January 20, 2024 | Last week, a reader of The Institutional Risk Analyst named Jeffrey asked a good question about our last missive. Why did we compare an equity REIT like Brookfield Downtown LA Fund Office (DTLAP) with a mortgage REIT like Blackstone Mortgage Trust (BXMT). The former holds the equity in office buildings and the latter typically holds the senior mortgage debt. But in today's market, mortgage REITs are becoming equity REITS.
Source: Google Finance
Notice in the chart above that BXMT is down less than half as much as DTLAP, doubtless reflecting the belief by investors in the former that there is still equity underneath their debt. Yet since the COVID pandemic, the public equity of many equity REITs focused on office properties is down significantly.
In normal times, comparing an equity REIT with a mortgage REIT is like comparing apples and oranges. Given that most commercial properties have 50% equity in first loss position, the holders of the secured debt are relatively senior in the credit stack. But when asset prices are falling and the value of the equity has been wiped out, the holder of the debt is now in the first loss equity position. That is, the debt is now equity.
If you are a bank or REIT holding a first mortgage or mezzanine debt on an office building in downtown (aka “East”) Los Angeles, odds are pretty good that you are in first loss position. The equity is gone. Thus we looked at DTLAP first and foremost as a benchmark for the mark-to-market haircut on asset prices. Second, the more than 95% diminution of value in the stock price of DTLAP over the past several years gives you a sense for the overall value of the portfolio and the market.
Truth to tell, commercial buildings from East Los Angeles to West Palm Beach are in trouble, in some cases because of the change in use cases and consumer living patterns since COVID. Another factor, ironically enough, is that the surge in new construction in many markets has resulted in a drop in the value of existing assets in that same market. That 20-year old strip mall in south Florida that has been a cash flow cow for decades now goes begging with the new malls starting to arrive.
In a strange way, the decision by the FOMC in 2019 to flood the market with reserves not only cushioned banks and other leveraged vehicles with cheap and plentiful cash, but also created a tsunami of new commercial real estate investments that has reduced the value of existing assets. If we look at the Invesco KBW Premium Yield Equity REIT ETF (KBWY), for example, we can see a broader picture of the discount being applied to equity REITs across the country.
With the increase in interest rates since 2021, the FOMC has now left many investments made in 2020-2021 underwater in terms of net cash flow. Indeed, many commercial assets financed over the past decade are underwater. If one assumes that interest rates are likely to stay in the current range for most of 2024, then the likelihood of a serious contagion affecting banks and other holders of equity and debt on office assets grows.
The key thing to remember with commercial real estate is the change in price volatility and direction that has occurred since COVID. Since 2020, we have seen the market for commercial real estate go from a secular assumption of asset price inflation to a presumption of price deflation. The world where CRE assets were financed with interest only mortgages has disappeared.
Now “owners” of commercial properties find themselves trying to rationalize putting new cash equity into assets that have falling valuations and net operating income. The Greenstreet Commercial Property Price Index provides a graphic description of what's happened to property values since COVID compared with the past 25 years.
Much of the mounting value destruction in commercial real estate has to do with COVID and the change in behavior since the lockdown forced upon Americans by the Biden Administration and many blue state governments. But the conduct of monetary policy by the FOMC and particularly the decision to flood the markets with excessive levels of reserves is also to blame.
If you ask a banker to state the appropriate quantity of bank reserves at any point in time, what is the answer? More. Bill Nelson at Bank Policy Institute observes in his latest Forward Guidance missive on the just released 2018 FOMC minutes:
“The Fed’s estimate today of the necessary quantity of reserves is probably about twice the level Chair Powell stated in 2018 would give him buyer’s regret. Why hasn’t the Committee changed their mind? One of the problems with the excessive reserve approach, as opposed to the necessary reserve approach, is that there is no binding upward limit on the size of the balance sheet. As a consequence, like the proverbial boiled frog, staff and leadership of the Fed may have become somewhat complacent about balance sheet size. Such complacency may have contributed to the Committee continuing QE4 in 2021-22 even though the economy was clearly recovering…”
The complacency and lack of care by the FOMC with respect to reserve levels over the past five years may cause many tens of billions of dollars in losses to banks, REITs and other lenders on commercial real estate. These policies will also cause the Fed to report massive financial losses for years to come, losses that are a very real cost to the Treasury and taxpayers. When the cost and benefit of Fed actions during 2020-2021 are tallied, the net balance likely seems to be negative and stretches into the trillions of dollars.
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