The Weekend Edition # 124 - Are CRE concerns systemic?

Welcome to another issue of the Weekend Edition!

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Here's what we cover

• Market Recap - Marching Ahead

• Macro - Are CRE Concerns Systemic?

• Closing Thoughts - Yields

• Calendars

Market Recap - Marching Ahead

February 26 - March 01, 2024

We’ve closed out February on a positive note for most markets around the world. Going into February there was discussion of seasonality playing a role, as February is historically one of the weakest months, but it would seem that the crisis has been averted.

For a while there, we were looking at a strong pullback when the US CPI numbers were released and the market started to adjust to the idea of “higher for longer” once again.

Surprisingly, that adjustment has taken place and yet, the markets were able to shrug that off and march higher. It’s not often that we see a positive correlation between bond yields and equities. But here we are…

Rate cut bets have also been adjusted not just for the US, but across the board. In fact, Goldman Sachs shows that rate-cut bets are now lower than what they are pricing in. So if we look at this as 25bps (or 0.25%) per cut, we have about 80bps for the Fed, which equates to 3 rate cuts, we have just over 100bps for the ECB which is 4 rate cuts, and just over 70bps for the Bank of England which is about 3 cuts.

Commodities

• Oil prices continue to trade in a narrow range.

• This week we saw US oil inventory increase by 4.2 million barrels, more than expected.

  • This marks the fifth week of inventory growth, reaching the highest level since November.

  • Despite the inventory build, oil stocks are still 1% below the five-year average.

  • Cushing, Oklahoma's oil inventories rose by 1.5 million barrels.

  • US oil exports decreased, and imports also fell slightly.

  • Gasoline inventories dropped more than anticipated, while distillate stockpiles fell less than expected.

  • Refinery operations slightly increased but are lower than last year's rate.

• China's oil demand growth is expected to slow in 2024

  • CNPC (China National Petroleum Corporation) forecasts a significant slowdown in China's oil demand growth for 2024.

  • Factors include slow post-pandemic recovery and a shift to new energy vehicles.

  • Expected growth is only 1% to 764 million tons (approx. 15.3 million barrels per day).

  • This is the lowest growth forecast in over a decade, not counting COVID-19 impacts.

While there are concerns that higher oil prices could continue to fuel inflation, we expect average prices around $75/bbl shouldn’t cause massive re-acceleration in headline inflation. However, remaining above this level for a sustained period of time could be troubling.

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Macro - Are CRE Concerns Systemic?

On Thursday, 29 Feb 2024, New York Community Bancorp's stock fell over 26% after hours after the company disclosed material weakness in internal controls from their loan reviews. The company will delay its annual report filing because of this. They also reported a $2.4 billion goodwill impairment from their acquisition of Signature Bank - this will be reported as a loss on their income statement and decrease their assets on the balance sheets. Finally, the NYCB’s CEO also announced that their CEO will be replaced.

As you can imagine, this is creating further concerns within the banking sector, particularly regional banks. The big question is whether this is systemic, meaning will we see more such cases and how bad can it get?

In a note, right after NYCB reported earnings, GS said that they didn’t think that the issue was systemic.

I fully appreciate that GS could be wrong here in their assessment and in times of a credit crisis, things can go wrong very quickly. Credit defaults can spread like a contagion, much like what we saw during the Great Financial Crisis in 2008. Most banks, however, don’t go bankrupt from a credit crisis but, rather a run on the bank similar to what we experienced last March.

Nevertheless, the concerns surrounding Commercial Real Estate, and office properties in particular remain because there is a heightened level of risk here. We examine some of these issues below:

Increased Vacancy Rates and Lower Rents

It’s no surprise that vacancy rates have increased in office spaces since the pandemic with everyone working from home. Many offices have not had employees return to work and many have permanently left the workforce. On a per capita basis, office space in the US is 1.6x vs. the rest of the world, creating even more room for long-term headwinds.

Office vacancies have jumped from 16.8% at end-2019 to 18.7% at end-2022, with rates in some cities likely even higher.

Some offices have decreased rents to retain clients. When a property earns lower rents, the value drops because cash flows are reduced.

Valuations are down 20% across real estate, but still better than the 40% declines witnessed during the GFC.

Interest Rate Environment

With the Federal Reserve raising interest rates to combat inflation, borrowing costs have increased. This affects both the affordability of financing for new projects and the refinancing of existing loans. Higher interest rates can depress property values and increase the risk of loan defaults.

This also leads to lower property values because when we discount cash flows at higher rates.

Loan Maturities and Refinancing Risks

20% of ~$4.7T total commercial mortgages outstanding are scheduled to mature in 2024, with office properties making up 22% of that.

Much of this is a result of loans refinanced soon after the Great Financial Crisis and have come due in 2023-2024. The latest research shows that in 2023, about 40% of the loans have been rolled over or extended until 2024.

25% of all office maturities are due in 2024.

Bank Exposure to CRE Loans

Regional banks, in particular, have significant exposure to commercial real estate loans and hold ~48% of the loans maturing in 2024, higher than the average of ~38% across all maturities.

For now, there are legitimate concerns surrounding US Commerical Real Estate. However, we doubt that this could spark a contagion within banks and a systemic meltdown.

Closing Thoughts - Yields

Since the US CPI Inflation report, we have seen bond yields in the US start to increase steadily since early February. However, the market has still marched higher. As we illustrated, in the market recap segment, this is unusual. When bond yields rise, stock prices fall, and vice versa. This is not what we’re seeing here and that is a tad troubling. Either we need to see yields go down or stock prices fall.

There’s somewhat of a valid reason though for some of these stocks to rise. Unlike the Dot Com Bubble, the stocks leading the market are not soaring based only on multiple expansions but are in fact, delivering earnings.

However, we still have to deal with the situation of the inverted yield curve. We’ve had the longest inversion of the Yield Curve (YC). By now you probably know that this is the 10Y US Treasury Yield - the 2Y US Treasury Yield. If you want to understand more about the yield curve, I wrote about it in detail here.

Back to the YC… in general, when rates start to normalize, the shorter end (the 2Y) starts to fall because the Fed is cutting rates. If the long end remains pinned where it is right now, then we will not likely experience pressure on bond prices at the long end, and consequently on stocks. However, in a situation where the long-end starts to rise, while the short end falls - a bear steepener - like we say in Aug-Oct 2023, we will definitely see pressure on bond prices and stocks.

How the yield curve resolves from here on out, will be crucial to stock prices.

Let’s be careful out there.

Have a great week ahead!

Sincerely yours,

Ayesha Tariq, CFA

There’s always a story behind the numbers.

Calendars

US Earnings

US Economic Calendar in Eastern Time (Source: Trading Economics)

None of the above is Investment Advice. I may or may not have positions in any of the stocks or asset classes mentioned. I have no affiliation with any of the companies other than explicitly mentioned.