Street Talk | Episode 126: Hunting the bears, making the bull case for CRE

Table of Contents

Presenters....................................................................................................................... 3

Presentation.................................................................................................................... 4

Presenters

ATTENDEES

Nathan Stovall

Rich Hill

Unknown Speaker

Presentation

Unknown Speaker

Welcome to Street Talk, S&P Global Market Intelligence's podcast that offers listeners a deep dive into issues facing financial institutions and the investment team.

Nathan Stovall

I'm Nathan Stovall, and on this episode, we're talking about what has been the topic à jour in the investment community, commercial real estate. Just spend a few weeks on the road sharing our view of bank's exposure to CRE. But in this episode, we're bringing in a veteran in the real estate space who will share their view of the asset class and what clues we can learn from REIT performance. Joining me on the show is Rich Hill, Head of Real Estate Strategy and Research at Cowen & Steers. Rich, thanks for coming on the show.

Rich Hill

Thanks for having me.

Nathan Stovall

Rich, one of the things that you've noted in your research, and I will openly admit that I borrowed and tried to attribute to you, is the idea that the publicly traded REITs can kind of lead to private real estate valuations, and that's something that's interesting to means as a bank guy because they're effectively sitting on a lot of private real estate in terms of their loan portfolios.

And we've tried to look at that as a way to follow where the exposure, the health of the exposure might go given that they have so much concentration, particularly with the smaller and regional institutions. I want to start off talking about what lessons we can learn from REIT valuations of late.

You pointed out in your research that we've seen a considerable rally in late '23 off of the bottom in October. What really drove that rally in? Was it very much driven by the idea that the Fed was going to have to pivot aggressively and cut REITs notably this year?

Rich Hill

Yes. Let's level set. The bottom for listed REITs was October 25, 2023. They were down almost more than 10% year-to-date. November ended up being a really, really great month for listed REITs. It was a top five month ever. In December, had a great encore with returns that were one of the top 20 months ever. We went from more than down 10% at the end of October to finishing up the year more than 10%. It was a huge, huge, huge rally.

Now there's a couple of different reasons for that. I think a lot of people will say, "Hey, look, REITs are just a play on interest rates." And there's probably some truth to that over the near term. And certainly, the Fed pivoting, or the Federal Reserve, signaling that they were done raising interest rates and the late October, early November time frame was a big catalyst for that. Keep in mind, October 25 was exactly when the 10-year treasury briefly went above 5%.

So in some regards, it was like peak bad for interest rates. But that's not all that happened. There's one fundamental thing that happened and one technical thing that happened. I'm going to lead with the fundamental thing because the technical thing's just sort of there for fun. But something else happened fundamentally that I don't think people spend enough attention on. It's that lending conditions turn less bad.

I spend a lot of time looking at the senior loan officer opinion survey. For those that don't follow this stuff and aren't as a big a dork as I am, the Fed puts out a quarterly survey that tracks lending standards for a variety of asset types, including commercial real estate.

Nathan Stovall

And we read it all the time. We're one of those dorks with you.

Rich Hill

What happened around the same time period is the second derivative for the senior loan officer opinion survey turn positive. That sounds really wonky. But what that means is there was deceleration tightening lending standards. That was one of the last signs that we were looking for to really start becoming pretty positive on listed REITs. Peak bad in the lending markets actually turned out to be a pretty good thing, so I think that's the primary driver.

But I also do want to point out something else that happened from a technical standpoint that I think is a little interesting. October 25, listed REITs were down from their peak, negative 33.3% on a total return basis. Why does that matter? Well, the trough in the GFC prior to the collapse of Lehman was in tens of basis points of that. Unless you thought that there was going to be another GFC Lehman collapse-like event, maybe the computers took over a little bit and said, "Hey, look, this is as bad as it's going to get."

So now as we stand, even with listed REITs having a little bit challenging start to the year, and we can talk about that a little bit more, we're still 17% above that trough. We think the worst is behind us with listed REITs. You are absolutely right, and I can talk about this a little bit more, listed REITs are leading indicators in downturns and recoveries. Listed REIT market is giving the commercial real estate market a signal that there is a light at the end of the tunnel.

Nathan Stovall

And it's particularly interesting that comp to GFC because there's no one to speak with in [ bank land ] and of course, they're going to try to put a good look on their book. But it doesn't feel like that at all. So to be in that camp, the market is pricing in a pretty dire scenario or at least they were in October.

Rich Hill

Yes. Look, I mean price returns were down 40% from their peak, really big decline. Look, I'm an old guy. I won't speak for yourself, but I'm an old guy. Like I remember the GFC.

Nathan Stovall

I was around.

Rich Hill

I was around. Those are really, really, really scary periods of time. Now I also tell people that if you're 37 years or younger, you weren't around for the GSE. And there's a lot of really senior people that are in that age bracket and this is the first downturn they've seen. I think this is a really explainable downturn. So is it a GFC? No. There's certainly some real headwinds facing the commercial real estate market, but this feels night and day difference to me compared with the GFC.

Nathan Stovall

We've seen REIT expectations change and you talked about how they're not just driven off of REITs, but we went from pricing as many as seven cuts this year too far, far fewer now. What has happened to REIT performance since then? And what do you think it suggest that investors are pricing at this point? I mean, you just noted that in October, it's this calamity scenario, there's a reason not to be there. What are they suggesting now?

Rich Hill

I have four kids. My youngest is eight years old. He's a classic fourth child. He overreacts to the upside and the downside. The reason I say that is, look, [indiscernible] like my eight-year-old. They get really, really excited about good things and they get really, really pessimistic about bad things. Heading into 2024, we sort of think the listed REITs market got ahead of itself. It's pretty amazing to believe that the markets, including the listed REITs market, at the end of 2023, were pricing in six to seven interest rate cuts by the Federal Reserve in 2024.

But that wasn't our house view. We were and we still are in the no landing camp. What the no landing camp basically means is inflation gets stuck around 3% or so and the Fed only cuts two to three times. We're probably more in like the one to two times this year. Look, the market got a little bit ahead of itself.

By the way, I think if the Federal Reserve was going to cut six to seven times in 2024, that probably wasn't for a good reason. So the market got ahead of itself. Fast forward to mid-April, the market was almost entirely pricing out any interest rate cuts. And if you look at the probability of an interest rate cut in July, very, very small. June, even smaller.

The market turned from being very, very dovish to a very, very hawkish. And so we actually think -- and ironically, that's a good thing because it took a lot of whatever froth there was in the listed REIT market. And look, listed REITs are off to a tough start to the year. They're down a little bit less than 7%. They're the only sector of the S&P 500 that is apparently giving the message that the Federal Reserve is not going to cut interest rates as aggressively as the market previously bought.

We think that is setting up for a really, really attractive entry point right now. And it's one of the reasons that we're bullish, I'll defer to you and then pause here for a second, but we run a lot of different interest rate scenarios right now, economic scenarios because it is uncertain. We don't have a crystal ball. We focus on commercial real estate fundamentals to drive our stock selection and how we think about REITs. So it is important to think about a lot of different scenarios.

Nathan Stovall

Certainly. Certainly. And you just talked about the idea of what effectively was being priced in, and now we backed up a little bit with REITs, but you feel good about the investment opportunity there. As you noted, you're not feeling like this is like GFC at all. What gives you confidence there?

I've been in that camp, I've been screaming to anybody who will listen to me because I remember how much stupid stuff I saw for the two years leading up. And I'm missing that, whether it's LTVs, crazy leverage. Crazy. And we were moaning the lack of loan growth in the bank space in '20 and '21 would have been the worst time from what was to be made. How suddenly have we all gotten totally over levered? Just sort of unpack that a little bit about how you look at that side of things.

Rich Hill

Yes. So there are so many misconceptions about commercial real estate and commercial real estate debt. I spend an inordinate amount of time talking through this. Let me give you what we think are some of the biggest misconceptions. First of all, lending standards, we're actually pretty conservative heading into this environment because look fast forward to -- rewind back to what the regulators were doing in 2015, 2016, 2017. They were beginning to warn banks that you're getting too aggressive on commercial real estate.

And by the way, Dodd-Frank regulation came in, so there's a lot of things occurring there. The second thing that we don't think the market appreciates at all is how much price appreciation NOI growth there's been since 2010, 2011, 2012. When you think about this price appreciation, it's actually embedded a tremendous amount of additional equity into the loans -- behind the loans that are securing these properties.

Even after taking into account, call it, a 10%, 20% decline in property valuations, which I'm sure we'll talk about a little bit more, a lot of these properties actually can do, still do cash out refinances. Here's a great stat for you that I don't think a lot of people spend enough time on. So commercial mortgage-backed securities, they give you real-time insights to what's happening with commercial real estate debt.

More than 80% of the loans scheduled to mature in 2023 paid off at or before the maturity. 80%. It's a pretty high number that no one really wants to talk about, given all the froth that was in the market. The final point, and I'm sorry to like point this out, given that you're a bank guy and I'm sure you know this, this whole statistic that small banks finance 70% of commercial mortgages, is completely bonkers wrong.

Nathan Stovall

So wrong.

Rich Hill

It's close. It's a half truth. Small banks finance around 70% of loans held on bank balance sheets. But guess what? Banks only finance 40% of mortgages. So that means small banks only finance around 28% to 30% of mortgages. There's a lot of other lenders out there. We just think there's some misconceptions. I'll put a ball on this.

We've actually seen the CMBS market, spreads in the CMBS market rally this year. And people keep asking me, "How are spreads rallying when underlying credit conditions are getting worse?" Well, it all comes back to this second derivative trade. The worst-case scenario that was priced in the CMBS market hasn't played out.

I completely agree with some of the commentary coming out from CEOs of the big banks that this is going to be a slow burn for the commercial real estate debt markets. But go back to a year ago, everyone was concerned that the market was going to collapse on itself. That just hasn't really played out. A slow burn, the truth is somewhere in the middle environment, ends up being a better outcome than what people were anticipating.

Nathan Stovall

Absolutely. I had two points I want to pick up on that I've made. And totally agree with you that the stat that I throw out to push against that 70% number that it is so silly is that life insurers own more commercial real estate debt than all regional community banks combined. And that's just sort of forgotten about. They're big players. They're not the only ones to your point. There's a lot of folks in here so I feel like that's a lazy comment.

The second one that you mentioned is we spend tons of time talking about regulators focused on bank's exposure here. They're very concerned about it and they're getting them to slow growth and build capital. But at the same time, they're not putting a gun to their head to purge the stuff. And we're seeing things extended out.

Now if you're in the camp that you'd like to buy this stuff on the cheap and have them bill that out, that might not be good news. But to me, it feels more and more like one of the things the market has missed is how long this is going to take, that this is likely just going to be played out over several years. I don't know if you agree with that, but I felt like I heard you almost kind of go in there.

Rich Hill

Yes. Look, there's no incentive for borrowers or lenders to do anything. We're actually solving the prisoners' dilemma. Let me explain what that means. First of all, banks have no incentive right now to take a property back on their balance sheet and it's for three reasons, really. They're not in the business of managing properties, number one. Number two, they don't want to take the loss.

But number three, and this is the important point that a lot of people aren't focusing on. Guess what? The regulatory capital charges for owning a property on your balance sheet are a lot higher than modifying and extending a 99% LTV loan. They actually have incentive from a regulatory capital perspective, which, by the way, the regulators set to modify and extend loans. That's the lender's perspective.

The borrower's perspective is pretty easy. They think their fundamentals are pretty good. Fundamentals in the commercial real estate market are holding up really, really well ex the office market. NOI growth is around 4.5% to 5%. Historically, it's 2.5% to 3%. In environments like today, it's usually flat to negative, so we're doing really well. Borrowers don't want to do that.

There's another point that a lot of people are talking about. Most bank loans are actually secured recourse loans to the borrower. That means if the borrower default on the loan, not only can the bank go back to the property, but they can actually go back to the borrower for all this other stuff. We all think about borrowers of commercial real estate being like New York City guys or you're in Charlotte, North Carolina, Charlotte, North Carolina guys.

But there's a lot of mom-and-pop investors that own one property or three hotels. This is their livelihood. And to get defaulted on those properties, get those taken away, and by the way, have a claim on their personal wealth, that's just a nonstart. I just don't think people understand how this really works. It's just taking time.

And so to your point about modifications, there's a little bit of a slippery slope of the narrative occurring. Everyone's talking about trillion of loans coming due in 2024. This time last year, there was only $650 billion of loans coming due. How do we get $350 million more of loans? It didn't just magically show up. What happened was there was a lot of loans in 2023 that were modified and extended and pushed into 2024 and beyond.

I'm pretty convinced. I've been wrong before, so maybe I'll be wrong again. But I'm pretty convinced this is going to happen again. And we're going to be suddenly talking about in 2025, this big wall of maturities and dismissing the fact that the same thing happened in '23 and '24.

Nathan Stovall

Right. And for my guys, it's an earnings issue in the sense that they're sitting on lower yielding assets, but it's not a credit issue the same way that folks are talking about it.

Rich Hill

100% agree with you.

Nathan Stovall

You alluded to this earlier that you think it's a great time, though, to invest right now in part because we're talking about the lack of nuance in the discussion. Where do you see the greatest opportunity right now? Certainly, office is challenged. And even with an office, you've got to think about Class A differently from Class B or plus C and the market itself.

And then, of course, is it medical office? The line I love is dentists don't have a return to office discussion and there's not a lot of nuance within that. But where do you think are the greatest opportunities? And can you break down maybe where is the worst to the best?

Rich Hill

Yes. So let me, first of all, maybe come back to why we're still [ constructive ] on listed REITs because I think it's important to understand. Look, we're running four different scenarios right now. We're running a soft landing scenario, a no landing scenario, a hard landing scenario, and a reacceleration scenario.

Soft landing scenario is pretty obvious. A lot of things are going to do well in a soft landing scenario with dead sticks to land in, the economy doesn't downturn, but inflation comes down and they can cut interest rates. Returns are probably going to be in the mid- to high-teens for listed REITs based upon our models in that environment.

A no landing scenario, which I mentioned is our base case, that's suddenly bullish because, hey, look, the market is pricing in that there's going to be no interest rate cuts or close to it. So that's a bullish scenario. What I don't think the market is spending enough time on is the hard landing scenario.

I mentioned to you, listed REITs are the only sector of the S&P 500 that's down this year. The market is pricing in a recession for at least commercial real estate. If we have a hard landing, the impacts of -- we focused on real REITS because we think that's the primary driver of returns.

The impact of real REITs going well below 1% far outweigh the headwinds coming from credit spreads widening and growth really slowing significantly. That's not to suggest listed REITs won't have a major reaction lower and sympathy with the broader S&P 500, but we actually think they can still put up high single-digit returns from here in a hard landing scenario.

And then a reacceleration scenario, we think that's already priced in, given that dividend yields are 4% to 5%, earnings growth of 4% to 5%. You don't need much multiple expansion here at all to get to the high single digits. It's an interesting dynamic for listed REITs. But your question about property types is a really important one.

A lot of people think about listed REITs or commercial real estate as a singular asset class. It couldn't be further from the truth. List of REITs are a broad section of 18 different subsectors. Yes, you have the main food groups of office, retail, multifamily, industrial, and hotel. But guess what? You also have things like data centers and cell towers and single-family rentals and seniors' housing.

There's a broad array of different ways you can play the sector. Probably not for this podcast, but active management actually really works in listed REITs. What are some of the subsectors that we really like? We really like data centers. Data centers are a cheap play on AI. I won't mention some of the high-flying AI stops, but if you compare their performance to what data centers have done, data centers look really, really cheap in comparison to a stock that's up 300, 400, 500.

Nathan Stovall

Some of our guys on our tech research side, focused on AI have been telling me they're getting calls from utilities right now because they're worried they're not going to generate enough power to support the data center load that's coming on, to your point, because the demand is just through the roof.

Rich Hill

That's exactly right. We like data centers. We also like cell towers. Cell towers haven't done particularly well over the past 12 to 18 months and there's a lot of reasons for that. But we think it's coming. Imagine if we ever even remotely figure out self-driving cars. It's going to be huge. By the way, if AI is actually a thing and you can start using AI in your cell phone, we don't have enough -- we don't [indiscernible] cellphone or iPhone. God, I'm old.

You really have all these other demands. We really like seniors' housing. Seniors' housing has this huge baby boomer demographic. Seniors can't live in their homes forever. Eventually, they transition away to a senior housing facility, which basically is a collage dormitory for older people. And by the way, labor shortages are going down. Labor costs are going down. No one wanted to work in a senior housing facility during the middle of COVID. They're probably a little bit more comfortable with it now.

We were negative on retail prior to COVID. We flipped that around and we think that's pretty attractive. But look, I mean I won't belabor the point on office. Office, we're pretty cautious on. But it's a really small percentage of the listed REITs market. It's only around 3% of market cap in the United States. Relative to the totality of the market, it's just small. We don't have a lot of exposure there. We're probably a little bit more cautious on hotels than some of our peers only because of our economic backdrop.

I mentioned to you a no landing scenario. We're not in the soft landing camp. But we prefer to play that a little bit more in the gaining sector. And the final point I'd make to you, which is a really important point, we've been, out of consensus, cautious on industrial, both in private markets and public markets. We've been running an underweight for industrial reach within our portfolio. Industrial REITs are the worst performing subsector year-to-date to listed REITs.

Nathan Stovall

Is that just valuation because everybody got too excited?

Rich Hill

It's a couple of things. Number one, it's valuation and against the backdrop of interest higher interest rates, cap rates have widened. But there's another thing. Growth in industrial is really strong over the next two to three years. But the industrial REITs have started saying long-term growth probably isn't going to be puppy dogs and rainbows forever. Great asset class, but things are normalizing down.

Suddenly, when you start running long-term NOI growth at a more reasonable but still above trend level, stocks get pressured. We sort of might be coming in the private markets as well. Multifamily, the listed REITs market is already priced it in. I can buy a listed apartment REIT for 6% cap rates. In the private market, they're still in the mid-4s. That's an impossible disconnect.

Nathan Stovall

Well, in some of this, it sounds like, when I hear industrial and you didn't say it's about retail, but I wonder about retail, and I've seen you write this is the idea that we recognize what was the trend line going there. And in some cases, we maybe overran it in industrial, the benefit. But on retail, we shook it out. Some of the weak players got shaken out there.

And so maybe we feel better about it that, yes, we know what that threat is. But that's been there. I was mentioning this to somebody that I did a podcast on the threat from retail to banks back in 2017 or something like that. We've been talking about this a long time, so it's not like this just cropped up.

Rich Hill

It's the worst kept secret in the market. Prior life, I was writing about retail, I want to say in 2010, 2011, and it was certainly a big focus of mine when I was at Morgan Stanley prior to COVID. But look, I'll make it really simple. No one was really dumb enough to build a retail property post-2010 because of the so-called retail apocalypse.

Then COVID was the great Darwinistic moment where it rightsized everything else that was on the margins. And when you put on top of that, that COVID taught retailers that you can actually use your physical stores for micro fulfillment, you have this great story where things are trading well below replacement costs.

So it's just a really attractive asset class that I don't think the market fully appreciates. The REITs, there's a few names in the mall space that we think are attractive. But within our private portfolios, it's really more of the open-air shopping centers that are pretty compelling to us.

Nathan Stovall

Well, at the end of the day, it sounds like in closing, your message would be do your work, quit the lazy take, it's all one asset class and understand that this time might be a little bit different. What's driven us here is not the same thing that drove us in '08 and that create a lot of opportunity. I don't know if you think that's fair or not, but that's what I've heard.

Rich Hill

Look, I'll make one more point. Well, two more points, maybe. Commercial real estate investors do a really poor job of buying low and selling high. I'm making fun of myself here because I'm a commercial real estate investor. We like to buy everything when it feels really good and sell everything when it feels really bad.

We think we are on the precipice of a generational opportunity to buy private real estate. These opportunities don't come around very often. They came around in the early 1990s, and they came around post the GFC. Valuations don't reset 20% to 30% lower very often, so for investors with new capital, patient capital that can deploy that today into tomorrow's valuation, you should be really excited about this environment.

Look, no one loves getting from point A to point B. That's challenging and we're somewhere between 2/3 and 3/4 of the way through it. But this is where really big opportunities emerge. We think listed REITs are a leading indicator for what's happening in the private market. I'll be really happy when the world returns to normal, whenever that is. I'll maybe get a little bit more sleep and spend a little bit more time with my family. But this is a once-in-a-generation opportunity that shouldn't be missed.

Nathan Stovall

Terrific. Well, I think it's a great place to leave it. Rich, thank you so much.

Rich Hill

Thank you for having me on. This was fun.