“If you think hiring a professional is expensive, wait ‘til you hire an amateur.” -Red Adair (oil well firefighter)
I’m sure today’s quote is painfully accurate for those who have opted for cheap or “too-good-to-be-true” solutions to their infrastructure or portfolio problems. [Remember when my family had an unsecured safe, no cameras, and no alarm system at our home? A proactive, professional solution really would’ve been helpful. 😊 Speaking of which, now that it’s been five months, my wife and I finally received our new passports…though the kids’ will take another few weeks or months]. But Mr. Adair’s quote is also witty and hilarious, and we could all use some levity in this environment of bank failures and scary headlines.
We interrupt this regularly scheduled program
In Part 5, we covered the risk/reward spectrum of commercial real estate at a high level, and my original intention for today was to continue with that topic. Instead, I’m calling an audible and going off on a tangent related to current concerns within commercial real estate markets, at least partially prompted from client questions. Here we go!
On the news tonight
Just this morning, I was in touch with a client expressing fear of “commercial real estate.” And who can blame them? A quick Google search results in headlines like, Commercial real estate continues to get pummeled, Commercial real estate is in trouble…, or New York Fed board member warns of commercial real-estate risks.
To the credit of CNN, in the second article, at least they point out the following VITAL (poorly written) caveat:
“A lot of people hear commercial real estate, and they think it’s all the same thing, and the trends are they’re all the same, but they’re not. The underlying fundamentals of multifamily and industrial assets remain relatively stable on a national level. It’s different for office and retail properties. There’s been a fundamental shift in how we use office space, and that has changed demand…”
If there’s one thing I’ve conveyed thus far in this series, it’s hopefully that real estate is very nuanced: all locations, property types, and properties are different. So, let’s not throw the baby out with the bathwater.
Empire state of mind
Let’s talk about New York City for a moment. [Also known as the Big Apple, which I needed to add as a segue into this incredible art installation I noticed on 6th Ave last week: The Gran Manzana.] My office window looks out at the Helmsley building (which you may have driven through, for reference). Behind it – and getting taller by the day – is the massive and mindblowing construction project at 270 Park Avenue that will become the new JP Morgan headquarters. That building will be very desirable and very occupied. Perhaps that’s an unfair example, as Jamie Dimon can fill the building simply by demanding that JPM employees come to the office 4 or 5 days per week (which they’re doing, based on my personal personnel interactions). However, I can easily name several other Midtown buildings that aren’t filled by a single employer where I don’t think occupancy is a problem.
Instead, the more problematic properties are those that are outdated and undesirable – like older properties in areas where businesses do not want space. Markets will eventually find an equilibrium between supply and demand. It could be painful, especially for existing equity holders. It could mean conversion to something other than commercial office space. It could mean overhauling interiors and energy infrastructure to appeal to new tenants. It could even mean a complete teardown of existing structures for new, state-of-the-art facilities. Regardless, solutions will be found, translating to real opportunities for those who can step in with capital and the skillsets to turn those situations around. In the meantime, Class A (aka higher-end) office space in NYC generally commands a significant premium over Class B and C properties; considerably more new space is under construction, potentially exacerbating the current “class gap.”
Breathe. Breathe in the air.
Forgive me if these things are already coming through loud and clear from the latest headlines, but let’s take a step back, breathe (as Pink Floyd would have encouraged us to do), and note a few things:
- Credit and equity are very different things: Equity holders of undesirable real estate can and should incur losses. That’s the risk of equity. As with stocks, equity owners benefit from upside appreciation and are the first to bear downside risk. Simply put, if a property’s assets aren’t worth more than the debt, then the equity is worthless, but it doesn’t mean the debt is worthless. The articles I’ve read fail to mention – especially those sounding alarms of banking troubles stemming from commercial real estate loans – that creditors will have an opportunity to recoup some of their investment, EVEN if the equity is wiped out.
- LTVs matter: At the end of the day, a bank can reclaim a building from the borrower (foreclosure process). If the underwriting was done responsibly, the bank should be able to endure between 40-60% of price reduction while fully recovering the loan’s value. The ability to recover value on a bad loan is why the loan-to-value ratios discussed in Part 5 matter so much. It would be concerning if you told me that many banks own substantial equity in highly levered, speculative real estate. But that’s entirely different from saying that banks have lent 50% against the value of some Class B or C buildings whose prices have declined 30%, for example.
- Know what you own: Is “office” real estate under pressure now? Surely some office buildings in specific locations are suffering. And surely some office buildings in those same zip codes are thriving. More broadly, different properties and property types in different areas are experiencing unique impacts (whether good or bad) from the current environment. Again, real estate has to be considered on a property-by-property basis. If you or the manager you invest with hold highly desirable properties in good locations, buoyed by favorable demographics and demand trends, then – as usual – my advice is to turn off and tune out the media noise…as long as you’re working with a professional.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
