurance companies, insurance companies are big investors in the commercial real estate market, both in terms of owning property and owning commercial mortgage loans. They're about 15% of the market. The other major piece is the capital markets and through commercial mortgage backed securities, CMBS, they are another 10 to 15% of the CRE market, the CRE debt market. And then the rest is made up by government agencies. GSEs have about 20% of, of these that are also, you could kind of group that with the with the capital markets portion in that they're, you know, they're, they loans that ultimately end up in the bond market. And the, the remainder is I think made up by REITs who have a, who have a, small portion of the debt. But yeah, the banks are the are the primary lenders. And if you think about most of the world's CRE, it makes sense that that the smaller banks would be the dominant lenders in that what this category really represents outside of office is like every, every strip mall or dentist office in America. And those just simply aren't at the scale where is going to be interested be interested in underwriting them. Right.

Steve Bleiberg

Right. So what's going to happen in these, in these central business districts where it sounds like that's where, you know, there has been kind of the weakest or the biggest fall off in occupancy for, for office, and you know, people tend to prefer newer offices and so as, as some of the older buildings continue to age out and the demand is falling off, what, what do you think happens to some of the older office buildings in the downtown cores?

Michael Beckerman

So this is a good question and we're going to find out in the next few years, but what we think is that you can't avoid going through what will be a long-term process of supply rationalization. So there will be there will be foreclosures, there will be restructurings, and ultimately properties will get repurposed. And so long as the you know, as they say in real estate the, things that matter are location, location, location, yeah. So if a property is in a good location and the building can be repurposed, turned into condominiums for example that will happen, and for the supply that can't be absorbed there will be there will be losses and write-offs. Or as it relates to banks we think as, as an investor in banks you'll do really well to identify the companies that are well capitalized, that have sustainable low cost funding, and they have they have exposures to not only CRE, but other credit risk that are diversified and diversified by category, by end market, and by and by geography.

Steve Bleiberg

Right. Okay. Well, I look forward to the day when there's a bowling alley on every bar, in in what used to be an office building. Well that's been very helpful and interesting. Michael. thanks for joining me.

Michael Beckerman

Great. Thank you for having me.

Steve Bleiberg

And we'll be back with another episode soon. Thanks. Remember to subscribe to actively speaking on Apple Podcast, Spotify, or Google Play. You can find all of our previous episodes and additional content on our website, www.tdgis.com.

Steve Bleiberg

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