KBE - Offices Are Emptying - A Concern For KBE And Office REITs?

2023-04-15 01:42:06 ET

Summary

• Work from home disruption, a slowing economy, and rapidly rising interest rates are combining to challenge office landlords like never before.
• Meanwhile, regional banks have outsized exposure to commercial real estate, particularly office buildings.
• In this article, we take a look at what this means for REITs and their bankers.
• We also share our investing approach to take advantage of the market volatility that this potential crisis is producing.

The work-from-home era has led to vacant or underused offices in cities like New York and Los Angeles. This has caught the attention of investors and regulators who are concerned about the impact that this development may have on the $20 trillion US commercial real estate market.

In fact, the impact is already beginning to be felt. For example, world-leading alternative asset managers such as Blackstone ( BX ) and Brookfield Asset Management ( BN )( BAM ) recently defaulted on office property-backed debt. As a result of scenarios like this becoming increasingly commonplace across the global economy, the value of office buildings is indisputably declining, which is obviously posing as a serious challenge to commercial real estate landlords, but is also raising concerns for their banker creditors and potentially even beyond.

In this article, we will look more closely at the headwinds currently facing office real estate, how it may impact office REITs ( VNQ ) and Banks ( KBE ), as well as our investing approach to try to profit off of the market volatility resulting from this potential crisis.

2023 Office Real Estate Headwinds

The Office real estate sector has been facing significant challenges recently. In the United States, valuations had dropped by 15% in March from their peak, as per Green Street data . The stock prices of Office REITs such as Boston Properties ( BXP ), SL Green ( SLG ), and Vornado ( VNO ) are down by even more. Over the past year alone they are down by between 60% and 70%:

The sector's decline has been the product of a perfect storm of macro trends. These include the rapid rise in interest rates over the past year, which has pushed up cap rates while also making it harder to finance and refinance the ownership of these properties:

Moreover, the surging work-from-home trend has resulted in a large number of jobs leaving the job either entirely or in part via hybrid arrangements. As a result, office landlords have lost their pricing power with tenants and the current average occupancy of US offices remains below half of the levels seen in March 2020, based on Kastle's data .

On top of that, as the economy slows companies will continue to reduce their office presence due to layoffs and efforts to cut costs. This means that office property values will likely continue to fall, with current estimates going as high as over 30% in further declines this year. As head of real estate strategy at Cohen & Steers ( RQI ) - Rich Hill - recently commented:

You have fundamentals under pressure from work from home at a time when lending is less available than [it has been] over the last decade. Those two factors will lead to a pretty significant decline in valuations.

How devastating this could be for office landlords remains unclear, but if the current trend of office real estate backed loan defaults accelerates, there could quickly be a huge glut of offices on the market, leading to a complete collapse in valuations. This would undoubtedly lead to mass bankruptcies as there would be a race to the bottom in rents and office REITs may be completely unable to refinance nearly any of their debt, leading to a spike in debt defaults at the corporate level in addition to the defaults at the asset level.

Potential Office Fallout On KBE

Of course, the impacts in such a scenario would not be limited to the landlords. Their banker creditors would also undoubtedly suffer as they struggle to regain the lost capital on the property-backed loans that go into default. If office valuations plummet badly enough and the market gets flooded with foreclosed-on near-empty office space, many of these creditors may not be able to even liquidate these properties for quite a while, much less recover all of their capital upon sale.

In fact, a worst-case scenario could result in an anxiety-driven run on these banks similar to what just happened with Silicon Valley Bank ( OTC:SIVBQ ). This would then likely lead to even more bank failures. Why is this such a big risk for banks? According to Goldman Sachs , roughly 55% of US office loans are on bank balance sheets, with regional and community banks accounting for 23% of the total. Meanwhile, Signature Bank ( OTC:SBNY ) - which has already failed - and the troubled First Republic Bank ( FRC ) have the tenth and ninth largest commercial real estate loan portfolios in the US, and have a larger percentage of their assets tied up in the sector compared to larger peers like JPMorgan Chase ( JPM ), Bank of America ( BAC ), and Wells Fargo ( WFC ). This puts them on very precarious footing and - if FRC eventually folds and its office-backed loans need to be sold at fire sale prices, it could lead to major downward pressure on the CRE lending market.

This is particularly the case when considering the fact that ~$270 billion in commercial real estate loans mature this year, about $80 billion of which are for office properties. These assets were almost all underwritten at higher valuations and substantially lower interest rates, making the refinancing environment extremely challenging. Moreover, the recent tremors in the banking sector make them even less likely to refinance debt that has become increasingly risky. As Eswar Prasad - an economics professor at Cornell University - recently commented:

Although this is not yet a systemic problem for the banking sector, there are legitimate concerns about contagion.

When looking at KBE's portfolio composition, we see how it could be in for a rough road ahead. Over 73% of its portfolio currently consists of regional real estate mortgage banks - the very banks that are most exposed and most at risk from emptying office spaces and rising interest rates (including a small stake in FRC).

These risks are certainly not going unnoticed by the market either, with KBE's stock price getting hammered during the banking sector turmoil and failing to bounce back at all since then:

With inflation remaining stubbornly high and the presence of numerous potential tailwinds to keep inflation elevated such as production cuts by OPEC+, no end to the Russia-Ukraine war in sight, and the acceleration of de-globalization and re-onshoring of supply chains, the Federal Reserve may well be forced to keep interest rates higher for longer.

This could pose serious problems for KBE, as its large exposure to regional banks and other commercial real estate lenders may suffer. Losses on CRE loan defaults coupled with unrealized losses on long-term bond investments on their balance sheets could lead to a serious capital crunch if depositors decide to make another run on the banks. At a bare minimum, profitability will likely suffer significantly due to elevated defaults and tighter lending standards moving forward.

Our Approach

How are we approaching this market volatility? First and foremost, we are staying out of KBE and have little reason to be bullish on it for the foreseeable future. The risks there are simply too high to make the potential rewards worthwhile. We are also staying out of direct investments in the common stock of office REITs.

That said, there are some conservatively positioned stocks in both the broader office REIT and regional bank sectors whose stock prices have gotten beaten down severely in the wake of these crises that are actually pretty well sheltered from the office real estate decline.

These include TFS Financial Corp ( TFSL ), a small regional bank which currently offers a well-covered 9% dividend yield and trades at a steep discount to its book value per minority share. It also has a very conservatively positioned balance sheet and management recently reaffirmed their commitment to the dividend while stating that their deposits are holding up remarkably well. It also has zero exposure to CRE, with all of its loans being focused on conservatively underwritten single family home mortgages. Yet, despite this, the stock is down significantly in response to the sector turmoil:

On the office REIT side of things, Alexandria Real Estate ( ARE ) is a life sciences lab space focused REIT that is experiencing very strong demand for its properties from high quality tenants and as a result is generating very strong rent and AFFO per share growth. It also has one of the strongest balance sheets in the entire REIT sector with a BBB+ credit rating and the potential to get upgraded to A- in the future. Despite these robust fundamentals, ARE's stock has gotten pummeled along with the rest of the office REITs recently:

Investor Takeaways

Office REITs and regional banks are facing serious headwinds and risks right now from the perfect storm caused by the work from home movement, an economic slowdown, and rising interest rates all accelerating simultaneously. While office REIT stocks and the price of KBE are both beaten down significantly already, the risk-reward remains unattractive to us given the potential for things to spiral further out of control and even bankruptcies to result.

However, at High Yield Investor, we are finding several attractive related REIT and regional bank opportunities which are relatively unimpacted by these factors yet whose stock prices have been beaten down anyway. As a result, we have already profited significantly from this market volatility and hope to continue doing so moving forward.

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