Opportunity Knocking: Commercial Real Estate

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Stacie Jacobsen: [00:00:00] Welcome to another bonus edition of The Pulse by Bernstein. I'm your host, Stacie Jacobsen. While the acute phase of the recent banking sector [00:00:15] turmoil may be behind us, the story isn't over yet. Some investors wonder whether there's another shoe waiting to drop and point to commercial real estate as the potential culprit.

To be clear, we do think real estate will have to reprice over the next several years, but [00:00:30] this isn't gonna be another 2008 where distressed real estate takes down the economy. In fact, today's guest, Dipak Patel, managing director of commercial real estate for AB, sees Selective pockets of opportunity amid the dislocation.[00:00:45]

Hi Dipak, thanks for being on the show today.

Dipak Patel: Thanks so much for having me, Stacie.

Stacie Jacobsen: Let's talk about the magnitude of the commercial real estate exposure. How big is the challenge we're facing?

Dipak Patel: When we look at the entire commercial real estate debt market, it's about a five and a half trillion dollar [00:01:00] market. And that's all the commercial real estate debt that's outstanding.

But when you're looking at the maturities, that probably goes from now to the end of 2025. That number is closer about a 1.5 trillion number.

Stacie Jacobsen: Okay. And we're talking about the entire [00:01:15] commercial real estate market here, right? Not just one particular sector like office.

Dipak Patel: Exactly.

Stacie Jacobsen: So now the question becomes how many of those loans are currently held by local and regional banks?

Dipak Patel: Well, about 50% of all commercial real estate debt [00:01:30] is held by banks, and of that 70% is held by regional and small lenders. So out of that near term maturity that I quoted earlier, 1.5 trillion, less than 20% is local and regional.

Stacie Jacobsen: Okay, but I heard the small and [00:01:45] regional lenders were extremely active and made up really a large portion of commercial real estate lending.

Dipak Patel: You're right, those lenders have increased market share over the past 12 months, going anywhere from about 20% to about 31% by the end of [00:02:00] Q4 2022. But if you look at a over a longer period, they only compose about 17 to 20% of the overall lending volume going back to 2011. So it's not insignificant, but it's worth putting it to perspective.

Stacie Jacobsen: Were regional banks providing better [00:02:15] lending rates? Is that how they were really able to gain market share?

Dipak Patel: Well, I actually think more of the story of their ability to gain market share is linked to transaction activity slowing down and other sources of lending. Really drying up financing activity in the fourth quarter was down over 50%, which led to [00:02:30] huge gain in market share for the local and regional banks.

While pricing you're right, is one. Important metrics that local and regional banks compete on. Typically, it's an entire relationship that they're competing in. They're not market makers at 20% of the market. Um, there are different [00:02:45] aspects, loan covenants and things that are more attractive to a borrower.

Stacie Jacobsen: Okay. So what I hear you saying then is that regional banks are a smaller portion of commercial real estate lending and also a small portion of the debt that's maturing near term.

Dipak Patel: Correct. And there are alternative sources of [00:03:00] capital that are on the sidelines just sitting, waiting to fill in the gap if these banks pull back on lending.

Stacie Jacobsen: Okay, Deepak. I do wanna get into that, but before we do that, I wanna play devil's advocate and share some real questions that we're hearing from our clients. [00:03:15] Uh, they've all read in the press that office buildings have high vacancy rates and they're struggling to find tenants as work from home does persist.

Um, they also know there's a wave of loans coming due and borrowers will be struggling to refinance in this higher rate environment. What do you say [00:03:30] to that?

Dipak Patel: Well, no question. There's gonna be some near term challenges in the office sector. A lot of echoes of what we saw in the regional mall landscape, uh, decade plus ago really creates a perfect storm for the sector.

We've got work from home, as you mentioned. It's a real [00:03:45] cyclical nature of the asset class. Going into a possible recession, you have the potential lack of availability of debt financing, and you've got supply challenges and adaptive reuse. Probably not gonna be the total solution here.

Stacie Jacobsen: Adaptive reuse. Can you give [00:04:00] us an example?

Dipak Patel: Yeah. When you're looking at, um, these large office buildings and large floor plates, the quick answer is, oh, can we convert it to something else? Can we make it into an apartment building? Can we do something else with all this space? Well, a lot of it is not. [00:04:15] Set up to be able to be converted.

Stacie Jacobsen: Okay, Dipak, so I'm still waiting for the reassuring part here.

Dipak Patel: Oh, you're right. The good part is office is just one part of the commercial real estate space. Used to be four categories, office, multifamily, [00:04:30] industrial, and retail. Now we're a lot more diversified. Gut data center, self storage, healthcare, and lodging. When you look within commercial real estate office, it makes about 15% of the entire sector, and even within office, not all [00:04:45] offices created the same.

You've got urban and suburban office, and even within urban, you've got newly amenitized properties that really cater to what the tenant's looking for. You've got selectivity, and that becomes the real question for [00:05:00] lenders as they look at and evaluate the sector.

Stacie Jacobsen: So up until now we've focused on the regional banks, but what about the larger banks that are looking to reduce exposure to commercial real estate?

Dipak Patel: Well, good part is, is a lot of those large banks post the GFC were forced to reduce [00:05:15] their exposure to direct real estate. They started pivoting and went to indirect exposure to the commercial real estate by providing financing to debt funds and mortgage weeds. So if they provide financing to these investors driven vehicles, and in doing so they have [00:05:30] additional cushion.

Both from the equity at the property level, from the borrower, and at the loan level, from the debt fund. They're at the first loss when it comes to the loan defaulting.

Stacie Jacobsen: Okay. Now that's more of the reassuring part that I was looking for, so thank you. Good to know. Um, [00:05:45] but I'd imagine there's a, there's a runway too, so in other words, not all these loans will be maturing at the same time.

Right. You mentioned that, uh, 1.5 trillion comes due by the end of 2025. When does it really become a big issue?

Dipak Patel: Well, yeah. Asset [00:06:00] classes that have short leases like hospitality, self storage, multi-family, they've held up well and their operating performance has improved. The other classes, asset classes that have longer term leases, they have longer term leases, so you've got more time to work through those issues.

Not as much of a [00:06:15] near term impact that you'll see on the cash flows from those properties. And we also need a catalyst in commercial real estate.

Stacie Jacobsen: Yeah. Catalyst, like what would that be?

Dipak Patel: Well, in 2008 there was a regulatory catalyst. Uh, in other words, regulators stepped in. They [00:06:30] said, we see a problem, we need to reset things.

And we saw improved underwriting standards come out of that. Without some external force coming in and say, you need to write these things down, probably have 12 to 24 months before the real trouble begins. You could argue that we're already 12 [00:06:45] months into the hiking cycle and we haven't had a huge correction yet.

Stacie Jacobsen: Okay. But as of now, prices are down. Right?

Dipak Patel: Right. Yeah. Uh, property prices are down and estimated 15% and public markets through public res, uh, leading [00:07:00] indicator implying that they should be down another 11%. Uh, commercial real estate loans. Benefit is they sit mostly in private markets, which are lagging, which is why it probably takes 12 to 24 months for the challenges to surface.

Stacie Jacobsen: So what I hear you saying, banking issues are likely to result [00:07:15] in fewer loans available, but it won't lead to a 2008. But with less lending from the usual suspects, the market is likely to reprice in the next couple of years, and other lenders can step in to take advantage, but with less competition. [00:07:30]

Dipak Patel: Exactly.

I think you're seeing what is the optimal time to be an investor in the debt space. It's really where we see the best risk adjusted returns for the sector at the moment. You've got reduced liquidity, creating a lender's market, um, got better [00:07:45] covenants, reduced leverage, higher yields from both base rates like SFR and spreads, and you've got more downside protection.

Got equity investors that are coming in with more capital, really creates a better credit universe for lenders to choose from.

Stacie Jacobsen: Okay, so there is a [00:08:00] lot of capital being raised right now targeting this opportunity, which means investors looking to take advantage of the dislocation do have a lot of choices. What should they really be looking for when selecting a strategy or a partner in this space?

I'm assuming that experience is [00:08:15] just table stakes.

Dipak Patel: Absolutely experienced operator, not just someone that's a loan originator. They've gotta have experience managing through the cycle with strong borrower relationships in this, you know, with established borrowers. Someone who isn't just coming in and outta the [00:08:30] market more opportunistically, but that really truly has flexible sources of capital that can address a variety of borrower business plans.

It's not going to be a one size to all solution.

Stacie Jacobsen: Okay, so this is certainly not the time to dabble at the first [00:08:45] opportunity that comes to you, that really partner with somebody that has experience in this space. Alright, Dipak, uh, we've really learned a lot from you today. Thank you so much for being on today's show.

Dipak Patel: Thanks so much for having me.

Stacie Jacobsen: Thanks for listening to our bonus episode. Don't forget to subscribe wherever you get your [00:09:00] podcast to make sure you never miss a beat. I'm your host, Stacie Jacobson.