SEPTEMBER 25, 2023 – Most importantly, only 3 months to Christmas:) And I am sure you have seen all of the Christmas stuff in the stores already. Next year it will be out in July. Ridiculous.
Two more recession indicators are wrong this time around. The (Mis)Leading Economic Indicator has declined for 17 straight months. I assume its purpose is to forecast a recession to occur within a few months after several negative readings. It has been wrong for over a year. Maybe this is where the broken record (look it up youngsters) recession mongers get their reasoning for thinking a recession is about to occur. Just fyi, the only other times it had this long of a streak was 1973-1975 and 2007-2009. The two worst recessions since The Great Depression.
The third indicator that has been wrong is M-2 Money Supply. It is more negative than it was in The Great Depression! Yet, no recession. In fact, it is looking like 3rd Quarter GDP may show an acceleration in growth to over 2%. However, I will say that is not a lock as I have seen forecasts from 0.5% to over 5.5% (Fed Atlanta). This quarter will be very unpredictable. But, it should definitely be positive and thus we can officially close the case on there being no recession in 2023.
Let me bring something up for the first time. I think I will be harping on this for the next few years. I believe the reason many prominent indicators are wrong this go around is due to what has happened since the pandemic. Almost all indicators soared to extreme high readings never seen before. And many are falling to record lows. What I am seeing is if you draw a straight line from say 2010 or 2015 through 2023, these indicators are exactly where they should be. i.e. The lows are evening out the highs and overall we are reverting to the mean.
I saw this recently in national retail sales. Adjusted for inflation, retail sales have been flat for the past 18-24 months. However, they increased significantly after the pandemic. If you apply the 2010-2019 compound annual growth rate to 2019 sales, you will be exactly where we are at in 2023. I will discuss more examples and provide more specific information as I encounter graphs showing this occurrence.
FED FUND RATES – The Fed did what it was told to do and held rates the same in September. Also, they went ahead and said what the market has forecast for a long time and that is another rate hike lies ahead. The 100% trend of the Fed following the market continues.
HOUSING – As I noted in a prior blog, the market is signaling weakness in the housing market after forecasting the strength we have seen all year. The homebuilder stock index has declined 10% from its July top. We need to continue to watch this play out. It is telling us we should see weakness next Spring. What will slow the accelerating strength in the housing market? Maybe 8%+ rates on 30-year mortgages? About the only thing I can think of. But, it doesn’t matter. The market just says it will happen. The price trend in the 4th Quarter will tell us if the Spring slowdown is just that or the start of a more significant downturn like we had in the second half of 2022.
REGIONAL BANKS – These stocks have declined a significant 15% from their July highs. Basically, they declined some more after the SVP failure, then soared over 40%, and now down 15% – in the end, they have gone nowhere since the Monday after the SVP failure. What is the market telling us? It definitely says not to expect the 250-400+ bank failures that so many people are predicting. Those people expected such to occur by now, in fact. As far as I know, the number remains at one small bank in Kansas. In regard to CRE loans, banks have been refinancing these all year long at higher interest rates. I haven’t heard of any significant issues. The problems have occurred in the CMBS market – gotta hand it to the supposed smartest lenders and investors in real estate:)
INTEREST RATES – Treasury Bonds have broken below last October’s low. This means interest rates are at new highs for this downturn. As I write this, I see a headline saying they are at the highest level since 2007. However, we are now on the clock to look for a final bottom in this multi-year downturn in prices (increases in yields). That doesn’t mean it will occur next week. I am thinking it is several months away. Maybe around the beginning of the year. Too early to give a reasonable forecast re timing and price (yield). The 4th Quarter price action will get us much closer to predicting when the bottom is in. What should follow will be a strong bond rally back to the range of the Summer 2022 and April 2023 highs (lows in yields). First things first. Let’s have the current downturn play out and get a bottom in place. Bottomline, mortgage rates will not be going down the remainder of the year. And they might head over 8% on the 30-year mortgage.
Well, that was a lot to cover. I will probably post again once we get the October inflation reading.
Til then, Happy Fall.
Shalom,
The Mann
Tag Archives: CRE
CRE LOANS AND SMALL BANKS
AUGUST 23, 2023 – I will just give the link to an article on this subject. It supports my argument that CRE loans are not a worry for the overall banking industry. However, I am sure there are other articles with other data that suggest otherwise.
Between the stats in this article and my posts showing that higher interest rates can easily be absorbed as CRE loans are refinanced, there just isn’t solid evidence that 200+ banks are going to go under by yearend. Or even in 2024. The count is at one small bank in Kansas so far.
It looks like the ones being hurt by CRE loans this cycle are the so-call sophisticated investors – CMBS lenders and REITs. Apparently, they outsmarted themselves:)
https://www.washingtonpost.com/business/2023/08/14/no-small-banks-aren-t-holding-the-bag-on-half-empty-office-towers/87080ff4-3a92-11ee-aefd-40c039a855ba_story.html
Shalom,
The Mann
CRE LOAN REFINANCING – A REAL LIFE EXAMPLE
UPDATE – AUGUST 10, 2023 – I just came across some interesting information. Over the past decade, regional banks only had 18% of their loan originations backed by office properties – larger banks had 26%. They also originated a lower share in hotels, industrial, and retail properties. Regional banks had 47% of their volume in apartments compared to 29% for larger banks. The concern about regional bank loan portfolios being decimated by office building loans is obviously unfounded.
AUGUST 9, 2023 – In mid-June I posted about the so-called CRE loan debacle that lies ahead. I provided some hypothetical numbers that showed for the most part borrowers will have no problem with their refis.
I just reviewed an appraisal of an apartment property that I also reviewed 5 years ago when the borrower purchased the property. The bank was kind enough to provide me the loan details then and now. So, let’s see how the numbers work out.
2018 – A $633,000 loan was made against an $800,000 appraised value (purchase price was $840,000). The LTV was 79%. Annual Debt Service was $49,670 based on a 4.89% interest rate and 20-year amortization. The appraiser estimated NOI at $60,387. The DSCR was 1.22.
2023 – The outstanding loan balance is now $527,230. The current appraised value is $1,280,000. The new LTV is 41%(!). Annual Debt Service will be $49,814 based on a 7.20% interest rate and 20-year amortization. The appraiser estimates NOI at $97,474. The new DSCR is 1.96(!). ((I was curious what interest rate would make the Annual Debt Service result in the same 1.22 DSCR as when the original loan was made. It is 14.27%! I shout to the moon that everyone can easily afford 7%+ interest rates!!! Wake me up when we hit 14%:) ))
This will be the case with most apartment and industrial loans. Net Operating Income has increased significantly more than Annual Debt Service. Higher interest rates of 200-300bp will not be a problem for borrowers.
As I noted in my June post, office and retail property loans probably will run into issues. I also think the above is more applicable to income-producing property loans than owner-occupied property loans.
As I write this, regional bank stocks are up 38% from their lows a few months ago. The market is telling us it has no concerns about CRE loans. I believe the market over the economists and pundits that are a broken record about CRE loan and a recession.
Shalom,
The Mann
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Addenda – In the real-world example above, I kept the refinancing at the current outstanding balance. The borrower is actually getting new monies and refinancing $800,000. The Annual Debt Service will be $75,586. The resulting LTV is 63% and DSCR is 1.29. Even with a significant increase in the loan amount, the loan ratios are in safe territory.
I continue to say both commercial and residential borrowers can easily afford 7%+ interest rate loans.
THE REMAINDER OF 2023 – BANKS & HOUSING
JULY 30, 2023 – This is my 3rd and last post regarding my forecasts for the remainder of 2023. Today’s topics are banks and housing.
BANKS – I have been saying since the SVB/SBNY closings that week after week goes by without any closures. Finally(!), last week we had a bank in Kansas get closed down by the FDIC. Also, PacWest was acquired. At this point, we remain closer to my forecast of 0-10 closures than the 176-200 closures forecast by many people.
As for CRE loan defaults, I have dealt with an office building (100% leased – it appears the borrower went bankrupt for some other reason) and two churches (same loan). We shall see if this picks up.
The Regional Bank Index (KRE) continues to soar and is about 20% above the low set the Monday after the SVB/SBNY closings. It is a full 40%+ (!) above its most recent low. Please let all of them people that told you that banks were going down the tubes what you think of their opinions! They have cost the masses a 20%-40%+ return – in less than 4 months at that!!!
As an aside, the market is saying that it does not believe there will be a CRE loan debacle for banks. Either not many CRE loans will default and/or banks are well prepared and capitalized to handle the defaults.
HOUSING – Let me just present a bunch of stats that clearly shows the strength of the housing market. New home sales increased 28.4% from July 2022 to June 2023. According to the Case-Shiller Index, home prices are within 1% of their June 2022 peak. Redfin reports home prices are up 2.1% from a year ago. The American Enterprise Institute’s (AEI) Home Price Appreciation (HPA) Index was up 0.7% month-over-month in June. It has been up every month this year. Annual appreciation is at 2.9% and projected to increase to 6%-7% by yearend. The Homebuilders Stock Index is up an incredible 60% (!)from last year’s lows. Those who forecast a crash in the housing market continue to be way off the mark.
SUMMARY – With both bank and housing stocks at their highs, the markets are saying both industries will do very well through year end and into early next year. There is no sign yet of a slowdown occurring for either industry. Sadly, all of those economists, market forecasters, and pundits have kept the public from making 20%-60%+ returns in these industries. But, that has been the norm since the world’s largest casino came into existence.
To sum up up the 3 posts:
Inflation will be stubborn and rise slightly over the remainder of the year – probably stay in the 3.5%-4.0% range.
The economy has a near zero chance of going into a recession. Yes, GDP will slow down from the amazing 2.2% rate that occurred in the first half of the year. I will put this hidden little sentence out there to refer back to in 12-18 months – The chance of a recession occurring looks to be 4th Quarter 2024 into 2025. I suspect that a year from now the broken-clock recession mongers will have given up and admitted the economy is strong, et al. Just in time to be wrong again:)
And, per above, banks and housing should be rock solid into the 1st Quarter of 2024.
I will provide updates per usual. But, will revisit the 6-month forecasts (for 1st and 2nd Quarter 2024) around the Holidays. Yes folks, less than 5 months til Christmas:)
Shalom,
The Mann
THE CRE LOAN DEBACLE – FACT OR FICTION?
UPDATE – JUNE 16, 2023 – One lender contacted me and said a 300bp increase in mortgage rates has occurred. So, I wanted to update the analysis below accordingly. Most everything stays the same below. Loan amounts, Market Values, and LTVs do not change. The only items that change are the new ADS and resulting DSCR.
For Apartments/Industrial the DSCR declines from 1.3 to 1.2, which is where it was when the original loan was made. Again, I do not think this would present problems for refinancing.
For Office/Retail the DSCR declines from 1.13 to 1.05. Per below, the new LTV is 72%. So, there might be some work to do on refinancing these property types. Are the hurdles significant? I don’t think so.
Thanks to all that provided some feedback on this post.
JUNE 15, 2023 – Besides the media hanging the threat of a recession over our heads for the past year, they have jumped on the commercial real estate (CRE) loans are going to go bad by the millions and take banks down bandwagon. So far, the financial institutions I talk with have seen virtually no pain. Of course, the pundits would say, just wait, it is coming. As you probably know, I am a numbers man. So, let’s do some math. What you will see below is some property types should have no problem refinancing at the current interest rates and other property types should have a little struggle. Is there a HUGE problem out there? Per the math, I don’t see it.
APARTMENTS and INDUSTRIAL – 3+ years ago we had a property with $100,000 PGI. 5% Vacancy and 30% OER and we have an NOI of $66,500. Using common appraisal acronyms, so hopefully you know what they mean. At a 1.2 DSCR the Annual Debt Service (ADS) was $55,417. At a 4% interest rate and 20-year amortization, the Loan Amount was $762,084. At a 6% cap rate, the Market Value was $1,108,333. A 69% LTV.
In the past 3+ years, rents for these property types have increased by well over 30% in most markets. So, today we have a PGI of at least $130,000. Let’s reflect the market decline of the past year and increase vacancy to 10% (pretty crazy for these property types today) and increase the OER due to inflation increases expenses (albeit rents probably went up way more). Our current NOI is $76,050. At a 7% cap rate (rates are up about 100bp over the lows last year…might not actually be up from 3 years ago, but…we are assuming the worst-case scenario), the Market Value is $1,086,429. The original loan has been paid down to $682,750, resulting in a 63% LTV. Using a 6% interest rate (commercial rates are not up as much as residential rates) and 20-year amortization, the new ADS will be $58,697. The resulting DSCR is 1.30.
So, we are refinancing today and the LTV has declined from 69% to 63% and the DSCR has increased from 1.2 to 1.3.
I am not seeing how these borrowers, and lenders, will have any difficulty with refinancing loans that are 3-5 years old. For these property types.
OFFICE and RETAIL – I won’t bore you with the same narrative all over again. I changed the rent growth to 0% from 30%+. One could argue rents have declined for these property types. If you have evidence of such in your markets, then the scenario described here is better than you will experience. I assumed 20% Vacancy and 40% OER then and now. Those are relatively pessimistic.
The original loan was $550,073 on a Market Value of $800,000. LTV was 69%.
The outstanding loan balance is now $492,810 and the Market Value has declined to $685,714. The LTV is now 72%.
To refinance at 6% for 20 years, the new ADS will be $42,368. NOI has remained at $48,000. So, the new DSCR is 1.13.
Again, I am not seeing where the borrower or lender will have trouble refinancing this loan. If I didn’t make such negative assumptions about these property types 3 years ago (but, remember back to June 2020 and virtual all office buildings were empty and most retail stores were closed) and used a lower vacancy, it is likely the LTV increase and DSCR decrease would be a bit more. But, still not problematic.
I know the CMBS market is getting killed. However, in talking with my clients, their borrowers that own office and retail buildings have shored up the loans and there isn’t a feeling of much risk. I know for sure banks lend much different than the CMBS market.
As always, we shall see how this plays out. Note, the above is about income-producing properties. Business loans are a different story. Lots of businesses can fail and lenders take back CRE as collateral. But, the loan going bad had nothing to do with the CRE market.
Glad to receive comments as usual.
I now think I have emptied my queue of ideas to post about. As my brain never stops thinking, I am sure it will come up with something else to write about soon. All I have to do is look at media headlines and I will be triggered. lol
Shalom,
The Mann
GUEST POST – BY JOHN CULBERTSON, CCIM, CRE, SIOR
MAY 5th – Happy Cinco de Mayo! Below is from John Culbertson, CCIM, CRE, SIOR of Cardinal Partners. He can be reached at jculbertson@cardinal-partners.com.
John gave me permission to reprint this. I totally agree with his take on this subject. I don’t only post things I agree with – I am open to anything that makes people think. Of course, non-political, non-religious, no insults, et al. I hope you find John’s thoughts of use as you hear people all over saying work from home is here to stay and office buildings are in big trouble, et al.
Stay safe.
The Mann
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ABOVE MARKET LEASES CANNOT INCREASE REAL PROPERTY VALUE
January 17, 2020 – I addressed this issue in a June 29, 2016 post. It is sad that almost 4 years later appraisers still do not separate the value of national tenant leases (almost always significantly above market) between Real Property Value and Intangible Value.
Recent examples I have encountered have been extreme. A proposed c-store ground lease had the land valued at $1,000,000 (based on numerous nearby land sales) and the lease valued at $4,300,000. Therefore, Prospective Value ‘Upon Completion’ (of the sitework) was $1,000,000 and Intangible Value was $3,300,000. Several ground leases to fast food restaurants weren’t as extreme. But, still the Intangible Value was over 100% of the Real Property Value.
Although I care less what the market does (See Mann’s Axiom), it is a common argument appraisers like to make when they are arguing that FF&E in Apartments aren’t separately valued by market participants (find me a Balance Sheet that does not have a Short-Lived Assets category…recent purchase contract I reviewed had FF&E separately discussed and one even placed a value on these items!) or national tenant leases sell based on the contract rent, et al. However, I came across the following standard wording in annual reports of several REITs:
Purchase Price Allocation
When we acquire real estate, we allocate the purchase price to: (i) the tangible assets acquired and liabilities assumed, consisting primarily of land, improvements (including irrigation and drainage systems), buildings, horticulture, and long-term debt, and, if applicable, (ii) any identifiable intangible assets and liabilities, which primarily consist of the values of above- and below-market leases, in-place lease values, lease origination costs, and tenant relationships, based in each case on their fair values.
So, that eliminates that argument:) In fact, the market does allocate value to above market rent to intangible assets. Case closed on this issue.
What was surprising to me was they also allocate the amount of value due to below market rent to (I assume) liabilities. That is interesting.
My post from 2016 is below.
Happy New Year to all. May 2020 be a great year for you.
The Mann
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Another item I have been shouting about for almost 25 years is the appraisal of drug stores, big box retailers, and other buildings leased to national tenants. Capitalizing these leases does NOT yield Market Value of real estate only. I may have been the only Chief Appraiser that required that the Market Value of Real Estate not exceed the Cost Approach indication with the additional value reflected by the Income and Sales Comparison Approaches having to be identified as an Intangible Asset. I admit that even allowing the Cost Approach indication to represent real estate value is being way too generous. These companies usually pay way above market for the land and the cost to build the improvements is absurd – I have seen costs for these basically shell buildings be more than medical office!
FIRREA and FDICIA require that 1) Market Value be of real estate only, and 2) LTV be calculated on Market Value of real estate only. We all know a shell retail building is not worth $300 or $400/sf as most drug stores have appraised at for 20+ years. Excluding the inflated land purchase price and using the real value of the land, these properties are lucky to be worth $100/sf in most markets. Yet, I am sure the vast majority of financial institutions have used the incorrectly stated Market Value provided by appraisers to calculate LTV and base their loan on. This is similar to those institutions that used, or may still use, Going Concern Value to calculate LTV.
Can we say violation of numerous federal regulations….but I digress.
All of this leads me to two recent articles that I believe finally end this absurd debate. I highly recommend you find the following articles:
David Charles Lennhoff, CRE, MAI, ‘Valuation of Big-Box Retail for Assessment Purposes: Right Answer to the Wrong Question,’ Real Estate Issues (Volume 39, Number 3, 2014): 21-32.
Stephen D. Roach, MAI, SRA, AI-GRS, ‘Is Excess Rent Intangible?’ The Appraisal Journal (Spring 2016): 121-131.
In my opinion, both authors prove beyond a shadow of a doubt that the excess rent present in almost all drug store, and similar leases, is not indicative of the market value of real estate. They use both theory and real data to prove their points. Mr. Roach sums up the logic better than I have ever seen (from page 125 of his article):
- “By definition, the real estate (a property) can produce market rent, but no more.
- By definition, excess rent exceeds market rent.
- By definition, excess rent is created by the contract, not the real estate.
- By definition, a contract is an intangible asset; it’s not real estate.
- Therefore, excess rent is intangible.
Each step in the argument is based on long-accepted definitions and concepts of the terminology.”
I challenge all of the Chief Appraisers in the country to step up and require appraisals of these properties to appropriately indicate the Market Value of REAL ESTATE ONLY with the huge additional amount above this figure being termed Intangible Value (or something similar). It is time both appraisers and lending institutions provide the correct value and LTV.
Plus, this will make the lives of us reviewers easier – it has been frustrating to lower the values 50%-75%+ all of these years! Of course, we could simply order these appraisals from the two authors above and have slam dunk reviews forever:)
CAN WE END THE DEBATE ON VALUING NATIONAL TENANT RETAIL BUILDINGS
June 29, 2016 – Some people have bucket lists. I guess I was born to have a list of pet peeves:)
For 25+ years, I have tried to get our industry to identify the correct interest when appraising an existing apartment complex or any property with arm’s-length leases. It has always been Leased Fee Interest, not Fee Simple Estate. I can say that finally the majority of appraisers have come to recognize this. The ‘urban myth’ that we were taught (i.e. if leases are less than 12 months long and/or contract rents are at market, then the interest being appraised is Fee Simple Estate) is almost eradicated.
For 30+ years, I have identified the kitchen and laundry appliances (and any additional common area items that might be in a club house or such) in apartment complexes as FF&E. Til this day, many appraisers still think refrigerators, stoves/ranges, dishwashers, washing machines, and dryers are real estate! As a lady on TV many years ago said – Stop The Insanity!
Another item I have been shouting about for almost 25 years is the appraisal of drug stores, big box retailers, and other buildings leased to national tenants. Capitalizing these leases does NOT yield Market Value of real estate only. I may have been the only Chief Appraiser that required that the Market Value of Real Estate not exceed the Cost Approach indication with the additional value reflected by the Income and Sales Comparison Approaches having to be identified as an Intangible Asset. I admit that even allowing the Cost Approach indication to represent real estate value is being way too generous. These companies usually pay way above market for the land and the cost to build the improvements is absurd – I have seen costs for these basically shell buildings be more than medical office!
FIRREA and FDICIA require that 1) Market Value be of real estate only, and 2) LTV be calculated on Market Value of real estate only. We all know a shell retail building is not worth $300 or $400/sf as most drug stores have appraised at for 20+ years. Excluding the inflated land purchase price and using the real value of the land, these properties are lucky to be worth $100/sf in most markets. Yet, I am sure the vast majority of financial institutions have used the incorrectly stated Market Value provided by appraisers to calculate LTV and base their loan on. This is similar to those institutions that used, or may still use, Going Concern Value to calculate LTV.
Can we say violation of numerous federal regulations….but I digress.
All of this leads me to two recent articles that I believe finally end this absurd debate. I highly recommend you find the following articles:
David Charles Lennhoff, CRE, MAI, ‘Valuation of Big-Box Retail for Assessment Purposes: Right Answer to the Wrong Question,’ Real Estate Issues (Volume 39, Number 3, 2014): 21-32.
Stephen D. Roach, MAI, SRA, AI-GRS, ‘Is Excess Rent Intangible?’ The Appraisal Journal (Spring 2016): 121-131.
In my opinion, both authors prove beyond a shadow of a doubt that the excess rent present in almost all drug store, and similar leases, is not indicative of the market value of real estate. They use both theory and real data to prove their points. Mr. Roach sums up the logic better than I have ever seen (from page 125 of his article):
- “By definition, the real estate (a property) can produce market rent, but no more.
- By definition, excess rent exceeds market rent.
- By definition, excess rent is created by the contract, not the real estate.
- By definition, a contract is an intangible asset; it’s not real estate.
- Therefore, excess rent is intangible.
Each step in the argument is based on long-accepted definitions and concepts of the terminology.”
I challenge all of the Chief Appraisers in the country to step up and require appraisals of these properties to appropriately indicate the Market Value of REAL ESTATE ONLY with the huge additional amount above this figure being termed Intangible Value (or something similar). It is time both appraisers and lending institutions provide the correct value and LTV.
Plus, this will make the lives of us reviewers easier – it has been frustrating to lower the values 50%-75%+ all of these years! Of course, we could simply order these appraisals from the two authors above and have slam dunk reviews forever:)