WAL - Commercial Real Estate: The New Potential 'Subprime'

2023-07-21 13:24:25 ET

Summary

• We are seeing more defaults in the commercial real estate sector as well as many fire sales around big office buildings in major cities.
• This trend is accelerating, and a new report from McKinsey projects $800 billion of commercial real estate values in major cities could be wiped out as a result.
• The potential ramifications from the meltdown in asset values in many parts of commercial real estate on the markets and the economy are highlighted below.

The world is a tragedy to those who feel, but a comedy to those who think ."? Horace Walpole.

I have been writing frequently recently, both on Seeking Alpha and Real Money Pro, about the plunging valuations in much of the commercial real estate space especially around office, retail, and hotel properties. It seems negative headlines are occurring on a much more frequent basis. Over $250 billion in commercial real estate ((CRE)) loans need to be rolled over by year-end and $1.5 trillion worth of CRE loans are due to be refinanced over the next three years. With interest rates on these types of loans roughly double what they were before the Federal Reserve began their current monetary tightening regime in March of last year. This has seen the central bank move the Fed Funds rate up 500 bps in a relatively short order.

Here are a few of these headlines I have seen over the past week.

• A 30-story office tower at One South Street in downtown Baltimore was sold for $24 million. This is a 63.6% discount versus the tower's 2015 last sale of $66 million.
• This was quickly followed by the sale of another office building in Baltimore that sold for a 69% discount or $55 million less than it was last bought in 2018. To be fair, that building's parking garage had a partial collapse a few years back.
• Starwood Capital Group defaults on a $212.5 million mortgage backed by an office building in Buckhead, a suburb of Atlanta, GA. The building was bought and renovated in 2017. The office vacancy rate in Atlanta was 22.4% in June.
• The Public Hotel on the Lower East Side of Manhattan is headed to foreclosure auction next month after its owners, Ian Schrager and Steve Witkoff, defaulted on an $85 million loan with Värde Partners.
• A recent report by McKinsey & Co. noted that because of the explosion of the virtual workforce and hybrid work, " As much as 40 percent of the core of retail and office corridors in the nation's cities could be rendered obsolete. An estimated $800 billion worth of real estate could be wiped out ."

And that is just one week's worth of headlines! Given the huge declines in the values of most office buildings since the pandemic and the explosion of the virtual workforce, this saga is just getting started. Unfortunately, this movie is just opening, and it is time for investors to get the popcorn out, as this film is likely to be a long tragedy.

And much like the Financial Crisis of 15 years ago, the damage is unlikely to be confined to just parts of commercial real estate. Much like the Subprime crisis was never " contained" despite soothing words to that effect from the Federal Reserve in 2007.

As more and more office buildings and other commercial real estate properties go into default, lenders will put them up for sale as substantial discounts further eroding asset values.

In addition, this will ding profits at myriad financial institutions, cause credit provisions to be hiked substantially and lead to further tightening of credit criteria across the financial sector. This could very well lead to a " credit crunch" that could end up being a major headwind to the economy. Very little of this scenario seems priced into the market at current trading levels.

I will be watching two key sectors of the market to see how all this plays out. The first is large REITs with major exposure to office properties in major cities. Two of these are Vornado Realty Trust ( VNO ) and SL Green Realty Corp. ( SLG ) , two of the largest owners of office properties in New York City. Both stocks have rebounded nicely over the past few months. I would watch if this recent rally holds, and how their portfolio of office properties performs in coming quarters.

I will also be keeping my eye on the regional banks given we have had three large bank failures (Silicon Valley Bank, Signature Bank, First Republic Bank) in this sector in the first half of 2023. In addition, the regional banking system provides some 70% of the loans to the commercial real estate industry. Two of the more well-known names here are Western Alliance Bancorporation ( WAL ) and PacWest Bancorp ( PACW ). Investors should watch key metrics like credit loss provisions and write-offs at these banks in the quarters ahead.

If a clairvoyant could tell me where PACW, SLG, VNO and WAL are trading six months hence, I am fairly confident I could tell you the direction of the overall market over the next two quarters. My view is that it will be significantly down from here.

Do I think commercial real estate is the new "subprime"? I am not predicting that dire of a scenario as the trouble sectors of the commercial real estate market pale in comparison to the size of the residential real estate market. However, few thought the troubles in subprime that began to emerge in 2006, 2007 would take down the entire housing market along with the economy a decade and a half ago, either.

While I await lower entry points in the market, my current portfolio is positioned in the following way. Approximately 50% of my holdings are in short-term treasuries yielding north of 5%. 40% of my portfolio is long via covered call positions in stocks with fortress balance sheets for the most part. About eight percent is in cash and the rest is in out of money bear put spreads on stocks and sectors that been mostly responsible for the huge rise in the major indices this year but looked close to being priced for perfection.

These include Apple ( AAPL ) , a name I outlined a bear put trade on recently. They also include Tesla, Inc. ( TSLA ) , Airbnb, Inc ( ABNB ) and Invesco QQQ Trust ETF ( QQQ ) , all of which have risen too far, too fast so far in 2023 in my opinion.

Not exactly the sexiest portfolio allocation, but a prudent one given the potential storm on the horizon that becomes move evident by the week.

Everyone has a thousand wishes before a tragedy, but just one afterward ."? Fredrik Backman.

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