Dave:
Everyone, welcome to On the Market. I’m your host, Dave Meyer, joined today by James Dainard. And this might be a pretty special day, James. We just saw that the Fed raised interest rates 25 basis points, but they are signaling that this might be the end of the tightening cycle. What do you think?

James:
Well, I’m not happy that we’re sitting at 5%, but I am happy because the increase is under control. I feel like it always makes the market so emotional, whereas we just need to get back to stability. So it’s like, “Get to where they want to be, kind of grow off off there.” But I will say, though, they didn’t tell us the truth. 12 months ago, he was saying that the high was going to be what? 4? 3.75 to 4? Was that what it was?

Dave:
Oh, yeah. But they’ve upped it, little by little, every month. They’re like, “It’s going up. It’s going up. It’s going up.” But I think this is the first time they haven’t said that there’s going to be future rate hikes, in over a year.

James:
One thing, though. I don’t trust what the Fed says or doesn’t say anymore. So we’ll see what happens.

Dave:
Yeah, that’s a good point. But I mean, I think a lot of people have been calling for a pause now for a while. They’ve said that they’re going to pause. Obviously, if inflation stays high, they’re going to reconsider. But to me, this is what I would do, is sort of take a break. And if I had a vote on the Fed, which I most certainly do not, I would say, “Take a break, and see what happens,” because there are signs that the labor market is starting to crack a little bit. Obviously, there’s been bank crisis, so to me, it doesn’t hurt to wait couple months and see what happens and reassess, than hiking at every single meeting. And they meet every six to eight weeks.

James:
Yeah, it’s just getting to stability. It’s going to be so important because we’re all on pins and needles every time he’s coming out. And it’s not like that they haven’t had the negative impacts. I mean, we have seen some banks fail. We have seen housing come down a little bit. And in the labor market, hopefully that breaks more because that has just still been the… I know it’s still tough for us, as business operators.

Dave:
Yeah, for sure. Well, we are recording this, obviously, early. This episode drops on the 15th of May. We are recording this on May 3rd. So in subsequent episodes, we will cover more… Maybe we already have… cover more sort of the fallout of this decision. But I was just excited and wanted to talk to you about it. But we have an incredible episode today. I mean, all of them are my favorite, but this was one I learned so much from, something I absolutely don’t know enough about. But maybe after today, I know a little know bit more. Today we have Rich Hill, who’s the senior vice president and head of real estate research and strategy for Cohen & Steers. And his expertise is all about commercial real estate and debt. And he just dropped some knowledge on us, James. What did you think of this interview?

James:
Oh, he’s definitely an expert. That is for sure. This was one of my favorite episodes we’ve done. There’s so much clarity in this, with the amount of hype behind what’s going to happen in the commercial real estate market and the banking. And some of the clarity he provided with me, it kind of blew me away. Like, “Oh, yeah, those big stats they’re throwing out are just normal.”

Dave:
Absolutely, yeah.

James:
It was refreshing to hear all what he was talking about, and he is one smart dude.

Dave:
For sure. And the reason we brought Rich on is because there’s been so much media coverage about the commercial real estate market and potential defaults and bank crises, and it’s in the media a lot, and I get a ton of questions about this, but it’s not really my area of expertise. So we got Rich to come on to explain to us what is really going on. And, spoiler alert, it’s not always exactly what the media says. But Rich provides some incredible data and information about what’s actually going on in the commercial real estate mortgage market, debt markets, and provides some ideas for opportunities he sees in the commercial real estate space as well. So we’re going to take a quick break, and then we’ll welcome on Rich to talk about the commercial real estate mortgage market.
Rich Hill, welcome to On the Market. Thank you for being here.

Rich:
Yeah, thanks for having me.

Dave:
Can we start by having you introduce yourself? And just tell us a little bit about how you got into real estate and all of the research topics we’re going to talk about today.

Rich:
Yeah. Good God, I don’t think anyone’s asked me that before. Where do I start? So, look, my name is Richard Hill. I’m head of commercial real estate research and strategy at Cohen & Steers. Cohen & Steers was founded in 1986 as the first manager to manage listed real estate. We now manage around $80 billion. About half of that is in listed real estate, and the other half of that is in other real assets, including private real estate.
So how did I get in commercial real estate? Well, look, I grew up in a real estate family, and my dad was a mall manager. I usually joke that that means he’s like one step up from the janitor. I had no desire to get back in commercial real estate after graduating undergrad, but ended up getting back into it, working on a interest rate derivatives desk, hedging commercial real estate developer and home builders’ interest rate exposure. Fast-forward, I joined a debt capital markets team. Did that until my services were no longer needed, in 2008. Was told that I had a couple months to look for a job. Went to work for myself, did some consulting in the Middle East. Figured out that was really hard. And someone was looking for a research analyst in around 2010. You couldn’t find someone that was more non-traditional than me because I had never been one before, but I became a research analyst focused on the debt markets, then [inaudible 00:06:15] REIT equity markets. And here I am today.
So hopefully, that’s a really quick Cliff Notes version that gives you an overview of sort of, maybe who you’re talking to today.

Dave:
Awesome. Well, you did plenty to qualify yourself for the questions that James and I have in store for you, because they’re all about commercial real estate, and a lot of them are about debt. So let’s just start at the highest level. There’s obviously a lot of media focus on the commercial real estate debt market and what’s going on. But can you give us your read on the overall commercial debt market?

Rich:
Yeah, well, so maybe I can start here, and I can size up the commercial real estate market for you because I think there’s a lot of misconceptions about what it is and what it isn’t. We think it’s almost a $21 trillion market in the United States. People immediately think of office or retail, multifamily, and industrial. I get it, because that’s where they live. That’s where they work. That’s where they shop, and that’s where they get their goods from Amazon. It’s things that people really understand. But believe it or not, that’s not the entirety of the commercial real estate market. There’s things like data centers and cell towers and single-family rental and seniors’ housing. So it’s a pretty diverse ecosystem of different property types, all under the same umbrella.
But I sort of like to describe it, it’s sort of like when I go into my kindergartner’s class, and they’re all running in different directions at the different times. So while commercial real estate gets a bad rap right now, there’s certainly subsectors of commercial real estate that are doing quite well. Senior housing is booming right now. Office is not doing so well. So my only point to you is, it’s easy to fixate on the office market, and I’m sure we’ll come back to that, but that is not the totality of the commercial real estate market.

Dave:
So, given what you just said, Rich, about how diverse it is, it unreasonable to ask you to give us an overall risk assessment in the market? Or if you could focus in, our audience is mostly focused on multifamily, but there are also people interested in retail and office space. I’m sure there’s some other ones, but those are probably the three biggest.

Rich:
Yeah, so maybe I can explain it this way. If we were having this conversation six to seven months ago, I would’ve been telling you a similar story to what I’m telling you today, but I would’ve said, “Hey, look, I’m pretty concerned about commercial real estate.” So I probably would’ve put myself at maybe a 7 or 8 out of 10 on concern. And so, why would I have been concerned? Well, seven months ago, I would’ve told you commercial real estate valuations are going to be down 10 to 20%. Certainly the 10% is likely off the table right now, and we think valuations are going to be down more like 20 to 25. But I actually would consider myself more like a 5 or 6 on the risk scale right now. Why is that the case?
Well, it’s because the whole market has gone student body left for the bearish narrative, and suddenly, a pragmatic, objective view on the risks and maybe some of the good parts of commercial real estate suddenly look ultra bullish, and maybe even, dare I say, puppy dogs and rainbows. So I think there’s just some misconceptions, and maybe the truth is a little bit in the middle. I don’t think the world is coming to an end. I don’t think the next shoe to drop is the thing that everyone says is the next shoe to drop. So I’m happy to dig in there, but I would tell you that I was pretty cautious seven to eight months ago. Things have gotten worse since then, but I actually feel like we’re in a better position now, given how bearish the debate has turned.

James:
Yeah, and I’m glad you brought that up, because that’s all you hear the last 60… no, the last 90 to 120 days, is the commercial real estate market is going into the deep end, and it is going to just explode and melt down. We’ve been investing up in Pacific Northwest for the last 15 to 20 years. It’s like every time you are expecting the bad thing to happen, and everyone’s talking about it, it almost never happens. And then, something randomly out of left field just comes and kind of hits you out of nowhere. And so I feel like the narratives are really, really aggressive because some of that narrative I’ve read is some valuations will go 40 to 50% down, is what people are projecting. Why are you guys looking at the 20 to 25%, which is still a very aggressive correction, but why are you guys kind of in the middle compared to some of the other valuations that people are talking about?

Rich:
Yeah. Well, let’s, first and foremost, talk about the 40 to 50 valuation that’s being thrown out there. I think there’s a really bad game of telephone occurring. So if someone gets one headline, and someone else picks it up without fact-checking it, and then it, just like three weeks later, been extrapolated out to mean something else. What you’re hearing is that coastal office property valuations could be down 40 to 50%. Is that reasonable? I don’t know. Maybe. Coastal REITs are down 50% right now from their peaks. So it’s not that crazy. But let’s game theory this out a little bit. When you suddenly say all office in the United States is going to be down 40 to 50, that’s a huge number, and I don’t think people actually understand what that means.
For office to be down 40 to 50% on average across the United States, that means something like San Francisco probably has to be down 80% because guess what? Nashville, Tennessee’s not going to be down 50%. It’s going to be down 10%, 15%, 20%. So the law of averages, to get to 40, 50% nationwide for office, that’s a really, really draconian scenario for major coastal markets. Never mind that across the nation, valuations aren’t going to be down 40 to 50. During the GFC, we were down 30%. This is not nearly as bad as the GFC. During the S&L crisis, we were down like 32%. This is not as bad as the S&L crisis. So how are we coming to 20 to 25? Look, I don’t have a crystal ball, but we do try to triangulate across a lot of different sources. We’re a big believer that REITs are a leading indicator for the commercial real estate market. REITs were down 25% in 2022. They were down almost 35% at their troughs in 2022. So 25% feels like an okay number relative to what the REITs are pricing in.
But what we also spend a lot of time on is a cash-on-cash return analysis. So, that’s basically taken into account my economic cap rate… So that’s your nominal cap rate after adjusting for capex spend… how much leverage I can get on it, and my cost of debt. Guess what? Economic cap rates are still relatively tight, relative to financing costs that have risen significantly. So my cash-on-cash return is well below historical averages. If I need to get it back up to the historical average, property valuations have to be down 20 and 25% on average. I don’t want to get too wonky here, but that’s just math. It’s just levered return math.
And so when we think about what cash-on-cash returns are telling us, what the REIT market’s telling us, and, by the way, what the private market indices are already starting to tell us, and I’m happy to unpack that for you, 20 to 25 doesn’t feel unreasonable. Now, a year from now, if you come back, and you say, “Hey, Rich, it was 27” or “It was 17,” I’m just not that smart. I think we’re directionally right. We’ll let the markets figure out if it’s 17 or 27 or 22.

Dave:
And is that across all asset classes within commercial real estate, or you think there’ll be some variance between assets?

Rich:
Oh, huge variance between asset types. That is a generic 18 subsectors that fall under commercial real estate. We think they’re going to be, on average, down 20 to 25. You mentioned multifamily is an important asset class. That’s going to hold up generically better than, let’s say, office. Multifamily fundamentals are in strong footing. Industrials are on strong footing. What multifamily’s dealing with has very little to do with the fundamental side of the equation. It has everything to do with the repricing of financing costs, and cap rates were below 4% two years ago. That is well below where financing costs are. So you have negative leverage. You’re just repricing to where the new normal is for interest rates. And again, happy to break that down, but I would not be surprised to see multifamily down, call it 10 to 15 percentage points, whereas office could be down substantially more than that, but it’s on average 20 to 25. There will be some property types that do quite well. There will be some property types that don’t do as well.

James:
Yeah, and I think that’s the problem with the narrative, is they’re lumping everything into one big pond of saying that commercial real estate banking can melt down, but then the multifamily asset class that is actually seeming to stay fairly strong besides cap rate compressions, and then office is getting put in the mix. And so that’s kind of where the negative… I saw there’s like $4.5 trillion in US back and multifamily commercial. It’s like when they go over all these stats in the media, they’re always jamming it all together. Have you guys broken out the difference between multifamily and office debt, and what’s coming due-

Rich:
Yeah.

James:
… and what that’s going to look like over the next 12 to 24 months?

Rich:
Yeah, yeah. So, we have. We spent a lot of time on this. And basically, [inaudible 00:16:22] me hitting my head up against a wall for two weeks straight, trying to figure out fact from fiction. Let me give you some numbers. Well, before I go there, we think the commercial mortgage market in the United States is around $4.5 trillion. There’s another half a trillion dollars of construction loans out there. So you get to around $5 trillion of total commercial mortgages. Sometimes you will hear a number of like 5.5 trillion thrown out there. That includes owner-occupied properties. So what’s an owner-occupied property? That’s like Amazon owning its own industrial facility and putting a mortgage on it. That has a much, much different risk profile than traditional commercial real estate. We don’t include that.
Sometimes you’ll actually hear a number much smaller than that, and that’s focused on banks. And I want to come back there for a second, but let’s just focus on the 4.5 trillion for a second. You’ve heard about this huge wall of maturities that are coming. The media loves to talk about this huge wall of maturities, that 40% of all commercial mortgage loans outstanding are coming due over the next three years. That’s sort of true. So let me give you the facts here. 16% of commercial mortgage loans are coming due in 2023. 14% are coming due in 2024, and 12% are coming due in 2025. I think you sum that up, that’s like 41 or 42%.
When I hear someone saying that, “Oh, my God, the sky’s falling. 40% of all commercial real estate loans are coming due over the next three years,” I laugh. And the reason I laugh is not because I’m flippant, but commercial mortgages have a seven-year wall. That means, by definition, 15% of all loans come due every single year, forever and always. I’ve been doing this 22 years. There’s 40% of all loans coming due for the next three years as long as they studied the market. That’s just the way that’s it is. So it’s not a wall of maturities. It’s just what happens. So I love to say it because it’s like when you think about it that way, it’s like, “Oh, my God,” Captain Obvious stuff.
The second point I would make to you is that everyone’s talking about office. So of the 16% of loans coming due, 25% of those are office. That sounds like a big number, guys, but I’m telling you, 4% of commercial mortgages are office loans coming due in 2023. That’s nothing. That’s not very big. And by the way, office is less than 20% of commercial mortgage exposure. Multifamily is actually almost more than 40% of commercial mortgage exposure. But multifamily benefits from GSEs. The GSEs, Fannie Mae, Freddie Mac, they’re there to support the housing market. And I don’t want to come back and say there’s not going to be challenges with multifamily. I’m happy to unpack what that actually means. James, you bring up these great questions. There’s all these facts being thrown around, and they’re half truths, and in the game telephone, it ends up being this lowest common denominator of who can be the most bearish. But it doesn’t really tell the whole story of what’s going on.

Dave:
I mean, there there’s concern, but this is why your concern level has gone down over the last six to nine months. Is that why?

Rich:
Yeah, look. We’ve done a little bit more work. Our views are a little bit more nuanced. And at the same time, everyone’s writing a story about how bad commercial real estate is. You guys might have heard that office is a problem, and there’s a lot of debt on commercial real estate. There’s probably been five stories written about how bad commercial real estate is in the 15 minutes we’ve been talking. It’s like a, “Me, me, me, me.” Everyone needs to write the story. Ironically, the more stories I hear and the worse the narrative becomes, I think we’re closer to the end than beginning. As an investor, I actually want to see these peak level takes. That tells me that it’s actually a time to buy.
Give you just maybe a quick anecdote here, but the equity markets and the fixed-income markets do a really good job of understanding this concept of “Buy low, sell high.” The real estate market does a exceptionally poor job of that. Everyone wants to buy everything when it feels really, really good, late cycle, and everyone wants to sell everything when it feels really bad, early cycle. It doesn’t make any sense. We’re actually beginning to approach a period of time where I think this is one of the most attractive entry points I’ve seen in my career. We’re not there yet, mind you. But look, property valuations are down 10 to 15 percentage points right now. You can look at the NCREIF ODCE Index, which is a widely followed index of core open-ended funds. All the other private indices are down 10 to 15. We’re all there right now. This is happening in front of us.
And I think people just need to understand that the grieving process, if you will, is moving much faster. We were in denial three months ago. We’re certainly not in denial anymore. We’re probably in an anger stage, but we’re quickly moving to acceptance. And I do think this is going to create a pretty big entry point. So why am I less bearish? I don’t think I’m less bearish fundamentally, but relative to where the narrative has gone, I suddenly feel like the guy out there that’s big bull.

Dave:
I wonder if some of the bearishness and the recent focus on this is due to the banking crisis with very different types of banks. Do you think people are just looking at the banking industry and now projecting these cataclysmic events?

Rich:
Oh, for sure.

Dave:
Even if they’re unrelated.

Rich:
Well, I do think they’re related. So-

Dave:
Oh, yeah. I mean, just commercial real estate and Silicon Valley Bank [inaudible 00:22:23].

Rich:
So, let’s break down what’s actually happening in the banking sector. So, the top 25 banks in the United States have very de minimus amounts of commercial real estate exposure. They have less than 4% exposure to commercial real estate as a percent of total assets. And their office exposure is tens of basis points. It’s really, really small. But this top 25 banks began pulling back on lending to commercial real estate 12 months ago, maybe even a little bit more than that. And as they started pulling back, regional community banks looked to take market share.
So, when I talk, the reason I lead with the top 25 banks is because the FDIC and the Fed classifies anything outside of a top 25 bank as a small bank. I didn’t know this stat a month ago, but do you know there’s more than 4,700 banks in the United States? That’s a lot. 4,700 banks. So it is true that these smaller banks have more exposure to commercial real estate. On average, it’s around 20% of total assets. And there are some small banks that have upwards of 50% exposure to commercial real estate. Some even have 70 to 80% exposure to commercial real estate. But I think the market assumes that there’s like 200 banks in the United States, and this exposure to commercial real estate is highly concentrated. It’s just not. It’s spread out across literally more than 4,700 banks across the United States. That diversity actually makes us feel a little bit better, assuming this doesn’t become a huge problem.
So I think people get scared about things that they can’t see and they can’t explain. And so you don’t know what the commercial real estate exposure looks like, what the lending looks like, what the property types are across all of these banks. It’s impossible to know. I’m not even sure the government, the FDIC, and the Fed can really monitor all of these banks in an efficient manner. I think it’s scary because we don’t know what’s out there. I do like to bring up this fact, though, because I think it’s important. You may have heard of the CMBS market, the commercial mortgage-backed security market. What a lot of people don’t remember is that the FDIC actually created this market in the aftermath of the S&L crisis. So they created this securitization vehicle to get small loans off of small bank balance sheets, and it was extremely successful. They actually used the technology again after the GFC. They issued a couple FDIC deals.
Our view is that if this small bank problem is bigger than we think it is… And I want to come back to why we don’t think it’s as big as people perceive it to be… I think they could use this technology again to help securitize and get small loans off of small bank balance sheets. No one’s talking about that, but I think it’s a really good point. But I do want to spend maybe a little bit of time talking about why we don’t think the risk to bank balance sheets is as big as maybe some of the media narrative suggests. So I just ask my next question? Or do you [inaudible 00:25:24]-

James:
[inaudible 00:25:24].

Dave:
James, were you going to ask a question? Because-

James:
Yeah.

Dave:
Rich, you can just go into it. Or James, why don’t you [inaudible 00:25:30]?

James:
Yeah, Rich, I have one little follow-up question with something you said. I just want to ask real quick. Rich, you had brought up that the 15 largest banks only have 4% of these real estate loans, these commercial loans, out there. And what we have seen over the last 48 to 36 months is a lot of investor activity because there was so much access to capital. These small banks were being very aggressive. I know we got very favorable terms out of a lot of them on what we were buying. What do you see happening to the market if these smaller banks are the ones that could have some potential issues there? What do you think’s going to happen to the access to capital? Because once capital can get locked up, that’s where we can see some market issues.

Rich:
Yeah.

James:
What are you guys forecasting? The requirements for getting loans, and moving forward as an investor to keep purchasing, what is that going to look like with these small banks? Because if they’re going to take a little bit of hit, they’re going to tighten all their guidelines dramatically.

Rich:
Yeah, so you’re asking the right question, and a really important question. The first point I want to make is that lending conditions were tightening prior to these banking headlines. We spent a lot of time looking at the Senior Loan Officer Opinion Survey, and you can see that lending standards were pretty tight in aggregate, and loan demand was beginning to fall off a cliff. Why is that important? Well, if you look at the correlations between the Senior Loan Officer Opinion Survey and property prices, they were highly correlated. And where you see the Senior Loan Officer Opinion Survey from a tightening lending standard, it actually looks like valuation should be down 20% right now.
We fully expect that lending standards are going to tighten more. So if your average LTB was 50 to 55%, and I recognize some small banks were giving more leverage than that, they’re going to tighten from there. But I think it’s a little bit different than what the market thinks. It’s not like lending standards are suddenly going to 30 or 40% LTB. Banks are just going to be a lot more selective as to who they lend to. And I think it’s going to end up being a binary outcome. You can still get loans on a high-quality office property right now. It has to be a high-quality property, and you have to be a good sponsor. If it’s a low-quality property of any type, good luck with that. So I think it’s got to become binary. You got to get financing, or you can’t get it. And so that’s where we think about tightening lending conditions. But mind you, look, banks are going to pull back.
Maybe one of the unintended consequences and the unintended bullish things that’s going to come out of this is non-bank lending. You’ve maybe seen some headlines. They’re not getting the attention, but you see all of these companies, smart companies, that are now beginning to move into commercial real estate lending, non-banks, private equity funds. We could end up seeing a five- to 10-year bull market for lending to commercial real estate in non-bank lenders if, in fact, banks pull back. We’ve seen it happen before in other asset classes. This might be one of the most attractive times to lend as a commercial real estate lender because financing costs are high, lending conditions are tight. And by the way, you can be super selective who you lend to. So I think you’re going to start to see it change, but I don’t think it’s suddenly going to be the bottom falls out. GSCs are still lending. Life insurance companies are still lending. Banks have pulled back. Non-bank lenders are there. It’s just not a wasteland like everyone thinks. It’s become a lot more selective than maybe the market perceives.

James:
Yeah, I think that’s the issue right now, is when you’re looking at deals, the money is there, but they’re requiring a little bit more money down. The debt service is a lot higher. And then properties in especially the commercial space aren’t occupied as much. So that’s where I think there could be the compression. Your cap rates and your cash-on-cash returns just drop dramatically.

Rich:
Well, that’s why valuations have to reprice. There’s just no ifs, ands, or buts about it. If cash-on-cash return went from, let’s say, 8 to 2, or maybe even negative at some points, that doesn’t work. You guys know that better than I do, as investors. I just write about things and let other people at Cohen & Steers invest in it. But you’re absolutely right. Property valuations have to reset because the returns don’t work right now.

Dave:
Richard, I want to get back to your question you asked yourself before. I have one follow-up question on this. You mentioned that REITs were down in a way that is sort of in line with what we’re saying, that things need to reprice to adjust to these changing conditions. Do you have any thoughts on why the private real estate market lags so far behind the public market?

Rich:
Yeah, a couple different reasons. Public markets get a mark on them every single minute of every single day that the stock market’s open. And believe it or not, the market’s fairly efficient. It reprices commercial real estate very quickly for all the reasons that we were just talking about, James. The market understands that levered returns, cash-on-cash returns, sort of suck. And so they say, “Well, I need to reprice the implied cap rate for REITs.” I’ll give you just a stat right now. REIT implied cap rates are around 5.7 right now. I can go out and buy very high-quality apartment REITs at 5.4 and 5.5 cap rates. These are super high-quality REITs, without naming names. The NCREIF ODCE Index still has their apartment cap rates marked at 3.8. That’s a huge difference. A huge, huge, huge difference.
So why is the private market lagging? It’s two reasons. The transaction market is non-existent right now because there’s such a bid/ask spread between buyers and sellers. Buyers don’t want to buy at the level sellers want to sell at because we’re still going through the grieving process. So when there’s no transparency on where properties are trading, you have to rely on appraisals, and appraisals are really hard. It’s not easy being an appraiser right now. They are slowly bringing back their property valuations because they’re recognizing that the financing costs are higher than where cap rates are, but it’s a slow-moving train.
This is playing out similarly to how we’ve seen every other single downturn, the property market, the listed market declines. It leads. By the way, when private markets start to decline, that’s usually the final leading indicator. That’s the time to buy REITs. It’s just a [inaudible 00:32:13] relationship. Public markets get a mark on them every minute of every hour of every day, and the private markets take time to correct. If you look at valuations between the two, the correlations between the two over a cycle are around 90%. They’re super, super high.

Dave:
Great. Thank you. All right. Let’s get back to your question. I think it was about mortgage exposure, right?

Rich:
Well, look, one of the things that’s really struck me over the past month, and I don’t mean this to be cynical or flippant at all, but what’s really struck me is the lack of maybe appreciation for what LTV means and the amount of cushion LTV provides to a bank. A couple comments here. Open-ended funds that own core commercial real estate have 22, 23% LTVs on current valuations. REITs have LTVs of around 34%. Your typical CMBS loan has LTVs around 50 to 55%. So let’s just use CMBS as an example. What does it mean that a loan has 50 to 55% LTV? That means the property valuation has to fall 45 to 50% before that loan takes a loss. I’m telling you that I think valuations are going to be down 20 to 25 on average. It’s a real significant decline to touch LTVs of around 50%, and I don’t think the market has a whole, great appreciation for what that means.
That doesn’t mean there’s not a problem here because, guess what? If you’re a borrower that bought a property in 2020 at peak valuations, you’re probably going to have to inject equity back into that property to refinance. If property valuations are down 20% from their peak, you have to inject 20% more equity. But let me take a step back because I still don’t think the market appreciates what this means. Property valuations are up 40% since the beginning of 2012. That means your LTV that was originally at 50% is now 33%, and that means that property valuations have to fall 70% for that loan to take a loss. Dave, the reason I think this is really important, and I’ll tie this back into multifamily, we actually think multifamily in aggregate is underlevered because not every property was financed in 2020, 2021, and 2022. There’s a lot of properties that were financed in 2012, ’13, ’14, and ’15, and they have LTVs, effective LTVs, less than 50%. So they can actually probably do cash-out refis right now, believe it or not.
I was re-underwriting loan, though, on a multifamily property yesterday. I’ll give you just a live example. This was a student housing property in Greenville, South Carolina. The property fundamentals are great. [inaudible 00:35:17] are higher. NOI’s higher. But the debt service costs have doubled over the past three years. And so suddenly to get your DSCR from 1 to 2, you have to pay down that loan by 50%. That’s a real example of, “Hey, look, there’s just too much leverage on this property.” The property worked fine when financing costs were at 5%, but they don’t work so well when LIBOR is where it is today and the spread’s at 4.50, so you’re closer to like 8, 9, 10% financing cost. That’s the real example where properties are just overlevered.
So I would argue to you that when the market thinks about the totality of this mortgage problem, as James said, it’s thinking about this and extrapolating. The problem is office. The problem is, to a lesser extent, hotel, and it’s some retail. It’s also properties that were financed, particularly with short-term floating rate debt, over the past three years. But that’s not the totality of the commercial real estate market. I think the totality of the commercial real estate market is underlevered, but there is some properties that probably need about $500 billion of new equity to refinance. That’s a lot. That’s a big number.

James:
Chump change. 500 million.

Rich:
Billion. 500 billion.

Dave:
I see you’re writing, James. Are you writing a check? Is that what you’re-

James:
I’ve been taking notes this whole time. This is extremely fascinating. So out of that 500 million that you’re seeing of liquidity that’s going to need to be brought to that asset class, over what time frame do you see that coming up? And then, what do you see as you’re forecasting down, right? Things that can substantially affect the market is a lack of liquidity. Right? If people all of a sudden have to pay a big bill, and they can’t pay it, there’s defaults.

Rich:
Yep.

James:
Where do you see, A, people coming up with this capital? Do you think there’s going to be secondary lenders now coming into the market to kind of bridge gap it? Or do you think it’s going to be one of those things where the banks are just going to go full steam ahead and try to close out the note?

Rich:
D, all of the above. So I know that’s a cop-out research answer, so let me explain to you what I actually mean by that. So your first question, how’s this going to play out? It’s going to play out over the next five to seven to 10 years. The idea that all of these loans are in trouble next year, that’s just actually wrong. A lot of the loans have pretty good DSCRs, especially if you had a fixed-rate loan. And as I mentioned to you at the very beginning, only 15% of loans are coming due in 2023. This exposure’s spread out pretty evenly over the next, call it five, six, seven years. That’s not great, but it actually is okay relative to how bearish the media has become.
So what are the solutions? I think there’s a lot of them. Some borrowers will find a way to refinance, particularly smaller borrowers. The second point I would make to you is there’s about $350 billion of dry powder on the sidelines that’s sitting in closed-end funds. Most of that’s opportunistic and value-add. I’m not suggesting all of that’s going to go to help recap borrowers, but there is a lot of money on the sidelines.
The third point is that some banks will modify and extend loans because they don’t want the keys back. And I do want to spend a little bit of time on this because there’s a really important point that no one’s spending time on. It’s the tax implications of defaulting on your loan. When you default on your loan and the basis in your property is less than the loan balance, the IRS considers that a sale back to the lender. And guess what? The IRS actually wants their money. So let’s assume you owned a property 20 years ago, and your basis is close to zero because you took all your depreciation, and you had a $50 million loan on it. It’s effectively a $50 million sale. There is a very real scenario where the tax consequences are equal to, if not greater, than the cash-in refinance that the bank’s going to require. Yet you don’t have anything to show for it. And this is a real issue for the smaller banks. Small borrowers don’t have that money. There is a real tax consequence for this.
So I think that ultimately means that there’s going to be a lot more structured solutions, a lot more loan modifications than the market thinks. And for some reason, the market’s not talking about this. But I’ll go out on a limb here. What are the odds that the IRS allows rich owners of commercial real estate to find a loophole by forcing the loans back to banks which are already in trouble, and the IRS doesn’t want their money? I would say that’s a very, very small probability. So, Dave, I can see you. I can see you. I don’t think the audience can see you. I see you somewhere between smirking and shocked and surprised, but I think it’s very real. And there’s some people that are a lot smarter than me… and, frankly, a lot wealthier than me… that are bringing this up to my attention, saying, “It’s not so easy just to default on your loan.”

Dave:
I didn’t even know that. James, did you? I’ve never even thought about that. That was my smirk. I was kind of just shocked. It’s really interesting.

Rich:
I think it’s called 1099-C. The bank will actually send you a 1099-C form when you default on your loan.

Dave:
Ah. Kicking someone when they’re down.

James:
Is that a similar call? I’ve remember back 2008 to 2010, tons of short sales going on, and then people were getting these 1099s for the gain on the property. And it was brutal. People were like, “I just got a tax bill, and I just got foreclosed and short sold my house.” That was a real thing that we saw every day. People were getting this stuff.

Rich:
Yep. It’s very real. And by the way, the IRS feels a little bit better for homeowners, so they’ve closed some of those issues in the GFC. They don’t feel bad for commercial real estate owners.

James:
Investors don’t deserve a break too?

Rich:
I’m going to plead the Fifth on that. The IRS does not think they do.

Dave:
All right. So, Rich, this has been fascinating. We do have to get out of here in a little bit, but I want to get back to something you said earlier about this being an attractive opportunity. You’ve said a lot about different asset classes, but what opportunities excite you the most in the coming year or two?

Rich:
Well, a lot of them. We think multifamily is intriguing here because the fundamentals are on sound footing. We happen to like listed apartments more than we like private apartments, although private apartments are resetting very quickly right now in terms of a cap rate. I think open-air shopping centers are very well-positioned right now and are trading at wider cap rates. I would even go as far to say, and I know this is taboo, but there’s some really attractive opportunities in the office sector, particularly in the private markets. The market is painting office with too broad of a brush and thinks everything is New York City or San Francisco office. That’s not the case. You can go to some Sun Belt markets and find office trading at attractive cap rates with really strong fundamentals.
So look, I don’t want to say that the opportunities are limitless, but there’s a lot of opportunities out there. I would go as far to say that heading into 2022, we were sitting here scratching our heads saying, “Stuff feels really expensive. What are we supposed to do?” Now we’re looking at things for the first time and saying, “This feels okay.” We’re actually getting back to decent levels. So look, mean, we like things like seniors’ housing, apartments, single-family rentals, also things like data centers and industrial. We’re picking our spots on the office sector. We’re probably a lot more cautious than we used to be on storage because fundamentals are weakening. But I do think that this is going to be a really big opportunity to pick up assets across the spectrum at levels that we haven’t seen in quite some time.
And what I would urge everyone to think about is be greedy when everyone else is scared. I know that’s cliche to say, but you’re not supposed to be buying stuff at the top of the market when everyone else is buying it. You’re actually supposed to be thinking about dipping your toes in now. So how do we think about it? Well, if you have three chips to play, play one of them right now because things are beginning to reprice. Play the second one at the depths of despair, and play the third one when it’s clear that you’ve missed the boat and the cheap opportunities are gone. That’s sort of the way we think about dollar cost averaging right now.

James:
I like that.

Dave:
I love that advice. Yeah, that’s a great way to put it.

James:
Yeah, three chips. My problem is that I like to throw the three chips in only when it’s in desperate and despair.

Rich:
Well, that’s why you’re on that side of the mike, and I’m on this side of the mike. I’ll leave it up to you if that’s a compliment or a back-handed compliment. It’s a compliment.

Dave:
All right, Rich. Well, thank you so much. This has been eye-opening, honestly. I learned so much today. I really appreciate you joining us. If people want to follow your work more, where can they do that?

Rich:
Yeah, you can just go to cohenandsteers.com. Pretty easy to spell. C-O-H-E-N and Steers, S-T-E-E-R-S dot-com. We have an Insights page. We publish there periodically. And anyone that wants to chat, I’m sure you can find my phone number or email someplace.

Dave:
All right. I have to ask, Rich, so it looks like you’re sitting in an office building right now, is that correct?

Rich:
Yep, I am.

Dave:
Are you in New York or where are you?

Rich:
Yeah, I’m in New York. I have been back in the office since August of 2020.

Dave:
So are you like by yourself in an empty office building right now? Are you the only one?

Rich:
No, man. So, that’s a fascinating question. Let me just give you a story. I have a wife and four kids. My wife and I try to steal away to New York City periodically. Even in the depths of COVID, when Midtown Manhattan was a ghost town, you Google “Downtown, West Village, Tribeca,” and it was like Mardi Gras. So this whole idea that New York City’s going to die, it’s not true. Midtown’s pretty bustling. I think high-quality office is in fine demand. The problem is the Class B and C stuff. It’s not in good shape right now. But I mean, I don’t know. I take a godly early train every morning, and it’s sometimes standing-room only. It’s like I’m not the only schmuck pedaling my way into New York City. Now, I recognize that’s not all of the United States, and there’s a lot of people that are different. But sadly, yes, I’m sitting in an office on Park Avenue with a lot of other people around me.

Dave:
Yeah, I’m actually from not far from New York City, so I grew up around there. I think there’s always been calls that New York City and all these markets are going to die, and it never seems to happen. Even though there is likely a correction, like you just said, I think there are still segments of the city that are probably thriving.

Rich:
Yeah, we could get really dorky about what happened after plague and what cities survived and what didn’t. And you actually want a really interesting story about how a city does die, look at Siena in Italy post-plague, and I’ll leave you with that, a pretty fascinating story about how one of the great cities of the world cannot survive post a radical change.

Dave:
Yeah, my data doesn’t go back to the plague, but I’ll check it.

Rich:
You don’t know what cap rates were then?

Dave:
No, no. For some reason, CoStar doesn’t have all the data back to Middle Ages Italy. All right. Well, we really appreciate you being here, and hopefully we’ll have you back again to see, once this has all played out a little bit.

Rich:
Yeah, you can tell me everything I got wrong. But thanks for having me, guys.

James:
Yes, good meeting you, Rich.

Rich:
Yeah, likewise.

Dave:
So, James, are we going to do an episode on the history of Siena after the plague? What do you think?

James:
I have written that down. I’m pretty sure as soon as we get off, I will be listening to some sort of podcast on that.

Dave:
Why don’t you just come over to Europe? I’ll meet you down there. We’ll go on a Bigger Pockets, On the Market exposé of what happened in Siena. We’ll eat some Italian food. It’ll be great.

James:
I’m a hundred percent in. I think what we should do is we take a layover in New York.

Dave:
Ooh, yeah.

James:
We grab dinner with Richard Hill. Let him explain it all to us.

Dave:
Let’s bring him.

James:
Yeah, we’ll bring him too.

Dave:
Yeah, we’ll bring him to Siena. We’re all going.

James:
That’s the plan. Yeah.

Dave:
But really, so what did you think of that episode in total? I mean, that was phenomenal.

James:
I feel like I just learned more about commercial banking, that in the short term, I’ve learned so much from what he was talking about and how thorough he could explain the positions, the data and the points, and really just always comes back to the same thing. These tidal waves of negative headlines are sometimes just… They’re not real. It’s just clickbait, and you really got to dig into the analytics and the data, and interpret it to make the right decisions as an investor. I think this was by far one of my favorite episodes I listened to.

Dave:
Totally. I saw you scribbling notes furiously, but-

James:
Yeah.

Dave:
I love what he was saying about the 15% of mortgages due every year, because it’s so interesting, and how he called the stats half-truths, because it is definitely true. He’s saying, “Yes, it is true that 40% of loans are coming due in the next three years, but that is not different than any other year.” There’s additional context that needs to be explained for you to fully understand what’s going on. And I think Rich did a really good job of breaking down what actually matters in this market. And so hopefully, everyone learned as much as James and I did here.

James:
This would be one to listen to twice, for sure.

Dave:
Definitely. I might be again. I mean, I thought that it was fascinating, and looking forward to some of those opportunities he was talking about. Man, I’m gun-shy on office. I’ve never invested in office, but I’d still be a little gun-shy. I was really interested in what he was talking about with the strong fundamentals for multifamily, industrial. What else did he say? Open-air shopping centers.

James:
Data centers are big.

Dave:
Data centers. Yeah. So-

James:
Yeah.

Dave:
And I also love what he was saying about the three chips, that thing. I really like that. I know it sound like you’re waiting to put them all in in the depths of despair, but I liked what he was saying about dollar cost averaging.

James:
No, I think that’s a smart plan. Play all markets. Right? I like to throw it all on black sometimes.

Dave:
All right. We’ll see how your chips play out. All right, James, thanks, man, for being here. We appreciate it. This was a fun one. I’m sure we’ll see you again soon. Thank you all for listening. We really appreciate you, and we’ll see you for the next episode of On The Market.
On The Market is created by me, Dave Meyer, and Caitlin Bennett, produced by Caitlin Bennett, editing by Joel Esparza and Onyx Media, researched by Puja Gendal. And a big thanks to the entire Bigger Pockets team. The content on the show On the Market are opinions only. All listeners should independently verify data points, opinions, and investment strategies.