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Commercial Real Estate (CRE) Issues and Long Cycle Markets and a "Credit Crunch" Explained
Level 2 - Value Investor
Welcome Avatar! Now that SIVB is gone and the bank fears are easing, it’s a good time to walk through the current issues in the financial system. Currently, the current issues are primarily with the regional banking system since those banks are the biggest lenders for Real Estate (particularly commercial).
No, this isn’t a perfect answer to all the banks. It’s simply easier to explain this way. Smaller regional banks compete with better rates and better customer service. That is the “bread and butter” when going head to head with the “big guys”.
Part 1: How is Commercial Real Estate Different
Many moons ago we wrote small posts on “buying buildings” if you want to make money in Real Estate. This was circa 2014/2015 or so where the move was to try and buy duplexes at minimum with a goal of acquiring larger multi-plexes since they are cash flow machines.
That is neither here nor there since that info is now stale/dead after the interest rate hikes (everyone knows our current view of RE by now!)
For the current issues in the banking system you have to think in terms of large/major loans. This would be those large building you walk into every single day to scan your company key card (which is time-stamp monitored by Karen in HQ) and sit in the office/cube for 10 hours a day.
Review Residential: The vast majority will only deal with 15-year or 30-year fixed mortgages. This means you lock in an interest rate of say 4% and that interest rate is *fixed* forever. You pay the same dollar amount every single month for 15 to 30 years and at the end you own the home/condo/duplex etc.
Commercial Real Estate: Welcome to The Colosseum Arena.
Commercial Real Estate has a lot more complexity assigned to it, the major differences are: 1) **Floating Rate Debt**, 2) **Lock-out Period**, 3) interest only periods and 4) good news money. Most also have pre-payment penalties on loans but that’s also becoming more common for various residential properties (in before someone complains that it should be included as #5 but it is what it is)
Floating Rate Debt: This is the big one. If you borrow say $10M for commercial real estate at 4%, that interest rate may be 10% or it could be 3% in the future. It depends entirely on the deal you signed which is typically tied to the LIBOR rate.
Instead of going through all the different treasury and swap rates. Keep it simple.
As the Fed raises rates these rates go up. Don’t overcomplicate it. With the Fed holding rates at 0% people could get commercial real estate loans for ~3-4% (example). If the Fed moves rates to 4.5% then you’re looking at 7.5-8.5%+ on commercial real estate (once again simplification).
As you can see the time to buy a ton of commercial real estate was 2011. The worst time to buy was January 2022. (all else equal)
Simple Disaster Explained: Person gets a $10M loan at 3% in Jan 2022. The contract says interest rates reset every year (more complicated than this but you get the point). You planned on making 7% a year on the asset, 7%-3% sounds great! Now suddenly Interest rates are up to 5% and the new interest rate on your $10M loan is 8%! On top of that layoffs are ramping up and you can’t even hit your 7% target and it collapses to 3.5%.
You’re now paying 8% interest on $10M = $800K a year and you’re only netting $350K a year = $450K annual losses. Massive losses.
Lock-Out Period: Welcome to more suffering! This is an unlikely scenario but not impossible. Most CRE deals come with a lock-out period. This means you cannot pay off your loan even if you want to during a specified time.
Say you are barely making money from a deal you got into and then rates go up rapidly. After that you enter into the lock-out period. Now you’re forced to pay all the high interest rate payments and can’t even pay it off with cash if you wanted to. Not ideal.
Interest Only Periods: This is the one silver lining (potential out for anyone who bought in 2022). Many CRE deals have a clause that say you only have to pay interest for say the first three years. Since you’re in construction mode building/repairing the asset, you are not asked to pay down principal. So you make minimum payments (easier on cash flows) and then you *pray* rates go down by the time you start filling the building. This would be an okay scenario for you since you avoided going under with minimal cash outlays in high-interest rate environment.
Note: we’re aware this could be “spun around” and argued that interest only is better with rates near zero( assuming you fill the building before rates go up). The point is still the same. The clause can be used to buy you valuable cash flows at the start of the project
Good News Money: The phrase is kind of funny in a high rates environment. That said, you can borrow more money if you hit certain metrics. (Ie. leasing commissions for example). This doesn’t really help anyone in a rising rates environment since no one smart would want to lever up more with higher rates unless the building was slaughtering all the ROI metrics.
The Big Picture Within This Mess
Since regional banks are the ones making these loans in many cases, they are over-exposed to the loans with floating interest rates. This means default risk begins to climb rapidly. Particularly if layoffs are ramping and *partial* remote work is here to stay.
Add another layer of headaches! Who was making all of these 30-year fixed 2.9% mortgage loans in 2021 for residential owners? You guessed it the regional banks.
Do you think the typical person “fudged” the information and claimed their AirBnB rental was going to be their primary residence? Of course.
Now the Issue is Clear: The regional banks have a lot of exposure to high risk Commercial Real Estate deals and low value 30-year mortgages. Who in the world would buy a 3% mortgage backed security product when you can buy a 30-year US Treasury bill that yields nearly 4%? No one smart! You have to sell these loans at a massive discount to make the yield attractive enough for an investor to purchase.
Choppy Waters: After the recent bank failures, treasury yields plummeted as people started betting on a pivot/rate cut sooner than later. This actually helps the banks that are trying to survive since a 4% MBS is worth something with 10-year t-bills at 3.5% and they are worth massively less if 10-year bills go to 6% (that would be brutal for the banks!)
Now you’re all caught up on why the Fed is concerned about CRE.
It’s all about the floating rate debt load and cheap loans!
Part 2: Why This is a Long-Cycle Issue
Time to add a layer of complexity.
Timing and the “Human” element (also known as incredibly irrational element).
If you found this side of the web you’re probably a bit different to be honest. You’re looking for fringe/niche info and have general distrust of mainstream media. Even our resident multi-millionaire Ferrari Driving ex-corporate executive level SE Real Estate expert admits to being completely unhinged as well (BowTiedBroke).
This means *your* actions do not represent the majority of people. You might be lining up every single paycheck for XYZ stocks, XYZ computer tokens, XYZ mortgage payments and a perfectly staggered T-bill ladder. This is *not* normal.
We’re not saying this is bad. In fact that’s the audience we want (people searching for mis-pricing/opportunities at all times).
Enter Timing: People are disorganized. Deals close at random times of the year. While there is general seasonality for all businesses (more home sales in spring/summer vs. winter, more consumer good sales in Q4 due to holidays etc.) the exact close date can be a mess.
Throw in a bunch of construction delays due to covid, ultra low interest rates and remote work changes… you got a splattered mess for the calendar year.
President Powell begins to raise rates and investors already signed. When does it impact them? Well it depends on the contract is it 6 weeks, 6 months, 12 months so on and so forth. How much money was it for? Which bank was it done with? Was it a new build? Was it already cash flowing? As you can see there are wide range of massive issues here.
In the end, the debt is not going to change every month on the dot. It is going to change randomly for various projects throughout the year. Also. The interest rate you are pegged to isn’t going to go up 5% in two days. If your floating rate debt goes from 3% to 4% you are no worried at all (you shouldn’t be). If it goes to 10%? You probably have problems if you were planning on a worst case scenario of 8% financing.
Now the Human Element: Say you’re the typical mainstream media follower. You jumped on the FoMo train and bought a home in 2022 or end of 2021 (absolute worst time). You locked in a 3% rate and borrowed as much as you could (it’s free money is the mantra) you buy that $2M dream home with a $300,000/year salary.
Pain Begins: Rates go to 6-7% and that home you bought for $2M is not worth $2M. It is likely worth $1.5M and your entire down payment of $200-400K is gone. Then you get a layoff from META/TSLA (insert any tech company).
Well in this case you’re really hurting because you have two options: 1) start selling assets - like your stocks/401K/RSUs to make home payments or 2) have a long conversation with your wife and kids about losing the house. While this isn’t a fun story to write it is all too common and happened in 2001 and 2008.
You know what actually happens. The parents will sell everything to try and keep the house. Constantly selling selling selling until they can’t sell anymore. These individuals usually make it out (barely). But. Imagine the same situation but the person foolishly bought a vacation home as well which is cash flow negative and down 30%!
These individuals are over-levered and are forced to sell. Pressuring the housing market for months.
At this point this general median sale pricing data below should make more sense
Unlike stocks or illiquid small cap computer coins, markets react a lot slower with emotions, leverage and longer sales cycles. Unlike selling your S&P 500 stock, it takes a long time to sell a home at a good price (months at minimum).
Add all this together and you now understand why RE cycles take time from peak to trough.
Part 3: Credit Crunch - Just Means Less Lending
Previously, we decomposed a CDS. Just word salad for “Insurance” (Source)
Now you’re hearing another phrase “credit crush” which just means “banks lend less money”.
We’re firm believers that new phrases are made up every year to confuse the average citizen. Instead of saying “shares” and “loans”. We have “equity, stock, shares… loans, bonds, notes”. Quite literally creating more and more words to mean the same thing. The funniest is when people say “invested capital” which means they invested 10,000 dollars.
While it is true that there is some need for clarification (who gets paid first in a bankruptcy), the amount of words created just seems to get worse.
Credit Crunch! Credit crunch means banks lend less money.
If you were in the business of making loans/lending money you would not want to sit on $10 billion dollars collecting 0% interest. So. You would be a lot looser with your approvals.
Fast forward. Now that $10 billion could be earning you $400-500 million dollars for free! Now you are thinking differently. Also. Since people are losing their jobs the dollars that were sitting around collecting dust are now *much* more valuable.
Simplified: Credit crunch in simple words 1) lending standards go up and 2) less loans are approved. That is all.
If you were previously approved with okay credit. You should assume you will *not* be approved today. That’s how significant the needle moves. You have to assume you will get approved for less money (if you’re lucky enough to get approved!)
Interesting proof point on increased risk. When people buy houses in major cities there are new “clauses” added to the contract. What is the clause? If the person is laid-off during the ~60-90 day close period, the transaction is void and the deposit is returned. Yes. Seriously. This is happening now. To remain balanced, it isn’t common but it’s a new contract structure since people are on edge about all the mass layoffs. (layoff tracker)
That’s it for today! All the noise and made up financial words summarized in simple english. As always love your support and if you’re interested in joining the jungle network which ranges from skin care experts to multi-millionaire RE investors who employ former felons… suggest you subscribe.
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Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are *opinions* written by an anonymous group of Ex-Wall Street Tech Bankers and software engineers who moved into affiliate marketing and e-commerce. We’re an advisor for Synapse Protocol 2022-2024E.
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