Giving some context to real estate concerns

Chief Economist Eugenio J. Alemán discusses current economic conditions.

When the Federal Reserve (Fed) cut rates in response to the COVID-19 pandemic, mortgage rates fell below 3% in 2021 and many households refinanced or obtained new loans. Today, ~40% of homeowners own their home outright while 60% of those with a mortgage have rates below 4%, insulating a large part of the population from increasing borrowing costs due to the Fed hiking rates over the last two years. However, financing for commercial real estate (CRE) is different than that of residential housing. Traditionally, households borrow using 30-year fixed mortgages, while commercial real estate loans are often shorter in duration and reset upon maturity. The estimate for the upcoming ‘wall of maturities’ for U.S. commercial real estate can be seen below, and it is making lots of noise because many CRE properties have lost value due to lower demand and the sharp rise in interest rates. While we agree that the commercial real estate environment can be compared to a slow-moving train wreck, it is also important to consider other factors beyond the incoming maturity wall.

The Commercial Real Estate Market by Sector

When the media discusses commercial real estate, saying it is in trouble and heading for an inevitable crisis, most investors immediately think of office space, and how post-pandemic, many workers have not returned to work full-time or are now working fully remotely, leaving landlords of these ‘empty’ commercial buildings in trouble. However, the office sector of CRE makes up only ~16% of the overall index, with the rest consisting of sectors like multifamily, retail, health care, industrials, and others.

Many of these industries are thriving, and present little concern to the broader CRE market. For example, hotel occupancy levels are near their pre-pandemic levels, while retail properties are experiencing only ~4% vacancies according to the National Association of Realtors one of the lowest among all commercial sectors. Fiscal packages like the CHIPS Act, the Inflation Reduction Act, and the Infrastructure Bill support the industrial CRE sector, while an ever-aging US population continues to support health care CRE. Lastly, multifamily properties should be monitored as vacancies are climbing higher, and as the supply of new housing increases, the vacancy rates could increase further. However, specialized CRE like data storage and warehouses are in very high demand due to the AI craze, likely offsetting weaker demand in some of the other sectors. It is also important to note that the issues faced by the CRE market are known and regulators, as was the case during the Great Recession, have been working with lenders and borrowers to minimize any potential disruptions to these markets.

Who owns the CRE debt?

Roughly 70% of CRE debt is owned by small regional banks and community banks, which are considered at a higher risk compared to their large bank counterparts. We’ve established in the past that these regional banks present little risk to the broad equity market as their combined market weight is less than 0.5% of the entire index, but what about economic risks? Historically, when CRE loans have matured, borrowers have just refinanced and moved on because interest rates have been on a steady decline for decades. However, with interest rates having doubled over the last few years, borrowers are unlikely to be willing to refinance and may be unable to pay off the loan. This situation leaves banks with two possibilities. First, to foreclose on the property and take on the burden of managing the building, but with high costs and limited resources, we believe this scenario is less desirable. Second, the lender may prefer to negotiate with the borrower to restructure the loan until better times (and lower rates) come around. Therefore, as regional and community banks are often deeply embedded in local communities, we believe that CRE defaults will likely be limited as many will attempt to renegotiate loans instead of taking the underlying asset.

Lastly, according to research from Cohen & Steers, not all office buildings have the same experience—newer construction benefits from strong demand compared to older buildings, while 60% of total vacancies can be attributed to 10% of mostly older buildings.1 Therefore, office space demand is not broadly weakening, rather tenant preferences have shifted.

Bottom line:

Interest rates are just one of the many factors affecting the economy and the CRE market. For example, employment drives demand for all sorts of CRE, and while we continue to believe that the labor market is slowing, we don’t expect it to experience any job losses. On the other hand, if we are wrong and the labor market turns negative, the Fed will likely cut rates quickly, which will be supportive of CRE. Our view remains that the Fed will likely cut rates by at least 50bps this year, with several more cuts in 2025, which will certainly provide both borrowers in the CRE markets and lenders some relief going forward. Additionally, as discussed above, office space is only ~16% of the overall CRE market, and regional bank exposure to CRE loans as a percentage of total loans is less than 20%. This analysis was not done to disregard risks in the CRE market but to illustrate that the situation may not be as bad as feared.

Economic and market conditions are subject to change.

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The Consumer Confidence Index (CCI) is a survey, administered by The Conference Board, that measures how optimistic or pessimistic consumers are regarding their expected financial situation. A value above 100 signals a boost in the consumers’ confidence towards the future economic situation, as a consequence of which they are less prone to save, and more inclined to consume. The opposite applies to values under 100.

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GDP Price Index: A measure of inflation in the prices of goods and services produced in the United States. The gross domestic product price index includes the prices of U.S. goods and services exported to other countries. The prices that Americans pay for imports aren't part of this index.

The Conference Board Leading Economic Index: Intended to forecast future economic activity, it is calculated from the values of ten key variables.

The Conference Board Coincident Economic Index: An index published by the Conference Board that provides a broad-based measurement of current economic conditions.

The Conference Board lagging Economic Index: an index published monthly by the Conference Board, used to confirm and assess the direction of the economy's movements over recent months.

The U.S. Dollar Index is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies. The Index goes up when the U.S. dollar gains "strength" when compared to other currencies.

The FHFA House Price Index (FHFA HPI®) is a comprehensive collection of public, freely available house price indexes that measure changes in single-family home values based on data from all 50 states and over 400 American cities that extend back to the mid-1970s.

Import Price Index: The import price index measure price changes in goods or services purchased from abroad by U.S. residents (imports) and sold to foreign buyers (exports). The indexes are updated once a month by the Bureau of Labor Statistics (BLS) International Price Program (IPP).

ISM New Orders Index: ISM New Order Index shows the number of new orders from customers of manufacturing firms reported by survey respondents compared to the previous month. ISM Employment Index: The ISM Manufacturing Employment Index is a component of the Manufacturing Purchasing Managers Index and reflects employment changes from industrial companies.

ISM Inventories Index: The ISM manufacturing index is a composite index that gives equal weighting to new orders, production, employment, supplier deliveries, and inventories.

ISM Production Index: The ISM manufacturing index or PMI measures the change in production levels across the U.S. economy from month to month.

ISM Services PMI Index: The Institute of Supply Management (ISM) Non-Manufacturing Purchasing Managers' Index (PMI) (also known as the ISM Services PMI) report on Business, a composite index is calculated as an indicator of the overall economic condition for the non-manufacturing sector.

Consumer Price Index (CPI) A consumer price index is a price index, the price of a weighted average market basket of consumer goods and services purchased by households. Changes in measured CPI track changes in prices over time.

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The NAHB/Wells Fargo Housing Opportunity Index (HOI) for a given area is defined as the share of homes sold in that area that would have been affordable to a family earning the local median income, based on standard mortgage underwriting criteria.

The S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index measures the change in the value of the U.S. residential housing market by tracking the purchase prices of single-family homes.

The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index seeks to measures the value of residential real estate in 20 major U.S. metropolitan.

Source: FactSet, data as of 7/7/2023