It’s Not Just a Flesh Wound

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I’ve been back from CREFC’s and RER’s annual meetings for a week or so, mulling what those confabs meant.  There’s been plenty of reportage on the events, the panels, the parties, the to-ing and fro-ing, but what I want to do is step back and reflect on the gestalt; the subtext, the hidden codex.  What just happened?

It’s capitulation.

About time, wasn’t it?  We met against the backdrop of pretty startlingly negative macro conditions.  A knife-falling equity market, rocketing interest rates, nosebleed inflation, 75 bps as the Fed’s new black, the war, CEO and consumer confidence tumbling, slower growth, marquee production indexes sneaking down on 50, recession talk abounding, ugly politics, tightening credit conditions, $9 trillion Fed balance sheet to unwind and a government apparently not willing to believe its own lying eyes on the depth and scale of the financial distress confronting us right now.

Oh yeah, there were reasons to be a tad despondent, but coming into the meeting there had been hope, hadn’t there?  One of the key reasons we all showed up was our compelling need to retest any possibility of optimism.  Was there a basis, in the face of objective reality, to still think things might get better in the short run?

Our industry hardly needs an excuse to get together.  We are very social and any opportunity to gather, talk, drink, backslap and belly rub is always welcome and these meetings delivered good fun.   But this time there was a special frisson; a need to find some reason to say it’s not as bad as we think it is.

It had been possible during the mid-spring to think that spreads that had blown out could come back in, right?  (Sidebar:  Jim VandeHei told me recently that no one reads anything beyond 200 words.  You’re there – fair warning.)  It was possible to believe that liquidity that was becoming dear would rebound and all return to those happy days of risk on.  Frankly, early days this spring, I’d rather expected that.  So, we had some inflation, a war, supply chain disruption, but it was a bang up first quarter and hey, the Modern Monetary Theory gang was telling us, “No worries, mate.  None of this really matters.”  Maybe they were right?  (Spoiler alert – they were not.  One of the dumbest theories not published by the Mysterious Q.)

But it hasn’t gotten better, has it?  And so, we met in New York.  The meeting was a coda, in a way, an exclamation point on the increasingly obvious and unavoidable denouement: we’re not going back to the amiable credit conditions of 2020, 2021 and early 2022 any time soon.

Spreads are now substantially wider than they were during all that period.  The forward curve has left the building.  Floating indexes are following Fed funds and all going up with startling speed.  The last I looked term SOFR was roughly 150 bps and the ten year was enjoying a short break from volatility at around 3.2%.  All inconceivable (or at least not conceived) as 2021 came to a halt.

No one can now think we are returning to the Great Moderation any time soon.  Sure, all changes to credit conditions are cyclical, but as we’ve often observed here, while you’re enjoying the ride, there’s not much difference between a long cycle and a secular change.  Nothing’s forever, but we’re clearly looking at tighter credit conditions, lower asset values, a likely reduction in liquidity and higher spreads for a considerable period of time.

It seems to me that that the debt capital markets have probably had the scales removed from their eyes before other parts of the CRE space.  I followed CREFC up with a meeting of the Real Estate Roundtable where there was considerably less despondency.  On the equity side of the house and from the bank and lifeco seats, the roiling discontinuous change in the debt capital markets is not so immediate.  There, the focus is on real estate fundamentals and indeed, there is a sense that revenue across much of the CRE space can remain strong in the short to medium term, preserving valuations, assuming of course cap rates remain stable and lending conditions remain constructive.  That is a hole in the bottom of that theoretical construct to be sure.

As we know, water finds its own level and these disparate views of fundamental macroeconomic conditions will have to reconcile.  My bet is that all parts of the CRE market will approach their capitulation moment sometime over the next several months.  The capital markets reality is the underlying reality and in some version of Gresham’s Law, capital markets’ valuations, capital markets cap rates and capital markets views about credit, risk and liquidity will ultimately drive out different or disparate views.

So, what does capitulation mean?

  • Spreads will continue to rise on fixed and floating rate loans and proceeds will go down. Notwithstanding the relative readiness of lenders far removed from the capital markets to react to changing credit conditions, and the general grumpiness of borrowers who have happily fed on low coupons for many, many years, loan pricing will materially increase.
  • Transaction velocity will materially contract because those who don’t need to transact in the short run, won’t.
  • Warehouse money will become increasingly constrained and increasingly expensive.
  • Cap rates in the commercial real estate market will go out and the views of cap rates from the equity and debt sides of the world will reconcile toward the more negative views of the debt capital markets resulting in significant pressure on valuations.
  • Consequently, property values will also drop as cap rates go out and leverage gets dear.
  • In general, the price of risk will go up and credit conditions will tighten. As the risk-free cost of money increases, the premiums for real risk will move up apace.
  • Underwriting will undoubtedly tighten. Why?  I don’t know, it’s just something we do when credit gets dear.
  • More folks will embrace the reality of the upcoming hard landing and recession. Conviction will become a reality and that psychology will turbo all the trends identified above.  A sort of doom by the professional economists and astrologists who are taught to tell us what or when, but never what and when, perhaps for the best.  To simply linger in stagflation for years, watching the economic activity slowly recede before finally hitting bottom, might cause the pain and damage from all this might to be worse.  So, perhaps a nice, quick sharp recession allowing the Fed thereupon to begin to reflate and stimulate the economy and take us back to the broad, sunlit uplands of financial success (thank you, Mr. Churchill) might be the best thing
  • Pirates will be out looking for bargains and cash and liquidity will be king.
  • Mezzanine debt and preferred equity opportunities will abound.
  • Velocity in the trading of troubled assets and any assets from troubled platforms will increase.

In the meantime, transactional activity is not going to zero.  As we reconcile ourselves to the enhanced cost of money and the price of risk, transactions will get done.  In some cases, the underlying opportunities will more than compensate participants for the increased cost of the leverage.  While it might be sad to fondly remember 9 bps LIBOR and 50 bps to 75 bps, 10-year Treasury money, if a trade works, it works.

Some will simply have to transact.  We’ve become extremely dependent upon leverage over the past decade and we’re not going cold turkey.  Leverage might not be as amiable as it was, but broad sectors of our marketplace, and particularly the non-bank sector, continue to need leverage.  As warehouse money may not prove to be a stable solution, we will see a reboot of the CRE CLO market.  No one (lawyers aside) may be happy about this, but capital needs to be recycled.

Fewer properties will trade as parties who have no compelling need to transact will not, but that hardly means that transactional activity will approach zero.  There are a lot of compelling reasons to transact even in an expensive leverage environment and those transactions will still get done.

Innovation will grow in popularity.  In good times, innovation is a hard sell.  Just rinse and repeat.  Good ideas may be interesting, but meh, not really necessary.  That changes when credit tightens and regular way is no way.  Thinking outside the box (ok, I’m talking my book here) will be more valuable and valued.  Stand by for new financial products, processes and strategies.

Somewhere in the middle of all this, we will have a distressed debt cycle.  Moderate coupon creep is not something that typically leads to a distressed debt cycle (boiling frog) but rapid, discontinuous increases?  Sure.  Refinance will get difficult and expensive, and if the health of the consumer is actually impacted by a serious recession, the health of the multi-family market, office, hospitality at least will be materially impaired.  Oh sure, balance sheets are healthier than at the time of the GFC, more institutional money is in commercial real estate and LTVs and DSCRs and debt yield going into this period of stress are relatively healthy, but they’ll still be stress and distressed.

So, the faster we embrace the new reality, the faster we can get back to business.  In the meantime, this does present opportunities to look for upsides.  There are ponies in there somewhere and innovation and dry powder can get you to yes.

As Dr. Venkman said in that foundational bit of American culture, Ghostbusters, “I love this plan!”

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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