Why do we bother talking about real estate at all? Well, real estate makes for about 35% of US households’ net wealth, and up to 55% for the ultra wealthy. So, this matters a lot.
Everybody and her sister has been talking about the property market stress by now, mostly inflicted by higher rates.
Commercial real estate, CRE for short, was recovering from the emptiness of the covid era, when it stumbled upon higher rates.
This has claimed the lives of the mightiest CRE colossus. Wework’s filing for bankruptcy this week is arguably the most vivid example. It is arguable, because Wework’s ambition to lock in long-term leases in prime business areas and offer hot desking at a fraction of the cost, plus perks, to startupers was a tough act in the first place.
There remains that Wework was commanding a large part of the stock of CRE leases in large cities (aka Traditional Square Feet Leased), of up to 35% in London, and 18% in NYC or Boston as per FY22 report.
In dollar terms, Wework accounted for $13.3bn of leases as of Jun23. Judging from its bankruptcy filing of $15bn of assets against $19bn liabilities at the company level, it is fair to say that some of its lessors are likely to be short-changed.
You might say it is an isolated example, but it somewhat reflects a growing unease in the CRE sector. The Fed report of Nov23 laid bare a sharp increase of defaults on CRE loans, with defaults on Office loans shooting up to ~5% in 2Q23 from ~1% in late 2022. Delinquencies also remain historically high in Retail and Hotels, as it proves difficult to completely normalize post covid trauma.
To be fair, the situation looks far better in the Multifamily and Industrial segments, reflecting pockets of strength in the US economy. Besides, defaults on loans remain at a ~1% low on average.
Banks will have to hope for this continuing strength. In the first 3 quarters they proactively provisioned for bad CRE loans. The fact that default rates are now concomitantly rising in CRE, auto loans and consumer credit will certainly test their resilience.
Regional banks are notoriously over-exposed on CRE, while their liquidity remains vulnerable. Deposits are close to a 1-year low, and liquid assets have come down from their 2021 peak.
As per the Fed “substantial declines in the fair value of securities are still a concern for banks facing liquidity constraints, which could force some of these banks to sell securities at a loss.” This sounds SVB-familiar.
Is the decaying credit quality of Financials priced in? After a peak-to-trough drop of 38%, US REITS seemed to bottom up at the end of Oct23. On the sentiment the Fed was done with rising interest rates, REITS rallied ~9% in a week. So did banks and small & midcap stocks. While REITS and regional banks have come back to long-term average, valuations still look rather lofty for small caps.
It is true that declining rates would give a massive tailwind to the interest-sensitive sectors, but for now the Fed policy stays restrictive. To me, a turning point will be the corporate refinancing walls of 1H24, which the Fed is certainly monitoring closely.
In the meantime, I’ll stay clear of weaker credit quality in regional banking or CRE, where more pain is bound to happen before the Fed changes course.
On average though, I see reasons for the rate-sensitive sectors to rally, and I buy it for long-term investors. However, there is a growing gap in credit quality within players. Whether for corporates, households, or in politics, I guess this is a sign of times.
Stay safe out there !
360 Advisory LLC is a Boston-based RIA managing investments