Summary

In the aftermath of the pandemic and the troubles faced by several regional banks last year, investors are on edge concerning unexpected losses on property loans, as well as a major step-up in provisioning in the commercial real estate (CRE) book for New York Community Bank (NYCB).  

In this episode of The Navigator podcast, Andrzej Skiba and John Guarnera discuss our view on the recent trouble spots within the US CRE sector and how we’re dealing with the turbulence. 

Key Points:

• It’s been an eventful start of the year and investors are concerned with the dynamics of the commercial real estate (CRE) sector.
• Occupancy is down and debt service is more expensive due to rising rates.
• Larger banks have been quick to address any asset deterioration, but smaller banks own 69% of the CRE debt.
• Periods of dislocation, in our judgement, can create the most interesting opportunities for fixed income investors, however careful credit selection is of paramount importance. 

Andrzej

Andrzej

Andrzej

John, can you give us your outline of the problem right now?

John

Sure. Let's think about it from a high-level perspective. So, there is 4.6 trillion worth of commercial real estate debt outstanding and both office and multifamily real estate account for about 24% each of total CRE debt outstanding within the banks. Banks hold about 38% of this CRE debt with the rest of it being held by life insurance companies, CMBS agency, etc.

As we think about the office space, it's helpful to think about the difference between owner occupied office and non-owner occupied because banks have both on their balance sheets. Owner occupied is an example of where it is based off of cash flow lending that is secured by real estate. So that could be something like a bakery that is that is underwritten based off of its cash flows, but it is secured by the actual building.

Non owner occupied is what we are focused on. And this is an office building where a loan is based on property valuation and ultimately looking for a takeout from some sort of refinancing or capital market transaction. Within the office space, the pressure that we've seen has come from changing occupancy and usage patterns following COVID. So, where we've seen case of hybrid working arrangements or work from home and usage spaces and usage needs have changed over time.

We're also dealing with a case of obsolete inventory where some of the office buildings that are out there are no longer usable in their current format. So, for example, they may have floor plate issues or they may have columns within the buildings, things that make them less desirable as properties. The other thing that we're dealing with in the office space is the impact of higher financing rates due to the higher interest rates.

This is putting pressure on debt service coverage ratios for many of the office owners that have debt financing within there. What may, it's helpful to think about what makes for an attractive property. So it's a combination of age, location, amenities and functionality. And as we think about this, 90% of office vacancies are confined to the bottom 30% of buildings that meet those various criterias.

So one study that we've seen out there is that for trophy office buildings, the occupancy rate right now is about 88% for what are deemed to be functional office buildings. The vacancy rate is I'm sorry, the occupancy rate is around 83%. And if you look at the rest of the population, the occupancy rate is around 79% for those buildings that are deemed to be less desirable.

You can't lump properties together and it comes down to not only do something between regions and cities and neighborhoods, but it's also building specifics. So you have the case where you could have two properties that are across the street from each other that are exhibiting very different dynamics within multifamily. This is less of an issue for most of the banks, but it still comes down to a case of geographic location and demographics and also rent control versus non non rent controlled buildings.

But again, this is really not much of an issue for most of the banks and the rates that we follow because the holdings, they are relatively small for banks. The issue that we've had is that coming out of Silicon Valley Bank and the failure that we saw there, there were a lot of questions surrounding the viability of these banks.

Questions about the stability of deposits, what their liquidity look like, asset quality, the strength of their capital bases. This has largely disappeared, although, as we saw with the case of NYCB. When something like this does happen, it does cause questions to reemerge and some confidence to erode in the space. So even though we've largely recovered from where we were last year, at this point in time, there's still a sense of fragile confidence that we have to be aware of when we think about the space.

Andrzej

So, John, it's been a roller coaster ride and not in a good way for many investors in the space. But now we have a lot more information about the issues at stake. So how big of a deal is office CRE to U.S. banks?

John

Yes, it was. The Federal Reserve puts statistics out there that says there's about 2.9 trillion worth of CRE loans amongst the U.S. banks. 2 trillion of this or 69% is confined to what are termed small banks and 0.9 trillion or 900 billion, which represents about 31% of the total is confined to the large banks. But it's really important about how we think about bank asset size and how these banks get classified.

So, the names that we follow really don't have nearly as much exposure to the office issue as some of these smaller banks that are well off of our radar. Some other ways to think about it is that banks that have more than 5 billion in commercial real estate loans, they actually represent the smallest percentage for commercial real estate as a percent of their overall capital.

One of the things that we like to think about is just what is an office portfolio look like for those names? For those names that we do follow. So, office loans as a percent of the total represents less than 4% of loans for all of the names that we follow. And in fact, most cases, it's less than 2%.

So, a relatively small percent of the overall loan portfolio as a percent of their overall capital, their 81 capital offices represent 32% or less. And in fact, most of these actually represent less than 15%. And why this is important, it's something that I'll talk about in just a second. But the portfolios tend to be very granular, both by geography and by tenant.

So it's very well spread out. And in 2027 and beyond, 35% of office loans mature. If you think about asset quality, which is something that we very much focus on for the banks in terms of in terms of their office portfolios. There's lots of headlines, but the reality is actually a little bit different. The banks have reserved about somewhere between 4% to 11% of their office portfolios and the assumptions that they're based on here are ones that were used based off of what they saw during the GFC and during the savings and loan crisis.

Banks are very well reserved against some of the issues that are out there. Now we've seen higher levels of criticized loans, but these are ones where banks are starting to assess what could potentially be problems. But doesn't necessarily represent loans that are actually not paying right now. The reality is, is that the number of delinquencies that we're seeing is actually quite low, although it is starting to creep up a little bit.

But the headlines where you see big percentage increases of office loans is more based off of an inflection from a very low starting point to begin with. The expectation is, is that we're going to see higher levels of nonperformance and charge offs going forward. But reserves feel adequate for right now. And the thing is, is that time is on the bank's side.

They have such adequate reserves right now and they generate such strong levels of earnings that they're going to be able to replenish any sort of deterioration that they have in those reserves going forward. The other thing is this from the ct1 perspective that I highlighted before, the level of bank of office loan exposures versus ct1 is quite low.

And what that would tell you is that in an absolute worst-case scenario, if all of their C if all of their office loans were charged off at one point in time, which is highly, highly unlikely, that the banks would still have plenty of capital to be able to operate efficiently. So based off that, we can see that we're comfortable with the large U.S. regional and money center banks that we have that are out there.

I guess investors would be keen to know is how is this reflected in our portfolios? Can you share views about our broad positioning within the bank space?

Andrzej

Sure. The first point worth highlighting here is that we like investments within financial space by historical standards. Financials are trading at pretty attractive levels. There have been many years were looking at opportunities within non-financial space compared to financial space, it was pretty evident that financials do not offer any interesting value or any interesting idiosyncratic stories that can help alpha generation within our portfolios.

That is not the case over the recent years. And we have seen a significant pickup in the amount of opportunities across financials. But from our perspective, the way we're implementing that in our portfolios, there are clearly geographical differences. For U.S. banks, we particularly favor senior bank debt that is trading wide of non-financial. While I mentioned that historically that has not been the case and there have been only rare periods when financial spreads have been trading at levels that exceed the dose of non-financials, we want to take advantage of that in the current environment and we think the risk reward within senior U.S. bank debt is the best for investors across the U.S. fixed income spectrum. When it comes to European banks, we actually prefer more of a barbell approach where yes, we also like senior that opportunities and reflect that within our strategies. But at the same time, we also like subordinated debt and for those strategies that can participate in the cocoa at Erewhon market, we actually like valuations close to high single digit yields for systemically important national champions.

The one space we underweight is within tier two. That in Europe because we preferred the risk reward at the senior and cocoa levels within that universe. At the same time, it's worth highlighting that we have limited exposure to banks in Asia and in Australia, mainly on valuation grounds. We also tend to avoid emerging market banks because in current markets they actually trading at yields that are quite similar to those of developed market institutions.

And we just think that the risk reward and liquidity is better within the developed market opportunity set like Europe or especially the U.S. So, when we're looking at what we can see as attractive opportunities across our portfolios, actually it's not just the story about banks. We're getting questions from our clients as well about other ways commercial real estate could impact portfolios and asking whether they're interesting opportunities that as well.

Andrzej

So that brings me, John, to a question about rates. What is your perspective if on the REIT space and office REITs in particular?

John

So, REITs is a space where it occupies 2% of total CRE debt outstanding and office rates are a small subset of that. The overall issue for Reed's is relatively small compared to what we were talking about for banks. But for rates, it's many of the same dynamics. It's all about property level distinctions. And so, you have to have attractive locations, both geographically, in terms of places where you've seen population inflows and neighborhoods that are in demand and close to transit centers.

You need to have high quality properties. The rates in general, while their portfolios may be less diversified than we see for many bank portfolios that have exposure to the office space. These are concentrated usually in the best assets and in the best locations. Some of the trends that we've been seeing in the office space for the rates that we cover is that we've seen a trend of large corporate clients.

They're actually scaling down their size due to changing usage patterns coming out of the COVID pandemic. But at the same point in time, you're seeing move ups from tenants that were previously in Class B or Class C type properties and taking advantage of space opportunities to move into Class A, properties that have better amenities. You're seeing within the class space, you're seeing positive net absorption, which is something that I think surprises a lot of people given then the negative headlines that are out there.

And you're also seeing the fact that class AA buildings, those with the best amenities and in the best locations, they're the beneficiaries right now of limited new supply because the inflationary impact has made the possibility of building new office towers to be very unattractive. So those buildings that represent good locations with good amenities, they're very much in demand.

One of the positive things that's emerged over the last six months is we've seen that the capital markets have been more accommodating to some of these office rates. And so, we've seen many of them be able to come and tap the unsecured debt markets. In addition to that, we've seen banks extend unsecured term loans and just the ability to go ahead and address some of their debt pending debt maturities has really allowed these banks the opportunity to extend out their debt maturity schedule, even though it's come at a higher cost.

So now that we've covered the the bulk of the space, it might be worth spending some time talking about specific investment strategies that we deploy, especially during periods of dislocation. Andre, how would you describe our approach?

Andrzej

I think you spot on that it's periods of dislocation that, in our opinion, create the most interesting opportunities for fixed income investors, like in recent times. That was to do with the headlines regarding NYCB. But over the recent quarters we targeted times when U.S. banks and regional banks in particular were deeply impacted by the headline risk within the space and negative investor sentiment during those periods.

Those were the times when adding to risk exposure for banks where we are comfortable with their fundamentals has proven to be the best trading strategy because the market soon afterwards realized a comparative strength of institutions within the space and some of the spread widening that would initially ensue would be reversed. But our choice of banks to add exposure to during those periods was clearly driven by bottom-up work.

When we wanted to focus on those banks with strong deposit dynamics, with limited exposure to commercial real estate, and also those with no issues to do with securities within their investment portfolios, as was a major headache for the markets about a year ago. So we waiting for those periods of dislocation and we very selectively add to our exposure to impacted banks.

And in the case of regionals, we look at those that trade at a significant discount to money center banks. And as you can imagine, as the market calms down and the spread differential between the two narrows, we book profits on those traits. We also see opportunities during periods of dislocation for rates and real estate service companies. However, what we would like to stress is that those issuers tend to be in the high yield market or within the crossover space in between investment grade and high yields.

And in that way, we find those better suited for high yield portfolios because they tend to be more volatile. But at the same time, they offer more interesting spread opportunities for investors within the space. And for a lot of these issuers, especially within the real estate service space, we like the fact that these are asset light businesses with no meaningful cash flow use needs so they can weather the storms in a pretty good shape.

However, they're not immune from the broader secular issues within the space, and that is the reason why you want to wait for the periods when spreads become more attractive to express a constructive view on such names. So as we're looking ahead, John, what would be your advice for investors focused on this space in terms of where should they pay particular attention and what kind of data points they should evaluate when making decisions about investments over the months ahead.

John

The devil is in the details here. And the details are in the data that is going to be released for the banks. As we look forward, some of the things that we're going to be looking at are going to include the need for further reserves against their office portfolios. We would like to we would like to get better details in terms of some of the assumptions driving those reserving practices.

We're looking for more details around delinquency roll rates. And so, loans that are transitioning from being criticized into actual non-performing or delinquent in terms of paying and as those roll through to charge offs, we'll also be looking for color commentary from management teams in terms of what are they seeing within their individual portfolios and any emerging trends that we need to be aware of.

Some of the stuff that we'll consider is absorption rates and any changes in terms of lease rate trends. We like to look for and listen for anecdotal pipeline information in terms of showings and letters of intent, as this shows any potential emerging demand for new space. And we'll also be looking to see occupancy trends and to see how these are holding up over time.

I think all of these help make decisions on a bottom up level. But as an analyst, I often see markets driven by macro forces that drive volatility beyond name specific issues. Andre How do we manage that at the portfolio level? What can we tell our clients and prospects about our top-down investment style?

Andrzej

Look, I think it's important to stress before talking about the top-down investment style and micro considerations, that bottom up is the most important part of our analysis. There is a world of a difference between an issue that is in a strong position to weather secular storms and those that are vulnerable, and no macro support will be sufficient to offset some of the inherent idiosyncratic weaknesses.

So, from our perspective, active issuer selection is absolutely key, and we passionately believe that it requires in-depth research and ongoing engagement with management teams. This is definitely not a market where you want to settle for passive exposures. This is a market where you have to make clear distinction between the haves and have nots as the outcomes are so binary.

But it is true that we need to respect the broader macro backdrop. And for us in these days, that is very much to do with Fed policy in the US. As you can imagine, Fed interest rate cuts when they start happening are expected to bring relief to the broader office and commercial real estate space. We would expect a positive market reaction within those sectors to rate cuts ensuing and continuing throughout this year and beyond.

But we also know that those rate cuts would not be a panacea for all of the structural problems that this sector has. So for the weaker issuers, we would not want to be tempted by a better macro backdrop ahead to gain exposure to vulnerable issuers. And we would more look at the macro tailwinds from the monetary policy side as a way to add to exposure to stronger issuers.

Those we already had confidence in. Well, at this point we think we covered so much ground that we just want to say that it was a pleasure to share our insights with you all today. Thank you to our listeners for tuning into this episode of The Navigator. It sounds like it will certainly be another eventful year ahead, so please make sure to look out for our next episodes.

Thank you very much.

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