How We Got Here.
by Shlomo Chopp, Managing Partner
To fully appreciate the magnitude of the current opportunity, let us delve into the history of real estate finance and distress.
THE SAVINGS AND LOAN CRISIS
The savings and loan crisis started in July 1982 with the collapse of the Oklahoma based Penn Square Bank due to exposure to risky energy loans. The Federal funds effective rate was 12.59%.
The crisis brought down thousands of Savings & Loan institutions with collective holdings amounting to hundreds of billions of dollars because they held portfolios of loans associated with risky and speculative real estate ventures.
In 1989, the U.S. government established the Resolution Trust Corporation (RTC) in response to the insolvency of the Federal Savings and Loan Insurance Corporation (FSLIC). The primary responsibility of the RTC was to manage and resolve the assets of failed savings and loan institutions.
One of the tools employed by the RTC was the Real Estate Mortgage Investment Conduit (REMIC). REMICs were created as part of the Tax Reform Act of 1986 to provide a tax-efficient structure used for the securitization of mortgage-backed securities (MBS) in the United States. They added liquidity to the process of efficiently disposing of defunct institutions assets, lowered mortgage rates and mitigated the negative impact of distressed assets on the broader economy.
Commercial Mortgage-Backed Securities (CMBS) and Residential Mortgage-Backed Securities (RMBS) are both examples of REMIC’s. In short, mortgage loans are contributed to a trust, which issues bonds to various investors, often those that wouldn’t otherwise invest in mortgages. The bonds often bear a credit rating, are granted pass-through tax treatment (not taxed at the trust level) and are managed by a designated third party, or Servicer. Mortgage payments by borrowers are then passed through to the various bondholders in accordance with a bond’s coupon and notional balance.
Adoption of these securities has grown dramatically with time, as many passive investors sought the refuge of these trusts offering a defined yield, a credit rating and the liquidity of the bond market.
The closure of the Vernon Savings and Loan Association in Texas in March 1991 is often considered one of the final chapters of the S&L crisis. The Federal funds effective rate was 6.12%.
Meanwhile, in a simple car driving to Seattle in July 1994, sat Jeff Bezos who quit his job at the hedge fund D.E. Shaw to launch the online platform for selling books (to eventually be known as Amazon). A few months later, in September 1994, Pierre Omidyar launched eBay. During the same period, on the other side of the divide, barcode technology was being introduced at retail checkout counters.
The Global Financial Crisis (GFC)
The Global Financial Crisis (GFC) of 07-08 was triggered by the bursting of the U.S. housing bubble fueled by subprime mortgage lending, and the subsequent collapse in the value of mortgage-backed securities and their derivatives.
Financial institutions had invested heavily in these securities, leading to substantial losses reverberating through the global banking system. Household names such as Lehman Brothers and Bear Stearns were lost and institutions such as AIG, Bank of America, Citigroup as well as Fannie Mae and Freddie Mac were bailed out.
Lehman Brothers failed in September 2008. The Federal funds effective rate was then 1.81%.
With the economy in shambles, the Federal Reserve introduced Quantitative Easing (QE) to inject liquidity into the financial system, lower interest rates, and encourage borrowing and spending. This involved several rounds of large-scale asset purchases of government securities and mortgage-backed securities and helped restore market confidence and aid the broader recovery efforts.
In total, from Nov 2008 through Oct 2014, the Fed bought appx $2.35 trillion of mortgage-backed securities and $2.07 trillion of US treasury bonds. In December 2008, the Federal Funds rate dropped to 0.18% bottoming out at 0.07% multiple times during the period between 2011 and 2014.
The GFC was the first test of the REMIC, and MBS/CMBS structures. While many investors, based on their previous experience of the savings and loan crisis waited for attractive real estate bargains, they did not ultimately arrive in large numbers. This was primarily due to the increased risk tolerance of large institutional capital to seek yield in an increasingly low yield environment for the safest investments such as government bonds.
The increased liquidity served to prop up values of healthy assets and artificially solve challenges of many distressed assets.
Using the multifamily real estate market as a barometer, according to CoStar, the period between 2000 and 2007 saw unit inventory increase by 9%, while values increased by 69%. By 2019 inventory had increased by 32% and values increased by 315%! Conversely, capitalization rates decreased by 30% from 9.2% to 6.5%. It rose to 7.3% in 2008 but was back at 6.5% in 2015 and declined further down to 5.7% in 2019.
In 2000, multifamily sales volume stood at $20.6 billion, with an average price per unit of $62,500, and in 2019, multifamily sales volume stood at $164 billion, with an average price per unit of $203,000.
Another reason there were few 'deals,' was that unlike the banking institutions that failed in the '80s, (as detailed in Part I of this series - see comments) where most of the 'paper' was held on balance sheets, the 'paper' in this case was often held in securitization vehicles. These vehicles assigned losses to bondholders, eliminating the need for the lender to engage in asset sales to raise cash for repaying depositors.
THE INSTITUTIONALIZATION OF CRE
Investors can also gain exposure through Real Estate Investment Trusts. The subject of the 1960 REIT Act allows for investment in income-producing real estate without directly owning, managing, or financing. REIT’s distribute 90%+ of taxable income as dividends and avoid paying federal income tax at the corporate level.
REMIC’s and REIT’s are similar in tax treatment and hands off investment for non-experts. Both vehicles have encouraged increased liquidity and risk-taking by even conservative investors due to its focus on assured cash flows. This requires simplification of property descriptions and also have limitations. Also, REIT regulations preclude from owning operating businesses and also, lenders won’t finance business revenues. Once developed, to attract further investment, operators must present leases and borrowers must produce assured cash flows.
As institutions became more comfortable, investment avenues have arisen around property equity for a hands-off investor to access tax optimized cash flows. Traditional owners focus on the smallest operational details but are inefficient at financing. Institutions treat assets as cash flowing vehicles to be capitalized and grown.
A mid-block office building with only one side of light/air can be valued the same as a building with three sides of light and air, so long as the revenues are the same. The reality, though, is that the latter is more attractive to tenants but it takes a downturn to highlight the difference. Also, once developed, buildings don’t innovate absent a tenant demanding it. This reactionary approach to innovation can be blamed for the decline in retail, as well as what occurred with office in the post-COVID environment.
While real estate was signing leases with dying Sears, J.C. Penny, Toys R Us and Payless ShoeSource, Amazon was grabbing market share with e-commerce. The convenience of e-commerce and their operators ability to absorb losses from shipping and returns had consumers skipped the store to go online. In 2007, e-commerce made up only 3% of total retail sales. By the Q1 2020 it was 11.9%.
As retail downsized and stores closed, real estate refused to innovate and lacked the ability to raise capital to do so due to their debt and equity capital structures. In short, high values tied to evolving business models preclude innovation without a decimation of the capital stack.
Billions were made by investors such as Carl Icahn, that shorted certain CMBS trusts heavily tied to malls using a synthetic vehicles — the CMBX index.
Remarkably, today, multifamily & office are suffering, but retail has emerged as an investment darling. As we will detail below, the opportunity is to employ cross discipline expertise to identify areas where standardization becomes over-simplification and valuable assets can be acquired at attractive prices.
COVID CASH
In late 2015 through July ‘19 the fed raised rates. In July ‘19, the Federal Reserve started cutting rates. By Feb ‘20 they stood at 1.58%.
Then by April they hit an all-time low of 0.05%!
- On 3/320, the fed lowered rates by 50 bps.
- On 3/920, Black Monday, market “circuit breakers” tripped due to massive sell-offs which caused trading to halt.
- On 3/15/20, in an emergency move, the Fed target rate was lowered to 0.00%-0.25%, and it launched a massive asset purchase program to provide liquidity support to the markets.
Typically, when stocks plunge, investors rush to the safety of US Treasuries. During the COVID-19 stock crash in March and April, however, Treasury markets seized up with a lack of demand. This pushed the Fed to invest over $3 trillion to add liquidity and the US government invested over $4.3 trillion into the economy.
Lockdown measures and stay-at-home directives across the United States were intended to curb the spread of the virus and mitigate the impact on public health. It also disrupted daily life, caused widespread business closures, and triggered a surge in remote work.
Ultimately in 2020 alone, COVID claimed the lives of 350,831 Americans, according to the Center for Disease Control (CDC).
With offices closed, technologies such as video conferencing highlighted the concept of work-from-home. In hindsight many recognize this approach to be less than ideal, but at the time it highlighted the vulnerability of the built office. It became clear that tenants do not “need” office space to operate.
Just like with retail, an external factor influenced the value of commercial real estate. It wasn’t about the “type of space” but rather whether the space was needed at all. Confined by its financial obligations and limitations, all real estate could do, was to argue that offices are a necessity for proper business operations and culture.
The argument, however, was countered by media reports extolling the productivity of work-from-home, social activists seeking to “empower the working class” and the resistance of employees seeking to avoid the trek to the office.
Among the funds injected into the economy were checks paid out to individuals and companies to help them meet their obligations in a period of economic stagnation. This emboldened employees who were in high demand prior to the pandemic when the unemployment rate was at 3.5%, and were now receiving government assistance with courts suspending evictions/foreclosures. Employers had no ability to force employees back to work.
In hindsight perhaps if office owners were “ahead of the curve” integrating technology, instead of promoting the maximum employees per square foot, they may have been better positioned to confront challenges to office that remain until this very day.
THE INFLATION FALLOUT
As time progressed and the market recovered, we were left with further increased real estate values, low unemployment and high inflation caused by the excess cash in the system. In the nearly 10 years since the GFC rates were cut to almost 0% and values skyrocketed.
In February 2022, the effective Federal funds rate was at 0.08%. After multiple rate hikes, it plateaued at 5.33% in August 2023.
To illustrate the effect on the CMBS market, even if all real estate assets were otherwise healthy, the $1.3 trillion+ of CMBS securities with a weighted average coupon of 4.06% (data courtesy of Trepp, Inc. as of 8/23) is unattractive as 10-year treasuries as of 12/15/23 was 3.91%, SOFR sat at 5.31% and prime is at 8.50%.
The result is forced selling at a discount to par.
These losses also flow through to the real estate underwriting. A property with a $1 million NOI is worth $13 million in a 6% loan rate market, down by ±$5 million from a 4% loan rate market. Even with no reduction in underlying cash flows, a 75% LTV becomes 100% LTV assuming a 200bps spread to cap rate.
Institutional capital helped drive up prices by adding liquidity indexed to the alternative of low-rate investments. It viewed real estate with little differentiation, to sell its products in an uncomplicated manner to generalist allocators of capital.
When challenges arose in the retail space, the entire asset class was blacklisted. With current challenges in office properties, office is now “bad.” As the market starts to decline in multifamily, previously aggressive investment in its debt and equity are looking challenging.
As challenges pile up upon challenges, the common thread is real estate exposure. How soon until real estate allocation cuts hit the market?
The National Association of Insurance commissioners recently recommended an increase in reserves against mortgage-backed security holdings.
In the S&L crisis of the 1980’s the government was able to stem the bleeding, partially, by making use of a new source of revenue, institutional capital.
In the GFC, “Main Street” suffering justified lower rates, saving real estate lenders as values bounced back.
Moving forward, these solutions may not be readily available:
> After helping inflate real estate values, institutional capital has concerns with commercial real estate, especially losses mount in their existing holdings.
> Given inflation, substantive rate reductions and asset buybacks are going to be difficult. As Jerome Powell has indicated, inflation concerns take precedence over short term recessionary challenges.
> Finally, so long as the pain is limited to commercial real estate and not the broader economy, there will likely be a hesitancy to employ macroeconomic solutions to a sectors challenge.
I guess we'll see. Thank you for following along!