The next commercial real estate downturn: It’s not a matter of when, but how

The next commercial real estate downturn: It’s not a matter of when, but how
A lot of the major risk factors that could cause problems for commercial real estate lending are not even on most people's radar in the industry, economist KC Conway says. (contributed)

A recent report shows that many systemic risks are re-emerging one decade since the last major recession and real estate finance disruption — aligning with history’s schedule of economic disruption every decade since the 1850s. But today, there are new variables at play to be aware of — possible game-changers.

CCIM Institute chief economist KC Conway, in partnership with the Alabama Center for Real Estate at the University of Alabama, released the report, “Commercial Real Estate Finance Disruption: Déjà Vu or Something New?” It identifies the sweeping changes taking place within commercial real estate (CRE) finance and the potential to cause the next major disruption in the industry.

“It is not a matter of when, but how,” Conway said. “We’re going to see a disruption in liquidity for commercial real estate lending as a result of accounting, regulatory, technological and financial product shake-ups — many of which are not on anyone’s radar.”

In this exclusive, Conway shared his insights into the signs of disruption, the risks, CRE’s evolution and transaction transparency.

GlobeSt.com: What are the signs of the inevitable disruption in the next six to 18 months, including bank concentration risk and escalating interest rates?

Conway: If we make it past 2Q 2019, it will be the first time since 1857 that the United States did not experience a recession in a decade. Unfortunately, the probability of a commercial real estate finance disruption in the next six to 18 months is as high as it was prior to 2007 to 2008. This time around, though, the likely suspects include the repeat offender of rising interest rates, a concentration risk the likes of which we’ve never seen and the Fed’s exiting of quantitative easing.

High on that list is CRE concentration risk. The contraction in the number of financial institutions over the past three decades, coupled with exponential growth in debt capital, has created a concentration we have never seen in history. Banks continue to garner the largest share of the growth and total debt, despite the Federal Reserve’s enhanced supervisory authority or bank stress tests, Dodd-Frank legislation and the real estate lending market modifying behavior after 500 bank failures (2009 to 2017). Combine that with assets being priced for perfection at record-low average cap rates of below 6 percent, and you have an environment with simply no margin for error.

CRE concentrations in the banks will only increase as maturing commercial real estate construction and “mini-perm” loans back up into the banks absent a fluid permanent CREF market. The resulting severe CRE concentration crisis would not be too dissimilar to the 2008 to 2009 disruption that shut down the commercial mortgage-backed securities (CMBS) market.

We all know that rising interest rates never bode well for the industry, and the Federal Reserve has raised them three times already in 2018. To further complicate the situation is the shift away from quantitative easing. The one-two punch of the Fed’s rate hikes and recent efforts to move away from quantitative easing is a particularly powerful one. All the securities purchased during the quantitative easing period following the latest financial crisis are now being sold back into the market. And by doing so, the Fed is re-injecting risk premiums into the system: precisely what is not needed at this time.

GlobeSt.com: What new risks are presented by emerging property types such as adaptive reuse, co-working facilities like WeWork and experiential retail?

Commercial real estate lending at the moment has no margin for error, economist KC Conway says. (contributed)

Conway: I asked a commercial real estate lender how they would underwrite a WeWork-occupied property today. In fact, I spoke with a cross-section of bank and non-bank permanent CRE lenders from Wall Street to Main Street and discovered that no one had a definitive structure in mind regarding the financing of a building that was majority-occupied by a co-working business. On top of that, their institutions currently don’t have a lending policy or guidelines for co-working offices, co-warehousing facilities or experiential real estate properties.

Let’s add the “Amazon Effect” on retail and distribution facilities, co-warehousing as an off-chute to co-officing and growth in adaptive reuse projects in response to a return-to-the-city trend by millennials to the mix as well. These unaccounted-for emerging property types are altering the commercial real estate landscape and present another distinct threat unto themselves if not addressed effectively. The industry needs to properly define these new property classes and underwriting requirements sooner rather than later to allow capital to flow as it does with other well-established CRE categories. By doing so, not only is a possible disruption avoided, but it’ll offer so many growth opportunities to the industry.

GlobeSt.com: How has commercial real estate evolved from an alternative investment to a mainstream asset deeply embedded in virtually every institutional and private investment structure, including retirement funds and pensions?

Conway: Commercial real estate finance has come a long way since 1955, when total debt capital invested was $250 billion. By the first half of 2018, outstanding commercial and multifamily debt totaled $4.1 trillion – that’s a 1,500-percent-plus increase in less than seven decades.

Evolving technology has been a critical catalyst in the development of commercial real estate finance. (contributed)

You can’t talk about the evolution of commercial real estate finance structures and participants without talking about advances in technology; the two go hand-in-hand. Specifically, technological advances in both data analytics and property cash flow software have been critical catalysts. These advances delivered the transparency required by regulated banks, institutional investment funds and public finance companies to engage more broadly in real estate finance. Whether it’s the impact of new and more sophisticated discounted cash flow software like Argus to value and underwrite more complex lease structures; or smartphones and apps that provide access to data anytime, anywhere; or emerging transaction technologies like blockchain, technology remains the high-octane fuel in the industry’s engine. These advancements in real estate finance have provided both transparency into an asset class that was previously regarded as local and more owner-occupied/single-tenant in nature; and data analytics to slice and dice increasingly complex lease and capital structures into investment products that can be packaged and securitized to more investors in much the way CMBS has transformed real estate into a bond investment.

What’s more, expanded market data analytics, like those provided by Trepp, EDR, Reis and Metrostudy, provide capital sources the confidence to venture more and more into secondary and tertiary metropolitan statistical areas. Bottom line, without this technology, commercial real estate finance would never have expanded to the $4.1 trillion market it is today. Commercial real estate finance is now too big and systemic to be put back into the alternative asset bottle.

GlobeSt.com: What are some of the dramatic shifts in the transparency and speed of transactions, including advances in financial technology such as Smart Finance, blockchain and SALT?

Conway: Smart Finance is considered the next big thing in CREF. By incorporating artificial intelligence to automate the underwriting and credit scoring processes, approvals and closings happen much quicker – and it simultaneously documents regulatory records and preloads all required information for annual Dodd-Frank-mandated stress testing.

Adding layers in blockchain technology and you have Secured Automated Lending Technology. SALT allows cryptocurrency asset holders to use their digital assets as collateral for cash loans. By eliminating the need to liquidate holdings, you have a digital-asset-backed lending market on the rise. SALT is already in use in commercial real estate.

GlobeSt.com: What is the effect of the sun-setting of Libor, the advent of current expected credit losses (CECL) accounting standards for banks and new lease accounting regulations for public companies that engage in any form of real estate finance activity?

Conway: While the industry is aware of all these factors, the actual impact of each is still a question. Libor is a great example. There currently is no definitive replacement for Libor once it sunsets in December 2021. Let that sink in. A benchmark rate that a total of $350 trillion in debt instruments rely on, including interest rate swaps and all adjustable rate financial products. So far, Secured Overnight Financing Rate (SOFR) is the front runner. Fannie Mae successfully issued several SOFR securities in 2018, but who knows? I think we’ll all rest easier once the new Libor is identified and adopted.

With CECL, financial institutions will be required to estimate the expected loss over the entire life of the loan – representing a substantial change in data analytics and financial methodologies. The real fear here is that banks will reduce real estate lending volumes as they build up additional capital reserves in 2020 to 2022 to comply with this standard.

And just around the corner is the new lease accounting in effect next year. The new Financial Accounting Standards Board accounting standard for leases, ASC 842, mandates that both lease assets and liabilities are recorded on a company’s balance sheet without any grandfather provisions. I don’t think I can overstate the impact of this one, especially on long-term lease structures critical to the triple-net lease market and permanent debt investors, i.e., real estate investment trusts (REITs) and life companies that rely on matching their longer-term liabilities to assets with long duration cash-flow assets. According to Moody’s, this new FASB lease accounting standard will add as much as $1 trillion in liabilities to corporate balance sheets. Adding insult to injury are the right-of-use asset calculation methodologies issued, in which the corresponding asset value is not determined or based on market values. We’re going to see net values and credit ratings of companies take a nose dive. It’s a legitimate threat to the future of longer-term leases, leaving the NNN lease market particularly vulnerable. This disruption should be on everyone’s radar.

This article originally appeared on GlobeSt.com. Conway is the director of research and corporate engagement at the Alabama Center for Real Estate at the University of Alabama.

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