Several weeks ago, I wrote a commentary called Funny Times in which I bemoaned the complete lack of coherent data, making the process of predicting the course of interest rates, cap rates and transactional velocity over the next couple of quarters awfully hard. This uncertainty, itself, contributes to a knock-on doom cycle sort of way to depressed animal spirits and transactional activity.
The CliffsNotes version of my June commentary is that while the data looked like a splatter diagram, it was likely that interest rates would stay elevated in the short- to medium- term and that the future path of interest rates (most notably one-month SOFR and the five- and ten- year Treasuries, the key interest rates for the CRE lending business), were materially uncorrelated to the headline inflation rate and the presence or absence of the most widely forecasted and still elusive recession in recent memory.
The opinion of the commentariat is as muddled as the data. Some, an increasingly large some, have gotten the ball rolling on a victory dance for the Fed’s engineering of a soft landing. Low inflation and no recession certainly would be grounds for a party! Some, an increasingly smaller some, still worry that inflation is not dead and indeed considerably more durable than the optimists think and that the choice remains accepting a higher notion of baseline inflation or triggering the long-predicted and continuously elusive recession. This is a not a debate between serious and credentialed, card-carrying members of the intellectual literati on the one side and the tinfoil-hatted, grassy knoll conspiracy fabulists on the other. There’s some of both in each camp.
There is plenty of conflicting data to be picked over by the participants in this mighty battle of the pontifical. Just for color:
- The chattering Fed heads are becoming more heterodox. There are soft landers and recession worrywarts there.
- The most recent CPI and PPI data is modestly encouraging, albeit hardly compelling. (People who are vastly more numeric than I have suggested that when one looks into the CPI and PPI indices and peels the onion, it would suggest that the headline numbers are overstating inflation and that material reductions are on offer rather soon.)
- Labor markets are cooling (maybe they’re not).
- Home buying continues to be suppressed. High interest rates or limited supply, or both?
- Paychecks grew last month. Consumer sentiment indicators continue to flash yellow.
- The Conference Board announced the 15th month of decrease in its economic index last month and said, “Elevated prices, tighter monetary policy, harder to get credit and reduced government spending are poised to dampen economic growth further.” They still see a recession in late Q3 through Q1 of 2024.
- Barr is fixing to significantly enhance capital across all banks with at least in excess of $100 billion in assets with full “global Basel III endgame changes”, which together with a continued application of CECL and pressure on NIM from the need to satisfy depositors with increasingly happy feet, are expected to depress bank lending. Net/net, banks are almost certain to be more conservative and lend less as the year goes on.
- GDP exceeded all expectations in Q3 and that much-feared recession seems no where in sight.
- Moody’s just announced downgrades of the bonds of ten significant banks, citing increasing stress to their balance sheets and increasing regulatory pressure.
- The Treasury yield curve inversion continues after more than a year.
- The Fed boosted the Fed fund rate last month for the 11th time by 25 bps and guidance suggests that while the Fed remains data-dependent and the end may be nigh, but nigh enough? Equities don’t seem to care.
It’s great fun to pontificate on all this. One of the joys of being a self-proclaimed talking head is that if you’re wrong, no one remembers and if you’re right, you get to endlessly remind everyone how brilliant, intuitive and insightful you are. Consequently, I’m happy to weigh in, and if I’m wrong, I’ll just shut up like all the other losers. But I will take this moment to remind myself and all my fellow nattering nabobs of certitude to remember that the lag between policy changes and actual economic performance remains of indeterminate length and indeterminate strength. The day of reckoning when all this comes home to roost is still in front of us.
Diving into the big muddy, my take remains that for CRE markets, much of the foregoing simply doesn’t matter. It’s largely noise (except, for sure, the regulatory jihad against the banks which will depress liquidity and depress asset values). Soft landing? Modest recession? I don’t see a set of circumstances which would lead me to conclude that the yield curve is likely to materially retrace the past year anytime in the near or even intermediate term. Saving CRE markets from the butcher’s bill and not enjoying our very own little crisis is simply not in the cards.
If you think inflation is stickier than not (I actually do), then the Fed’s going to continue to push up Fed funds or at least slow walk any sort of retreat. (If you think that interest rates have nothing to do with inflation, you indeed do qualify for your own tinfoil hat.)
If, on the other hand, a soft landing is indeed engineered and economic activity begins to accelerate, that will also substantially slow the pace at which Fed funds will begin its retreat. The only circumstance under which Fed funds can step down as rapidly as it had accelerated is if we experience an extraordinarily hard landing…a GFC 2.0. That’s blessedly unlikely and while it fixes our interest rate problem in an iceberg-trumps-deck chair sort of way, in that lies a completely different and equally unamiable set of issues for commercial real estate.
While contemplating higher for longer, we should remain somewhat comforted by the notion that for decades our economy worked just fine and the commercial real estate industry functioned just fine with a 5% Fed funds rate and a positively sloping yield curve. Look, if you look at Fed funds over the past 25 years or so, while there have been periods of stress where the Fed funds rate dropped precipitously, more often than not, Fed funds was closer to 5% (and sometimes more) than it was to the zero bound. We knew how to run the economy and grow CRE markets in those credit environments and we’ll do it again. Might Fed funds drop into the 3-4% range sometime over the next couple of years (note I said “a couple of years” here)? Sure. But it won’t approach the zero bound unless GFC 2.0 shows up. That means that the legacy book (anything originated prior to the 2020 run-up) will still be under considerable stress. Moreover, new transactional activity will still be dependent upon reconciliation between buyers and sellers as to the permanency of this interest rate environment…a thing will happen, but it’s a slow burn.
So, in some ways, both the pessimists and optimists are correct about our market. Market conditions will inevitably cause us to experience a period of significant strain as assets acquired in a low interest rate and low cap rate environment will simply not pencil. Note this is not just the office sector, which is the popular epicenter of current anxiety, but all sectors across the board. (Multifamily? Who knew?) Concomitantly, with constrained liquidity and pressure on asset values, many portfolio lenders, both banks and non-banks, will feel a compulsion to reduce their loan book and particularly their CRE loan book.
And the optimists are also right. The economy seems considerably more robust than could have been expected even many months ago, and the prospects of a soft landing are improving. A soft landing will facilitate more rapid reconciliation between buyers and sellers to the new normal but won’t fix our broken toys problem. A substantial sea of loans on life support will be at risk of default.
From an anecdotal point of view, this assessment of conditions is confirmed by our Global Finance practice which is getting considerably busier. The warehouse lending and fund formation businesses are alive and well. There’s life and love in the SASB space and in a miracle akin to finding Jesus’ profile on a piece of toast, the CRE CLO business is showing some life.
This is our new normal. In this new normal, assets are mispriced, liquidity is limited. But take heart, over the next several quarters, several galvanic forces will emerge or accelerate to create a reasonable level of transactional activity and get us all back to some semblance of business.
As Fed funds stabilize, and maybe even begin to drift lower, folks will again transact as uncertainty diminishes, even if its removal leaves a fairly dreary landscape. The gap between buy side and sell side will continue to shrink, as it always has done when fundamental interest conditions have stopped moving furiously, as the first mover risk of looking foolish ameliorates and folks begin to reconcile to the new normal. There is a ton of capital on the sidelines which simply needs to get deployed. This is particularly true of closed-end funds where investment periods are waning while managers continue to stare into the abyss of interest rate pain. Win one for the optimists.
Progressing along a very different path, but also producing enhanced transactional activity is the virtually inevitable wave of distressed debt and the need of distressed balance sheets to transact. In some respects, we’ve been in a phony war, reminiscent of 2008 (or 1939), where a strategy of hope that a restoration of tolerable interest rate conditions will occur magically, allowing us to avoid the butcher’s bill. Time’s running out on that forlorn hope. The lender community (including the capital markets and servicing community) appears disinclined to kick the can this time without considerable fresh equity. In many cases, the equity will not be available as it’s simply non-economic to provide it. Assets will change hands and assets will reprice. Remembering that there are no bad assets just bad pricing, the bad pricing we have right now needs to be washed out of the system. A distressed debt cycle will do that and it is certainly not entirely unappealing for those of us who sup at the well of transactional velocity.
So, while far short of a restoration of robust health, the CRE market and the CRE finance market, will, over the next six months, show enhanced activity when compared with the past year. Come on now, folks. It can be fun.
Here’s what you need to do.
- Jawbone those sellers; convince them that sub 4% cap rates ain’t coming back and the numbers are the numbers. So, if they want to transact, it’s time to get real. There are no bridges to the other side, merely piers to the middle of the deep and darkening lake.
- If you’re a balance sheet ladened with NPLs and performing but criticized assets, take the first loss, which is often the best loss, and get out.
- If you’re a balance sheet, consider a securitization using CRE CLO strategy as an exit as opposed to exposing pools of loans to the tender mercies of the bank open-bid marketplace. A sale of a pool of loans into a securitization vehicle with an acceptable B-buyer will allow derecognition, reduction of risk-based capital and provide the institution with the ability to buy the senior security from the transaction, thereby putting a great deal of the purchase price back to work with lower risk-based capital charges.
- If you’re a bank and no one has explained Reg Q, make someone do it. Credit risk transfers are alive and well and likely to grow exponentially over the next 6 months. With a little bit of regulatory help, credit linked notes will become a fantastic means of repairing balance sheets. Credit risk transfer will begin to be a quotidian feature of the financial landscape.
- Embrace your inner workout competencies. Workouts do not always lead to bad outcomes. If you’re a lender, in many cases it’s probably your asset already.
- Whether you’re a buyer or seller, think about NPL securitizations. The technology is with us. The ratings agencies are reconfirming criteria and there are a lot of folks who are thinking about using this to poke at the midden heap of distressed debt. It’s going to be a thing.
- If you’re a portfolio lender, and your borrowers can’t step up with a significant infusion of additional equity, get to your remedies and move on. This time, time won’t fix it.
In any event, transaction velocity is set to increase. Embrace your valiant warrior self. The confluence of brains, capital and conviction will out. That’s something to look forward to.