Until recently, and despite the Federal Reserve’s dramatic rate hikes, the U.S. economy has shown surprising resilience. Even the latest Q2 statistics show an annualized trend of 2.8% real GDP growth, exceeding expectations. However, we are beginning to see signs of economic weakness with the latest jobs report showing unemployment at 4.3%, the highest mark since 2021. Further clarity will be needed to understand how meaningful the increase in unemployment really is, but this news has spurred major volatility in both the stock market and the U.S treasury bond market (note: unwinding Japanese “carry trades” following BoJ interest rate increase has also been major culprit of stock market retreat). Fortunately, the Fed’s primary goal, inflation, is continuing to moderate after posting three consecutive monthly declines. Fed Chairman Jerome Powell can now turn his attention towards economic uncertainty and has indicated that there could be a rate cut in September. The size of that cut (and whether the Fed will even cut rates) is the source of considerable debate today.
We are just over a year removed from the collapse of Silicon Valley Bank, which of course was only the first domino in several prominent regional bank failures including other household names like First Republic and Signature. The catalyst for these failures was, without question, the rapid increase in interest rates which created insurmountable balance sheet losses for banks with exposure to long term U.S. treasury bonds. While it could be viewed that the worst is behind us, the reality is that the full effects of these rate hikes have yet to materialize with the elephant in the room being the commercial real estate fallout.
The most commonly reported commercial real estate exposure right now is the office sector. It is well documented that reduced demand in the post pandemic world coupled with higher rates and an ill-timed wave of new supply have crippled office building valuations. This problem, while having been present for the last two years, has not faced its day of reckoning yet. Lenders are not keen on foreclosing; operating office buildings (or any asset class for that matter) is not a core competency for banks and forcing a sale in a down market means realizing material losses on a balance sheet (not good for banker bonuses). Lenders have been willing to work with sponsors on extensions in hopes of a seller’s market returning, which would mitigate lender losses. The market has not improved, however, and lenders are starting to capitulate in all classes of commercial real estate. According to the Wall Street Journal, portfolios of foreclosed and seized office buildings, multifamily, and other commercial property reached $20.5 billion in Q2 of 2024. This equates to a 13% increase over Q1 2024 and is the highest quarterly mark since 2015. This number is expected to drastically increase over the coming months, especially once regulators start auditing and forcing lenders to act. It seems likely that regulators are delaying forcing banks to clean up their balance sheets because we are in an election year. If true, expect significant upheaval following November.
The question then becomes, just how much exposure do banks have to commercial real estate? The data, unfortunately, suggests this is a colossal problem for many banks. Rebel Cole, the Lynn Eminent Scholar Professor of Finance at Florida Atlantic University, has done an extensive analysis on publicly available data examining the percentage of total commercial real estate exposure to the bank’s total equity at 157 of the largest banks in the U.S. According to Cole, a ratio of over 300% is considered excessive risk. As of Q2 2024, there are currently 67 banks with over 300% commercial real estate exposure relative to the total equity reported on their balance sheet. To quote Jerome Powell, “there will be bank failures.”
While the potential for further bank failures is a concerning topic with a broad economic impact, astute investors realize this presents an opportunity to purchase. It is impossible to predict exactly how much stress will materialize in the world of finance or real estate or when we truly hit the bottom of a new cycle. It’s not clear whether we will experience another fallout akin to the Great Financial Crisis, but it stands to reason that at a minimum there will be more buying opportunities over the coming years at prices heavily discounted from peak pricing we saw in 2022. In fact, we are already seeing substantial discounts in the current market.
Fortunately, there is data that would suggest that you don’t need to time the market perfectly; surgical precision is not necessary to make a smart investment especially, the data shows, in apartments. Wharton economist Peter Linneman and his team have put together an analysis of total return data from the National Council of Real Estate Investment Fiduciaries from the fourth quarter of 1977 through the fourth quarter of 2023, which was the entirety of data available at the time of analysis. The analysis was performed on various sectors of commercial real estate looking at ten-year, seven-year, and three-year hold periods. Incredibly, multifamily did not have a single instance of a negative unlevered return on ten-year or seven-year hold periods beginning in any quarter since 1977. The same analysis was done on data available from the National Association of Real Estate Investment Trusts for the same hold periods but this time using modest leverage. The multifamily results indicated no instances of negative levered returns on ten-year holds periods, only 0.7% instances of negative returns on seven-year hold periods, and 9.5% instances of negative returns on three-year hold periods. Essentially, as long as you do not over lever your investment and intend to hold long term, multifamily has historically been an extremely low risk investment.
A key takeway from the data is this: buying at times of distress as we are entering now naturally affords the investor the opportunity to enjoy outsized, risk adjusted returns. However, since investors don’t get an email one morning advising them “today is the day to start buying”, investors are not well served attempting to precisely time a market bottom. Rather, the time to buy is when one can buy quality properties in strong submarkets at a meaningful discount to replacement cost. These opportunities are beginning to present themselves to us and we anticipate an active acquisition pipeline for our investors in the near term.
