The Looming Shift in Commercial Real Estate: Navigating Post-Pandemic Challenges

Following are several summary bullet points followed by a link to the 60 Minutes story from last week.

• $1.2 trillion in commercial real estate loans expire in the next two years. Interest rates have risen.
• Peek inside all the vertical real estate in NYC, and there’s a fundamental question. Where is everyone?
• More than 95 million square feet of New York office space is currently unoccupied. That’s the equivalent of 30 Empire State Buildings,
• 61 Broadway near Wall Street. Half the building lies empty.
• In this post-COVID world there is the changing nature of how people work and live. We’re not going back to where we were, said the owner of 61 Broadway. It’s a different world, and it’s going to be turbulent.
• Fridays are dead Mondays are not much busier as tenants shrink their office footprint office landlords are confronting the fact that some of their buildings have become obsolete.
• The CEO said we invest a lot of equity. If it works, we make a lot of money. If it doesn’t work, the lender can take over the building. You have to face reality, and reality is coming your way.
• The reality is the price of office buildings is tanking as much as 40%.
• Since the pandemic uptown and Columbia Business School Professor Stijn Van Nieuwerburgh, a professor of real estate, has modeled out the impact of hybrid work on pricing and calls it a train wreck in slow motion.
• And this is just the beginning. The reason it is just the beginning is that there are a lot of office tenants who have not had to make an active space decision yet. Do I want to renew this space? Do I want to vacate? Maybe I’ve signed a new lease for half as much space. This is what tenants have been doing for the last three years. So when you take all of those current and future declines of cash flows into account, we end up with about a 40% reduction in the value of these offices.

Professor Stijn Van Nieuwerburgh has been meeting with captains of industry in the Federal Reserve on this very point.

• Commercial real estate is a huge part of the book of business of your typical bank. And I’m talking mostly about these smaller and medium sized maybe regional banks. They have a lot of exposure, which is their bread-and-butter activity. About 30% of all their loans are commercial real estate loans. And here we are sort of seeing weakness in office. That is something that we have never seen before. And banks need to come to grips with that. I think we’re at the beginning of a crisis.
• There’s a potential crisis here in December 2024.
• Nationwide office loan delinquency rates are 6%, almost four times what they were a year ago.
• But banks have been reluctant to write down those losses.
• There’s this buildup of bad debt in the system, but it’s not being dealt with just yet.
• And that’s largely because the banks have been kicking the can down the road as best they can, trying to push this off as far as they can.
• What does that mean? It means that banks are entering into extensions on a lot of their bad loans, which essentially change their classification. From a non performing loan alone that’s in distress to a performing loan a healthy loan, even though they haven’t received a pay down on the loan.
• And the collateral value on that loan continues to drop, extend-and-pretend… that’s right.
• It works really well when interest rates are low because the banks can keep the status quo going.
• But once rates are high, it doesn’t really work anymore.

 

Market Valuation

 

A data point we might use to check in on the stock market is its overall valuation, represented by the S&P 500’s cyclically adjusted price-to-earnings (“CAPE”) ratio. When the CAPE ratio gets up to around 20, it means the market is getting expensive. When it’s above 25, you’re in “bubble” land. And when it’s 30 or higher, you’re undeniably in mega-bubble territory.

The CAPE ratio was 44 in December 1999 and 38 in October 2021 – within several weeks of enormous mega-bubble peaks. Today, it’s squarely in mega-bubble territory at 32.

The CAPE ratio in mega-bubble land is a huge warning. Stocks don’t go up forever, and they can trend in a way you’d never have predicted for a lot longer than you’d ever believe possible. Though the CAPE ratio is a non-factor 90% of the time, it’s dangerous to get too complacent when it’s this high.

Now, the CAPE ratio has occasionally spent years in mega-bubble land without a big crash, like it did from 2017 until 2022 (the March 2020 pandemic crash notwithstanding). So while history suggests a CAPE ratio of 32 is concerning, it’s not a given that a market decline is imminent.

However, adding the CAPE ratio to the market’s price action since the 2021 and 2022 top tells me we MAY still in a bear market. It might sound irrational. But it feels like history is rhyming.

 

The Fed

 

• Fed officials continue to push back on market expectations for rapid-fire rate cuts this year.

 

 

• Waller’s comments sent Treasury yields higher.

 

 

• The December PPI report was below forecasts, …

 

 

 

• The decline in business markups (trade services) was a drag on core producer inflation. This indicator points to softer corporate margins.

 

 

The downside PPI surprise has heightened market expectations for Fed easing, with predictions now almost at 170 bps in rate cuts for this year. This contrasts with the December FOMC forecasts, which indicated just 75 bps in reductions. Numerous analysts perceive the market’s stance as excessively dovish.

Despite a pushback from some Fed officials, markets see a March rate cut as highly probable.

The 2-year Treasury yield declined again, …

 

 

 

• Sharp declines in the money supply signal slower inflation ahead.
• Goldman sees Fed rate cuts starting in March.

 

 

US Economy

 

• Small businesses are reporting falling sales. What does that mean for larger firms?

 

 

• The NY Fed’s manufacturing index plunged this month as demand deteriorated.

 

 

• Is it noise? Seasonal adjustments?

 

 

• Source: MarketWatch   Read full article
• The decline doesn’t bode well for factory activity at the national level. The Philly Fed’s index will give us more clues on Thursday.
• The December retail sales report topped expectations.
• Vehicle sales increased again.
• Growth in online sales remains robust.
• Treasury yields spiked in response, as the market further repriced Fed rate cut expectations.
• The GDPNow estimate for Q4 growth was revised upwards following the retail sales data release.

 

 

• Overall, 2023 was a tough year for the nation’s manufacturing sector.
• Last week, mortgage applications held at their lowest levels in years, approximately 35% below the nine-year average
• Initial jobless claims remained very low last week.
• Mortgage rates are no longer falling.

 

 

Market Data

 

• Goldman’s sentiment indicator shows investors becoming more cautious.

 

Source: Goldman Sachs; @MikeZaccardi

 

•  Corporate insiders are very nervous.

 

 

• The momentum factor has been outperforming.

 

 

• The S&P 500 hasn’t had a 2% down day in almost a year (225 trading sessions).

 

 

• Investors see the tech mega-caps as the most crowded trade.

 

 

• Who owns the US equity market?

 

 

• The S&P 500 has been holding resistance at 4800.

 

 

• Market breadth started deteriorating in recent days.

 

 

• What do investors see as the biggest tail risk?

 

 

• Percentage of US households that own stocks:

 

 

• Pharmaceuticals’ market capitalization has been bolstered by weight-loss medications. Eli Lilly has ascended into the top ten companies of the S&P 500 in terms of market cap.

 

 

• Renting vs. owning:

 

 

Great Quotes

“For every minute you are angry you lose sixty seconds of happiness.” – Ralph Waldo Emerson

 

Picture of the Week

 

Lake Louis, Banff Canada

 

 

 

All content is the opinion of Brian Decker