Text on screen: PIMCO
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Text on screen: What is the current state of the commercial real estate market?
Text on screen: John Murray, Portfolio Manager, Commercial Real Estate
Murray: The commercial real estate market is in a state of disarray – public securities are wrapped up in the broader public market volatility, lenders are retrenching, and equity buyers and sellers are paralyzed with uncertainty around cap rates, recession risks, and higher debt and construction costs
With this backdrop, traditional transactions are dead and there’s limited visibility into pricing, but regressions and our ground-level experiences suggest pricing is down as much as 5-20%+, depending on the sector
Text on screen: Commercial real estate owners have turned to “special situations” financing
Images on screen: Commercial real estate exteriors
a lot is happening beneath the surface, as CRE owners needing liquidity have turned to much more specialized solutions.
Text on screen: Stages of distress in commercial real estate markets
For commercial real estate, this is the biggest downturn since the Global Financial Crisis of 2008, and we see this downturn following the same general stages as past downturns.
Text on screen: Stage 1: Public market dislocations
Images on screen: Office exteriors
The first stage is characterized by public market dislocations, which we’ve certainly seen this year.
FULL PAGE GRAPHIC: TITLE – REIT Values Have Declined… and CMBS Spreads Have Widened. The graphic consists of two line graphs, one depicting price changes of REITs (Real Estate Investment Trusts) and the other depicting the spreads of CMBS (Commercial Mortgage Backed Securities). The REIT graph spans the period of March 2019 until October 2022, while the CMBS graph spans from January 2021 until October 2022. The REIT graph shows an increase in 2019, a large decrease in 2020, a very large and rapid increase in value over the course of 2021, and a large decrease in value this year, 2022. The decrease is highlighted with a red box and the text “Decline since 2021.” Next to the REIT chart, the CMBS chart shows an increase in spread widening of almost 100% over the period it covers. Spreads started around 350 basis points in January 2021, and remained in this neighborhood throughout 2021, with a brief dip near 250 in June 2021. In December, they began to rise over the course of the next year. Currently, basis points for CMBS spreads sit around 650, almost double where they were a year earlier. The chart shows that while equity values are declining in the REIT sector, credit spreads are rapidly widening in the CMBS sector.
REITs are down over 25% year-to-date, and CMBS BBB spreads have widened by over 200 basis points.
Now, this public volatility has hit private commercial real estate, as REITs are forced to the sidelines, CMBS originators have disappeared given the volatility in the fixed income markets, and even balance sheet lenders have tightened due to increased regulatory pressures and limited paydowns this year.
As a result,
Text on screen: Stage 2: Special situations
Images on screen: Office exteriors
we’re now entering stage 2, or, the special situations stage.
Over the past month, we’ve seen a dramatic shift from traditional buyer/seller deals to more complex and often under the radar restructurings.
Examples include multiple rescue capital situations where CRE owners now need bridge capital to finance upcoming loan maturities or existing projects.
On the lender side, we’ve seen a tremendous pickup in loan sales from banks looking to get ahead of risk downgrades.
Images on screen: Central banks
with central banks tightening aggressively, we expect this special situations stage to persist for at least the next 1-2 years.
Text on screen: Stage 3: Deeper distress
Images on screen: Office exteriors
a likely global recession would eventually push us into the final stage of a CRE downturn beginning in late 2023, where deeper distress builds as a recession leads to tenant defaults and downsizing.
These fundamental pressures will collide with ballooning loan maturities starting in 2023, foreshadowing a second wave of loan defaults and non-performing loan sales.
Text on screen: Where are the investment opportunities today, and what tail risks give you the most concern?
With dislocation comes opportunity, particularly for those who can provide creative structuring solutions and/or move across the four quadrants of public and private CRE debt and equity.
Text on screen: TITLE – Areas of opportunities: BULLETS – Public markets: Tactical opportunities in CMBS and REITs, Private markets:, SUB-BULLETS - Senior loans, Junior debt, Preferred equity, Discounted loan purchases from banks, Rescue loans to non-bank lenders
On the public side, given the broad and somewhat indiscriminate public market selloffs today, we see tactical opportunities in both CMBS and public REITs.
On the private side, it’s a great time to be a solutions provider. With nearly all forms of lenders shut out of the market, we’re seeing an explosion of opportunities in these stage 2 situations ranging from senior loans that can generate yields in the high single digits, to junior debt or preferred equity positions that offer mid-teens+ returns.
As CRE lenders look to reduce risk, we see a number of opportunities to provide solutions, including discounted loan purchases from banks facing regulatory pressures, as well as rescue loans to non-bank lenders facing margin call pressures.
In addition to the obvious macro pressures, commercial real estate faces another tail risk in the form of redemption pressures that could overwhelm open end core funds and create an unprecedented technical pressure on the commercial real estate market broadly.
Text on screen: TITLE – Why core funds face risk of reversal in capital flows: BULLETS – The “denominator effect”: public security mark-downs imply an over-allocation to private CRE, Little movement in core fund valuations despite CRE prices being down
As rates have reversed, these core funds face the risk of a significant reversal in capital flows from a confluence of factors:
First, the “denominator effect” is impacting allocations to CRE broadly, as the drop in public securities implies an over-allocation to commercial real estate for large pools of capital including pension funds.
Secondly, despite implied commercial real estate values being down 5-20%+ this year, core fund marks have barely moved.
FULL PAGE GRAPHIC: TITLE – Total Returns— ODCE Index vs Equity REIT Index. The graphic consists of a bar graph measuring the total returns of the ODCE Index (Open-End Diversified Core Equity Index) and the NAREIT Equity REIT Index (National Association Of Real Estate Investment Trusts Equity Real Estate Investment Trust Index), over a 10-year period, a 5-year period, 3-year period, 1-year period, and the 1H2022, the first six months of 2022. Over the 10 year period, 5-year period, and 3-year period, the ODCE Index outperformed the NAREIT Index by 1.4%, 2.2%, and 4.9%, respectively. It returned 9.7%, 8.9%, and 10.2% over these periods, while the NAREIT returned 8.3%, 6.7%, and 5.3%, respectively. Over the 1-year period and the 1H2022 period, the ODCE continued to outperform, by a far more dramatic margin. NAREIT values declined 5.9% in the year, and 19.2% in the 1H2022, while the ODCE returned a 21.5% gain in the 1-year period and a 12.5% gain in the 1H2022. The graph shows that ODCE has outperformed the NAREIT over many different periods of time, and, further, the outperformance has grown especially stark in the past year.
This is astounding when you consider the nature of a typical core fund portfolio, which includes substantial exposure to long term, fixed rate leases which have undoubtedly repriced in the private markets given the dramatic move in rates.
Logically, many investors in these funds are starting to anticipate that core fund marks will drop in the coming quarters, and are heading for the exits.
Considering the speed and scale of the rate moves this year, this wave of redemptions could be even worse than what we saw in the global financial crisis.
Core funds will eventually need to shed assets, which portends yet another negative pricing pressure for commercial real estate in the coming years.
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All investments contain risk and may lose value. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Collateralized Mortgage Obligations (CMOs) may involve a high degree of risk and are exposed to risks such as credit, default, market, interest rate, prepayment and extension, and certain classes or series may have more or less volatility depending upon the predictability of cash flow for such class or series. Investors may lose some or all of the investment and there may be periods where no cash flow distributions are received.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
The MSCI US REIT Index is a free-float adjusted market capitalization weighted index that tracks the performance of 136 equity REITs that trade on public markets.
The FTSE NAREIT All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. equity REITs. The 208 constituents of the index include all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property.
The National Council for Real Estate Investment Fiduciaries’ (NCREIF) Fund Index -- Open-end Diversified Core Equity (ODCE) provides quarterly and annual total returns for 28 institutional open-end commingled real estate funds. All the funds in the ODCE pursue a “core” investment strategy and some have performance histories going back to 1978. The NFI-ODCE is market-weighted and reported both gross and net of fees. The computations are time-weighted as described more fully on the NCREIF web site at http://www.ncreif.org
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