2023-03-28 09:06:14 ET
Summary
- Elon Musk recently warned that the Federal Reserve's interest rate policies have brought commercial real estate to the brink of crashing.
- This in turn would hammer small banks and then tear through the broader economy, potentially bringing on the next great financial crisis.
- We share our approach to investing in light of this looming risk.
Mega billionaire tech tycoon Elon Musk of Tesla ( TSLA ) recently warned that the recent bank failures and ongoing fallout could very possibly spread to the real estate sector, leading to a real estate crash. In fact, he recently tweeted that it is "by far the most serious looming issue".
Elon Musk Tweet (Twitter)
In this article, we discuss the merits of Mr. Musk's warning, its potential secondary and tertiary impacts on the economy, and our investing approach in light of these cautions.
Is It Time To Be Bearish On CRE?
Mr. Musk's tweet was in response to a report that $2.5 trillion in commercial real estate ( VNQ ) debt will mature in the next five years and many borrowers could default, potentially exposing smaller banks ( KRE ) to major losses. This is because smaller banks hold about 70% of total U.S. commercial real estate debt ("CRE"). With so much CRE debt coming due in the coming years at a time when interest rates are at levels not seen in years, it is highly probable that landlords will determine that their properties will not be sufficiently profitable if they have to pay market interest rates on their refinanced debt.
As a result, they will instead elect to default on their mortgages and hand the keys to the property over to the lender. Meanwhile, the combination of higher interest rates and the potential flood of defaults bringing a sudden surge of CRE supply to the market for urgent sale, will likely combine to lead to a sharp decline in valuations on these assets. This will in turn prompt even more landlord defaults (since a growing number of properties will now be worth less than the debt attached to them), further accelerating the decline in property values and leading to even greater losses for banks.
Defaults on maturing CRE mortgages have already begun among some of the biggest names in the business. Blackstone ( BX ) recently defaulted on a $562.5 million bond backed by a portfolio of offices and stores and Brookfield ( BN )( BAM ) defaulted on $755 million worth of loans related to two office buildings.
Finance expert Genevieve Roch-Decter has also warned about the risks of a spike in defaults on commercial real estate loans and the potential for steep losses in banks' portfolios.
As Musk stated :
This is the real problem. Many cities have high office vacancy rates. Mortgage portfolios are at risk too if housing prices drop significantly.
Further compounding the issues being caused by higher interest rates are potential tighter lending standards in the wake of the recent banking sector turmoil, an expected sharp economic downturn, and the persistence of the remote-working trend that was catalyzed by the COVID-19 lockdowns. Big banks Bank of America ( BAC ) and JPMorgan ( JPM ) have also both warned that CRE could be the "next shoe to drop" for the economy.
The stock market is clearly not blind to this either, with the commercial real estate sector getting pummeled since the beginning of February:
Not surprisingly, office REITs have been hit extremely hard, with blue chip Boston Properties ( BXP ) getting routed and higher leveraged peers like SL Green ( SLG ) and Vornado ( VNO ) getting crushed over the past year:
Our Approach To The CRE Crash
At High Yield Investor, we invest in both the real estate and banking sectors, so this macroeconomic development certainly impacts us. Fortunately, we have largely skirted the sharp downturn in both CRE and regional bank stocks thanks to our strategic approach to both sectors. We have largely invested exclusively in triple net lease REITs like W. P. Carey ( WPC ) and Essential Properties ( EPRT ), which have held up much better than the broader REIT sector over the past two months:
Moreover, we are now finding opportunities to invest in CRE that have zero refinancings coming due in the coming years, very strong investment grade balance sheets, assets that enjoy high occupancy, resilient cap rates, and robust rent growth, and yet are having their share prices plummet due to being (mis)associated with broader office real estate.
Meanwhile, on the regional banking side of things, we have been investing in regional banks that have very limited to nil exposure to office real estate loans, conservative balance sheets, and yet still trade at deep discounts to book value while offering attractive and well-covered dividend yields. An example of this is New York Community Bancorp ( NYCB ) which we bought aggressively on the dip at $6.50 two weeks ago before reaping a massive profit since then. Its office loan portfolio makes up well under 10% of its total loan portfolio, and is conservatively financed with longstanding counterparty relationships that span into other industries.
As a result, we believe that we are enjoying optimal risk-reward in these investments by capitalizing on selloffs in these sectors without assuming much, if any, of the risks that are driving those discounts.
Investor Takeaway
Mr. Musk once again generated headlines by issuing a bold macroeconomic caution. That said, we believe there is significant merit to his caution in this case, with the dominoes seemingly aligned perfectly for a tremendous crash to wreak havoc on the CRE sector, many regional banks, and the broader economy as a whole. However, for investors willing to swallow the volatility that comes with buying stocks in businesses on the outskirts of the CRE space, but that are largely sheltered from the risks discussed in this article, the potential for substantial alpha is very possible if not probable.
As illustrated by NYCB's vulture-like acquisition of certain Signature Bank ( SBNY ) assets for cents on the dollar and the massive profits for shareholders that followed, conservatively capitalized businesses in these industries that are also shielded from these risks could be the biggest winners by picking over the carcasses of the failed players in the space in the years to come. In the meantime, investors can buy these potential future winners at steep discounts. This is where we are focused in these sectors at High Yield Investor as part of our well-diversified high yield portfolios .
For further details see:
Elon Musk Warns Of A Real Estate Crash: Our Approach