State of the Commercial Real Estate Market

Lonnie Hendry:Yeah, thank you, Lisa. I'm super excited to be here and really looking forward to the discussion today. So as mentioned, this can be as interactive as everyone would like. We'd love to have some back and forth. And so without any further ado, we'll kind of jump into the data here. So a couple of things as we kind of kick off this report. There's a few things that I like to state kind of at the onset of these presentations. One by definition, real estate is a local and sometimes hyperlocal endeavor. And what that means is that some of these headlines may be true for some markets, but they don't necessarily resonate across every market and some of the data when we look at delinquency, when we look at special servicing, when we look at some of these other more granular data elements of delinquency or default, again, it doesn't mean that the entire market is facing the same challenges.

So we will work through some of those details. High level here, we've just put together kind of a hodgepodge of 2024 headlines and I have a little joke that I said if the headlines were actually true, we'd be doing this webinar at the local bar and not online today. There's probably some truth to some of the headlines, but it's not as bad as what the headlines would make you think. One thing that I think we can all come to terms with is that through covid, through an unprecedented rate hike cycle, through all of these challenges that real estate's faced, it's a very resilient asset class and there's been a lot of activity even though muted, it's unlike the great financial crisis where we had no liquidity, there was no availability of credit or financing and everything completely ground to a stop. Unlike that time. This time we've seen some muted transaction volume of velocity, but those things are actually starting to turn a corner and we'll talk a little bit about that.

So just a couple of highlights here. There's a lot of talk around the banks being in trouble. We had three bank failures fairly close to each other in the latter part of 23, 24 where everyone was on pins and needles. I think we pretty much stabilized that. The banking sector generally is on pretty good footing. You certainly have some institutions that are a little out over their skis in terms of CRE concentration, but generally speaking, the mass hysteria that the bank failures brought has kind of died down at some level. We now have a president elect, and so wherever you fall out on the political spectrum, the uncertainty of having an election was something that really drove some hesitation in the markets. At least now people know what we're going to be facing for the next four years. They can make decisions, positive, negative, et cetera.

And a lot of these larger institutions, whether it be Blackstone, Brookfield, others, Starwood, you're starting to see a lot more activity from them on these large portfolio transactions. And so just in the last couple of weeks we've had Blackstone taking down a reprivate $4 billion. Brookfield had a couple of billion dollar transactions announced last week. There was another almost $900 million student housing transaction that was announced this week. So for every negative headline, I think there's a lot of really positive stories out there in the marketplace. So we'll kind of bring a balanced approach to today's topics, understanding that both things can be true. You can have some really strong green shoots in the market and you can have some areas that are really struggling. So with that, we'll roll into just some general broad discussion around sales and lending activity. And so we'll start off here with sales information and we've tried to look at some of the major market players.

So we put California, New York and Texas and the reason for that is that they constituted about one third of the total CRE sales transaction volume in 2024. You can see just from this small sample set, California led the way with just about 20 billion in sales. New York City was over 12 billion. Texas came in at about 384 million. Texas is a little bit of a misnomer in this because Texas is one of about 12 states, so you don't have a lot of publicly available sales information here. The highlight though is the cap rate data. So with the Fed raising rates as significantly as they did, we had about a 500 basis point rate hike in about 15 months, which was unprecedented. You would expect cap rates to expand significantly, and there's kind of a misnomer in the market that interest rates and cap rates are directly tied together, and I think this disproves that at some level.

If you look at average cap rates between 2019 and 2023, they were in that six and a half range. If you look at cap rates in 2024, not a huge delta here. So California is about 50, 60 basis points higher. New York is a little bit more 80 basis points or so higher Texas in that 50 basis point range, but the national average is only up about 23 basis points in the 2024 transaction. So that resiliency I spoke about earlier I think really shows itself here where even if some of these transactions that took place in 24 were done with negative leverage at the onset of the transaction, people are still bullish on their ability to raise rents, generate higher NOIs, and make profitable investments in a challenged marketplace. As we transition into some of the lending volume, this gives you a little bit of perspective on those same three markets from a lending perspective through third quarter 2022.

So if you look at California, about $8 billion worth of new, this is CMBS loan origination. So if we look at CMBS loan origination in California, it's just over 8 billion. New York City was just about 6.2 billion in Texas was about 7.9 billion. If you translate the new origination and overlay somewhat, the delinquency delinquency for these markets ranged anywhere from about 4% California to just over 6.3 in New York. Context across the nation was about 6.4% rate, and we're going to have a slide that goes really deep on the delinquency stuff through third quarter of 2024 issuance as I mentioned, was about 60 billion. As of right now, we're sitting at just over a hundred billion in issuance. So the fourth quarter of 2024 has been really, really strong to the tune of about 35 40 billion of issuance. Some of those may not close in December, but we are hoping that we're going to have a hundred billion dollars CMBS issuance year this year. That's a pretty significant milestone. Last year, the year previous to this was somewhere around 40 billion in issuance. So this is a significant uptick year over year and we have some more granular detail. We'll have some links at the end where we can share some additional reports and other things that give you some of that historical perspective on issuance. If we transition here, let's look just Lonnie ahead. Lisa,

Lisa Knee:We just went back while we're still on cap rates, there was a question that came in about rate spreads and that they still haven't convert reverted back to historical norms. And do we see any continued cap rate expansions or are we witnessing a new paradigm in the pricing?

Lonnie Hendry:Yeah, I think we're probably venturing into a new paradigm with pricing. I don't think if the interest rates going up as quickly as they did only had an immaterial impact on cap rates. I think people are just accepting of the fact that they're going to have to pay more for that same dollar of NOI on a go forward basis. And so what you're going to see is a flight to quality, and that's what we've seen. So I'll have a slide here in just a second that shows a lot of this new loan origination is in what we call SASB loans, single asset, single borrower. They're generally trophy assets and trophy locations and have really strong sponsorship. There's been downward pressure in terms of pricing even when you would expect an expansion of cap rates. Now with that being said, for the office sector in particular, we're still very early in the distress cycle from my perspective.

So even though distress and delinquency surpassed 10% in November, I could see that number getting closer to 20%. When it's all said and done, you're going to see the cap rates on offices have kind of blown out. So you're going to see a huge delta in cap rates on office relative to the other property sectors, but with people not investing in office anymore, that used to be a preferred asset class for institutional investors, that capital is now being deployed into things like lodging, industrial multifamily, which puts downward pressure on those cap rates. So I think we're probably seeing just a new paradigm in what people are willing to pay for that same dollar of NOI relative to the historical norms. That's a great question. I appreciate that. So just kind of gives some, and it's a great segue here. So in the terms of new issuance, as we mentioned, we're just over a hundred billion, right?

About in 20 24, 60 9 billion of that. This is year to date data is constituted of single asset or single borrower deals. We've had 107 SASB deals issued in 2024, just over 69 billion. Compare that to our conduit. So just for those that maybe you're not as familiar with the CMBS space, as I mentioned, single asset, single bar where your cream of the crop effectively the deal is either comprised of a single asset, which is enough to constitute a full CMBS issuance. So one Vanderbilt as an example, an office in midtown would be an example of a single asset or you could have a single borrower, so maybe it's multiple assets but all under the same borrower. So you might have Great Wolf Lodge, the hotel that has 10 or 12 hotels across the us, they may do a single asset, single borrower deal where it's multiple assets, but it's the same borrower.

Conduit is a little more of a barbell where you have some office, some retail, some multifamily, some industrial with geographic dispersion, a bunch of different borrowers. And so they're just two different types of bond issuance. Traditionally, SASB deals have usually been less than the conduit issuance. We've seen a reverse of that due to this flight to quality given where we're at in this current real estate cycle. So in this instance, SA B'S kind of been the deal of choice. And what's interesting is we wanted to highlight office has still had some lending activity even in this down market for office. So across the size B deals about 7.3% of that 69 billion is allocated to office. And what's really interesting is lodging has really picked up the slack. So we're capital used to be allocated to office properties. We've seen a significant uptick in the lodging space.

So lodging is now about 35% of that total, 69 billion of issuance. On the conduit side, it's actually more concentrated to office about 15% and just over 10% for lodging. For historical context, conduit deals generally have had 25 to 30% office concentration. So we're sitting at about half of what a historical norm is. But I think for all of the negativity around office, the fact that we're seeing any office issuance is actually a really positive sign for the sector. So people are still saying maybe we're over office for functionally obsolete class B 1980s office space, but if you're not one of those, we still have a lending program for you and we still want to loan you some money. So we'll talk a little bit about that bifurcation at some point throughout the presentation here.

So as we come into a breakdown of that new issuance, just to give some perspective, it's one thing to see the deal type, whether it be conduit or SASB, it's one thing to look at that in terms of total volume. This gives you a little better perspective just where the allocation has been across all of the asset types. So you have office with the purple and the yellow ring, retail is red, multifamily is blue, et cetera. A couple of interesting takeaways for me, if you look at 23 and 24, the lodging sector as we mentioned, picked up a large swath of origination volume. So that green bar in the last quarter, 23 and second quarter and fourth quarter 24 has been pretty significantly increased over historical standard industrial, which has been probably the most preferred asset class coming out of covid. You saw a pretty good spike of issuance in first quarter of 24.

Those deals in CMBS market ebb and flow some because they're usually really large portfolios, Blackstone or Prologis or others. So you might have a quarter where there's a lot of heavy concentration. There's been no decrease in appetite for industrial even though the issuance maybe doesn't show to be super strong here. Multifamily has been an interesting endeavor. This is looking just at the property type. So what you're seeing here, and we have some bank slides that we'll show in a moment. There's been a pretty strong pullback on bank lending, and so some of that's been absorbed here in the CMBS market and multifamily has been a benefactor of that even though there's some storm clouds brewing for multifamily broadly. And we'll talk a little bit about that. And then retail, if you've listened to our podcast or you've seen me present before we've transitioned from the retail apocalypse, I had to get my retail apocalypse tattoo covered up with one that says retail renaissance because we've entered this new paradigm for retail where if you're not a regional or super regional mall outside of that, retail has come back really, really strong and it's a great thing to see.

You still have some big box retailers, bed Bath and Beyond Big Lots and others that are having some bankruptcy challenges and have gone out. But for every one of those store closures, you've seen Burlington come in and backfill them or some other big box tenant that's like ready in the wings to come in and immediately backfill. And then local community shopping, strip malls, shopping center, those things are at all time high in terms of occupancy and rental rates. So retail's been a really great story in 2023 and 2024.

Lisa Knee:What's in that blue category of other that seems large as well?

Lonnie Hendry:Yeah, so others is an interesting category that would encompass your self storage, your mobile home park, some of these other non-traditional asset classes as well as some of your mixed use properties. And so some of that SASB issuance that we saw in the previous slide is comprised of those mixed use properties where it's maybe some office and then a bunch of retail, or maybe it's some retail and multifamily. So you've seen the really high end class A facilities that are mixed use see an increased appetite for people wanting to lend on those. And so one of the headlines on the very first slide was the Rockefeller Center deal that just got done there in midtown to the two, about three and a half billion dollars. That's considered another because it's got so many different uses there. It's office, it's retail, it has restaurants and dining. So it's a pretty large swath relative to what we've seen from that historically. And I think it's because you've seen a pullback in some of the other dominant sectors like office where that capital has to find a home and it's found in some of these other non-traditional asset classes.

Lisa Knee:And to stay here for one more minute, you had mentioned that there was no appetite for CMBS to lend to industrial. Is there a reasoning for this? I mean it seems like it's been fairly or is it really private lenders that are coming in and doing that?

Lonnie Hendry:Yeah, so I think industrial, there's still an appetite for lending on industrial, but in the CMBS market, most of the industrial loans are large portfolios tied to Prologis or Blackstone or one of these major players. There are only so many of those deals that can get done. So I do think you've seen industrial, it is been the asset class that's been preferred by any lender. Rental rate growth has been incredibly strong post covid. The supply side can't keep up with the demand across most markets in the us so I think there's still a very strong appetite for industrial. The CMBS market just is probably not the best proxy because it's really just the larger portfolio deals that we see, the private lenders for sure, across all asset classes, you're seeing a huge influx of private lenders entering the space, and I think that's one caveat that needs to be considered when looking at this downturn relative to the great financial crisis is the sophistication of the private lending market now is significantly better than it was coming out of the GFC.

So when banks and other lenders pulled back coming out of the GFC, there was really no other option at scale. And what we've seen during this downturn is that there's no shortage of private lenders there to fill the void. And honestly, we've had several people, non-traditional lenders come on our podcast and it's a very interesting paradigm for them in the sense that they can get equity-like returns in the debt space on what they think are really good assets in good locations. So there's a very strong appetite for lending given the current challenges, and I think it's imperative for all of us to remember that in all of these challenges creates opportunity. So if you're the owner of a building that's facing foreclosure, there's probably not a lot of opportunity for you as the owner, but for other people that can come in and reposition the asset or for lenders that can maybe take advantage of that circumstance and charge a higher interest rate if they think it's a good asset or you're a good operator, there are a lot of opportunities created from the disruption.

So I still think we're early in that cycle too. You've seen a proliferation of this private lending space. I think you see that continue to expand as we head into 2025 as well, and the maturity. So this is another thing I think on the headline front, we're not allowed to say maturity wall anymore. There's a negative pushback on maturity wall. Everyone's tired of hearing it or wave of maturity. So now we just call them a maturity schedule, which is fine, but the maturity schedule is pretty significant here. So the challenge we see, and I have a slide in a second that'll talk to this, is that over the last couple of years you have a lot of loans that are performing, so they're still making their mortgage payment, they've done everything they need to do, but the maturity date has come and they're unable to refinance because they've had some value munition, especially in the office sector where they can't refi because the current value of the property is maybe at or less than a loan balance, even though they haven't missed a mortgage payment.

So what you end up with are these extensions or modifications or some sort of kick the can if you will, down the road a little bit, and what that does is it just compounds that upcoming year's maturities, and so you have all the stuff that was slated to mature in 22, that rolls to 23, likewise, 23 to 24, et cetera. At some level, we're going to have to get where rubber meets the road and these deals get addressed. Right now, the guidance from the regulators have been if you have a borrower willing to pay and willing to work with you as a lender, you should work with them. And so the lenders have taken that to heart and they've done a lot of these extensions, modifications, et cetera. A couple of interesting tidbits on that. The extensions and modifications are not free. The borrowers are having to put down, in some cases, some sizable fresh cash into the deal in order to secure the extension or the modification sometimes to the tune, call it 3,000,015 million.

We've seen some at $40 million depending on the size of the loan. Usually that's either a pay down of the loan and or some sort of or leasing commission reserve to try to get the building reten. The other thing that's interesting is most of these extensions have been 12 to 24 months, so about 70% of the extensions that we've seen have been in that 12 to 24 month bucket. Now, logical part of my brain says, that's great, they got an extension, they get a little bit of a reprieve. But it begs the question, do we really think the market's going to be in a considerably different place in only 12 months for some of these people that extended in 23? Here we are year end 24, and guess what? Interest rates and everything are effectively the same. So that extension didn't really get them what they were hoping for in terms of refinance relief.

I'm hopeful at some point the Fed started making their pivot, even though treasuries have stayed the same or gone up at some point we get some reprieve or the interest rates become a little bit more favorable. One of the other interesting nuances coming out of the GFC was that the Fed was aggressively cutting rates to try to stimulate the economy. So in real estate, every dollar of NOI was becoming worth more for your property every time the fed cut rates because interest rates were coming down precipitously. On the flip side, now the mortgages in place are usually, most of these deals that were originating in the last cycle were three, three and a half percent interest rate loans. Even if the Fed cuts another a hundred basis points, and even if we get some relief on the interest rate side, you're probably looking at a five handle on the coupon.

You're talking about a 200 or 150 basis point increase on the interest rate. So even though it's better than a seven, a lot of these borrowers, even in a best case scenario, we're going to have to pony up because the interest rates into the new financing are going to be significantly higher. So nothing super interesting on this slide in terms of like, oh my goodness, the sky is falling. There's a pretty heavy concentration this quarter for lodging maturities. I think that's great. Counterbalance we saw on the previous slide, there's been a huge appetite for lodging origination, so they shouldn't have any problems refinancing. Anecdotally, I travel a lot. I think hotels are super tired. I don't think they've had their PIP plans put in place. A lot of these hotels were needing renovation and had their PIP plans in 20 19, 20 20 covid hit, they shut down.

They used those reserves to keep the loan current. Then everyone came back. Revenge travel, RevPAR and A DR at all time highs. They don't want to take the units down to renovate them. So now you have some hotels that haven't been renovated for 10 years, but they're still getting top of the market rates. There's a disconnect there. If lenders underwrite the financial performance, there'll be no problem getting these things refinanced if they start doing a little more due diligence to start underwriting the individual asset physically site touring the property. You have a lot of hotels right now that probably couldn't even keep their flag if people paid a little more attention to 'EM office, obviously, without saying here challenged, I don't foresee any reprieve for that over the next couple of quarters, probably the next couple of years. I think we're in a long drawn out process for office.

I do think office will come back, but I think that we got to work through this Class B functionally obsolete office property that people don't really know what to do with. We've seen some headlines around some office conversions, the residential, we'll talk about that in a little bit, but overall, I think we're in pretty good shape for maturities as long as the regulator doesn't start cracking down and saying, no more extensions, no more modifications. Transitioning here, this just highlights, and I won't spend a lot of time on this, but there's about a hundred billion in debt extended this cycle. So if you look, this just highlights that 2023 and prior unresolved column on the far left of the chart. That's basically that rollover compound effect that I was talking about. When these deals get extended or modified and they just effectively push that maturity data out to a date in the future, it just compounds the problem if we look at delinquency.

So this has been something that's super top of mind for everyone in the market for obvious reasons. Anytime there's a disruption, delinquency becomes a focal point, some positive and some negative news here on delinquency. It's important for people to remember that we didn't hit peak delinquency coming out of the great financial crisis until July of 2012. So the GFC effectively started 2008. So it wasn't until four years later that we hit delinquency peak at 10.34% in the CM CMBS market. Now what's really interesting here is if you overlay that on this current downturn, the Fed started raising rates about July of 2023. You go out four years, I would surmise we're probably pretty close to where we hit peak delinquency in this downturn. The headlines just move a lot faster than the distress does. Borrowers are incentivized to protect their equity. They're going to fight for every penny in the property until they just can't anymore.

Lenders are not incentivized to take the property back. That means by definition, they're increasing the risk that they're going to lose money in the business of making loans, not operating or selling real estate. So both parties are incentivized to try to find a resolution. That's kind of where we're at in this current cycle. Overall, delinquency ticked up in November, we're at 6.4%. If you compare that to 12 months ago, we were sitting at 4.58% in November of 23, so pretty significant increase year over year. The headline story here is the office sector sitting at 10.38% delinquency as of November of 24. Now we have some slides that'll come up and show you historical high watermark there. I'll give you a little bit of a headstart here. 10.7% was the high watermark for office coming out of the GFC. I think we surpassed that and maybe even in December.

In terms of delinquency for office, I wouldn't be surprised if we see that number getting closer to 20%, and I think it's just there's some external factors with office that are really challenging that sector. Overall though, we're still at 6.4% compared to a high water market, 10.34%. So there's still a long ways to go before we actually have realized distress anywhere close to what we saw coming out of GFC. This is a more detailed chart that kind of gives you all of the great financial crisis era high, all of the Covid era highs. And then where we currently are, so interestingly enough, the Covid area delinquency, and we have a slight error on the overall rate here. This says 10.3% in July of 2012. That should be 10.34%. That was the high watermark. Covid reached almost the same watermark, 10.32% in about 60 days. So we went into lockdowns in March.

By June, we had 10.32%. We thought we were surpassed the 10.34, but we didn't. But you can see some of those individual sectors. Lodging as an example, coming out of the GFC hit a peak of almost 20% in Covid since they were effectively shut down with everyone being locked at home. They went to 24% delinquency during covid. You see, office was at 10.7, currently at 10.38, and retail was another one with covid that saw immediate impacts 18% delinquency by June of 2020. The GSC was at 8.14. So I think the narrative here is that even if office, let's just say worst case scenario, office eclipses 20%. It's not outside of the range of what we've seen with other property types during other disruption. So if we look at lodging now, lodging's doing really, really well post GFC, post covid, like lodging's on fire. If we look at retail outside of the regional super regional malls, it's never been better. So I think there's hope for office. We just have to work through some of this distress.

This just gives you another historical perspective, so we won't go into this. We've talked about it, but you'll have this for your own notes in the slide deck, but this just gives you historical CMBS delinquency by property type going back to 2007 to current. So it just gives you a different visual way to see the ebbs and flows and distress given GFC and the current interest rate cycle. Another interesting way to look at the distress is to look at both the delinquency, which we've talked about at this point and the special servicing rate. So special servicing is effectively when the lender either thinks the borrower has broken a covenant, the borrower borrower's indicated proactively to the lender that they're not going to be able to pay off the mortgage at maturity, or they have a large tenant that's vacating the space and effectively the master servicer who services that loan transfers the loan to what we call special servicing.

And at that point, the special servicer gets involved, they order a new appraisal on the property and they take a much more white glove approach to try to managing some of those disruptions. Special servicing is a pretty good indicator of where we're headed from a delinquency perspective. While some of these really have no bearing on delinquency because it may just be a covenant issue, in a lot of instances, the special servicing transfer is due to imminent monetary default, their inability to refinance, et cetera. So if you look at where the special servicing rate here is in November of 24, it sits at 9.53%. Overlay that with the delinquency we just talked about at 6.4%, you have some reason to believe that you're probably going to see an increase in delinquency just based on where the special servicing rate currently sits. If we overlay this on the last previous high coming out of Covid special servicing hit a high watermark of 9.6% while delinquency was at 6.52.

So if you just wanted a relative perspective on where distress is, it's about where it was, call it early part of 21, mid part of 2021 coming out of covid. Now, the one difference is covid was really an external factor that impacted the markets in terms of just people not being able to go out. So you saw this really quick recovery with covid as soon as people got vaccinated and stores opened back up, et cetera. I don't think you'll see as quick of a rebound with this current disruption just because these are much more fundamental financial impacts that actually impact the value of the property or at least a perceived value of the properties. But interesting, I wouldn't be shocked if we see December 1st part of 2025, the overall delinquency rate ticking up again. Now, this just gives you a different perspective on the special servicing rate.

So again, all time high May of 2012. So while the delinquency rate was in June, as we mentioned, special servicing can sometimes act as a precursor or a leading indicator. In this case, we hit the high water mark in May of 2012 for special servicing. Delinquency was June of 2012, both four years after the GFC. The current rate's 9.53. If you look at that 12 months ago it was 6.84%. So you've seen even a more significant increase in special servicing on a year over year basis as compared to delinquency instead of 10.3% delinquency. In the office space, you're looking at about 14.6% special servicing rate and retail driven largely by the regional super regional malls is sitting at about 12% special servicing. So again, not great news, but I don't think any of this in and of itself is catastrophic for the markets. I would view this as a positive.

So one of the ways I like to look at the delinquency is the overall delinquency was 6.4%. That means 93 plus percent of the properties were making their mortgage payment. Now, back when I was in school and I was in grad school, if someone said, you can get a 93 in this class, I'm taking that with a big smile on my face saying, let's go, this is great. Sometimes the headlines make you feel like everything is delinquent, no one's making their mortgage payment, consumers have no spending left, all this stuff. When in reality where we're at today is 93% of the buildings are making their mortgage payment, and in the worst of the worst office, 90% of the offices are still making the mortgage payment. So it's not great, but it's not nearly as bad as what people would suggest. Now, just as a kind of funny aside, when somebody does something bad in the news cycle, they're hoping that somebody else does something worse.

So they take the headline away from them. So retail has been praying for one of these property sectors to kind of fall off for the last 10 years. So over the last couple of years, they've been more than happy to introduce people to their cousin in the office, which is way worse than retail. So they're stealing all the headlines to everyone in retail, super happy. So I'm happy. I've been in this space about 25 years, and I'm glad that retail is finally being redeemed. It's nice to see. This just gives you the full historical perspective of office distress. We won't belabor this, but if you look at the early two thousands, effectively, no delinquency, no special servicing, you saw the.com bust, you see the gfc, you see covid, you see the interest rate spike. All of this makes sense. All of this is logical. There's a reason behind why you see these spikes in delinquency and distress. And the one thing we know about real estate, I said earlier, it's a local and sometimes hyperlocal endeavor. It's also a cyclical endeavor. Every free market goes through growth, equilibrium, stabilization, decline, revitalization. Those are components of the cycle. We're just starting to see some of the more negative components of that.

Lisa Knee:So just to jump in here real quick, and looking at the recovery and the distress rates and looking at the challenging operating costs for some of the sectors, would you think that there would be more retail and lodging unit reductions or just more closures? That's too much inventory. Yeah, go ahead.

Lonnie Hendry:No, go ahead. Go ahead and frame that for me, Lisa.

Lisa Knee:No, it's just how would you set that up that it's going to be more reductions, or do you actually think it's going to be more closures out there in the market?

Lonnie Hendry:Yeah, so I think going to be both. You've seen Walgreens as an example. They've announced recently they're going to close 1200 stores. That's not an inconsequential number of stores for their business. For them, that's a pretty sizable store closure announcement. You have others that are basically saying, we're going to restructure big lots as another one where they're going to close a sizable number of stores, but on a percentage basis of their inventory, probably not as daunting. And they're basically just trying to restructure. So they're really using that bankruptcy as a way to leverage and try to get more favorable leasing terms. I do think that at some level, we still are over retailed in certain sectors. If you look at the coffee shops like Starbucks as an example, I was at the conference a few years ago down in Miami, and I was standing at the corner at a Starbucks and I could see three other Starbucks within eyesight of where I was at.

That's a problem. You're going to have to remedy that. Now you have these Dutch brothers, Duncan, all these others that are making that a super competitive marketplace all vying for the same market participants. So you're going to see some consolidation, some store closure, some stuff there. But broadly, I think retail has really done a good job. Covid actually was a blessing for retail in the sense that if you were an obsolete retail operator or storefront, you didn't make it through Covid. And those that did realize that in today's market, you need to be omnichannel, you need to have a bricks and mortar, you need to have a curbside, you need to have an online. And if you can do that effectively, you can be really competitive. So I think you'll still see announcements of bankruptcies and store closures. You'll also just see some general downsizing that just makes economic sense.

But for every one of those, there are several stores announcing great expansions across the US to hundred of stores. Yeah, Burlington, I think they said 540 stores over the next couple of years. I'm bullish on retail given where we are right now. And it seems like contrary to logic, consumers still have money to spend. They still have credit that they're willing to put things on, and so the retail sector has benefited. Now, it's interesting, we had a discussion on our podcast a couple of weeks ago about how Target and Walmart have diverged in terms of performance. Like Walmart seems to be doing really, really well in this market, which makes sense. They're kind of a value and a lot of grocery component of their strategy is tied to grocery, whereas Target is a little higher end and with some of the inflationary pressure on consumers, maybe that's impacted them.

I think my take is really it's the experience of the shopper. If you go into most targets now in urban areas, they have almost everything locked behind plastic locks, and you almost have to call a representative to come and get, it was in Chicago a few months ago to get deodorant and a toothbrush. I'd have somebody come unlock the locked mechanism. That's not a great shopping experience. I'm probably not going to go back there. I'm going to go somewhere else to get those goods. I don't want to have to wait on somebody to come unlock it. So retail has some nuance to it right now. I think location's a primary factor, but I think the experience is really, really important too. So I think retail is in a good space. The retail delinquency is driven in this charts primarily by the regional, super regional mall stuff. It's a lot of really old regional and super regional malls. That number ebbs and flows based on if those get extensions or modifications or if they cure. This is a dollar weighted calculation. So if you have a $900 million mall that gets resolved, that drops the delinquency significantly just because it's such a large loan. So on a property basis, it remains relatively constant, but the loan balance can fluctuate month to month. That's why you might see some fluctuation on the retail side.

Lisa Knee:So there's nothing significant for the October to November

Lonnie Hendry:Uptick. In fact,

I think there's about a billion dollars worth of regional malls that got resolved. So, or that came online and that was what the change was. So shifting gears slightly here. We also track nons securitized. So non CMBS data. We have a couple of data consortium that we manage. One of them is a bank consortium called to, it's an acronym for trip anonymized loan level repository. So we have about 20 banks across the US that contribute their balance sheet loan data to Trepp on a quarterly basis, and then we anonymize that data and then we bring it back to the marketplace so we can get some color. We have a similar consortium called Life Comps. It's made up of life insurance lenders. So we have a real 360 perspective on the lending space to securitized the agency, Fannie Freddie stuff, bank balance sheet loans, and then the life co loans.

So this just gives some perspective. I think that the major takeaway here without getting into the nitty gritty, is if you look at originations, we've really troughed in the latter part of 23 and 24, which really interesting is I think if we had pulled the audience at the beginning of Covid when everyone didn't know what covid was or what it meant, but we were all at home and we're scared to death and everyone's drinking too much wine and all of that stuff is going on, I would've expected everything to fall off a cliff like lending origination volumes and transactions to just stop. And quite honestly, there was about a 60 day period where nothing happened, and then after that, things picked up pretty quickly. If you look at 2024, you can see the impacts of the Fed's influence on the markets. When they tightened credit, when they really ramped up the rates, it drew back issuance at a level that was significantly more restrictive than even Covid was.

So it just kind of gives me as an outsider, non-economist kind of perspective that says the government control mechanism is very real. If they want to want to restrict lending or make it less favorable, they have the ability to do that. And it's evidenced here with this origination. Now, as we've talked about, it doesn't mean that originations stop happening. Private lenders step in, other people step in. But if you're a bank and rates go from effectively zero to 5% in a very short period of time, that creates challenges for you on your balance sheet, and it creates a very non favorable lending environment for a lot of these lenders. So major takeaway here is we've seen a real pullback on bank lending. I think we're seeing maybe a reprieve from some of that heading into 25, at least some psychological boost of the fed pivoting.

It hasn't translated to rates yet, but I do think you have a president-elect that's coming in now that's very much in favor of deregulation and very much in favor of real estate and real estate lending. So I think you're going to see, at least at some level, people being more optimistic around just the general bank lending atmosphere. Now, whether that translates into more deals remains to be seen, this gives you some perspective on just the migration on the lender's risk rating of where loans have fallen out. So in the data that we get from our bank lenders, they have a standardized rating one to nine. Anything that's six or higher is considered criticized. And so you've seen a pretty strong migration from things that would be like one or two, like not even registering is any risk moving or migrating down to that three, four, or five area.

So the largest cohort of loans are in those rankings, which just means that they're all feeling the downward pressure from the broader macro impacts of the marketplace. So total loans have criticized have increased to 22% up from 18% a year ago. And we actually have this chart broken out by MSA on some other slides. If that's of interest, you can reach out, we'll send them to you. Just off the top of my head, like San Francisco and the office market has about 60% of their office loans are criticized. At one point it was over 70%. DC is over 50%, and even in the multifamily space, there's a lot of criticized loans in the Sunbelt region. So a lot of people that bought 1970s vintage multifamily stuff at the peak price in 20 20, 20 21, they're having some challenges because with the Fed raising rates they've had, if they've had floating rate debt, that was very problematic.

And they've also restricted their ability to increase rent. So we've had about 1.3 million new apartments delivered in the last two years. There's been a lot of downward pressure for multifamily. So criticize loans on the multifamily actually jump off the page when you think about it because there's really no delinquency in multifamily, but there's some shadow in the risk rating and criticized loans. This just gives you risk rating and basically another way to look at the previous chart that looks at office and multifamily and lodging and industrial and retail, all the food groups, I got almost all of 'em there, I think. And it gives you a perspective on them by risk rating. Again, as long as the regulators take a laissez-faire approach, none of that is super problematic. In terms of near term challenge, if the regulators start being more proactive, if they actually start requiring lenders to mark to market some of their loans and the property values, it has the potential to become more problematic.

I think that we're probably going to see them still taking a little bit more of a laid back approach in the sense that they don't want the consumer to fear the stability of the banking system. We saw what happened when banks failed, and it is really interesting. As soon as banks fail and you go into your bank, you actually notice that little plaque next to the teller that says that the FDIC is there and everyone feels good about that, but it's backed by the full faith and credit of the United States government. Well, if there's no faith in the system, that's a challenge. And so they're going to be very proactive in keeping people's belief in the banking system as strong as they can. So they have to balance that with the reality that these properties have seen some value decline. But I think you'll see people just generally working through this.

You'll see some consolidation in the bank space. You've seen a lot of banks, CEOs and others that have been on CNBC and these other shows saying they expect for some consolidation to happen, and I agree with that. I just don't think we're going to see some sort of systemic challenge or bank runs across the industry. This gives you some occupancy perspective. Occupancy on the whole have remained pretty strong. We have a little bit of selection bias in the industrial stuff in the fourth quarter of our data here. Industrial vacancy is not increased that much in the sample for this. It does look that way, but industrial occupancy is still north of 90% on the whole for this sample, it is a little bit lower. Office is the one that jumps off the page. Stabilized vacancy in most markets now is around 20, 25%. I saw an article yesterday San Francisco sitting at about 36% vacancy.

Those are challenging markets. Retail, industrial, multifamily, all relatively within their historical norm range of occupancies. And then if we look ahead a little bit to 2025, so 2025 is primed for a very interesting year. We talked a little bit about the president-elect and the election being over. That's a huge sigh of relief for everyone just because the lead up to that and everything. I don't think any of us wanted to see any more political ads on TV, radio in our sleep. We're glad that that part of the equation is done. What does it mean for CRE? It'll be very interesting to see. You're going to see winners and losers. You're going to see things that, like the city of yes vote that just took place. There's going to be a lot of activity that's trying to spur redevelopment or development in certain markets. And I think what you're going to see is this continued regional focus.

Neighborhoods, not neighborhoods, regions that have seen net migration are going to continue to be growing. They're going to continue to have outsized transaction activity. If they have a diverse economy, if they have underlying fundamentals that draw people to those markets, you're going to see continued growth. I mean, you look at in Texas where I'm at today, it's on fire. I mean, there's been some talk that they're going to change the state bird that the construction crane, because there's just so much new construction going on here. You go into Dallas uptown, I mean, crazy tall office towers being developed in 2024 when the national narrative is nobody would ever touch an office building again. So Dallas has been the benefactor of some of these other people leaving high regulation, high tech states, and moving to Texas. Miami has seen some similar circumstance. North Carolina has seen some similar circumstance.

Even pockets of California have seen some of this. Some other regions have seen the negative side effects of that. They have negative net in migration. They're losing people faster than they're gaining them, and they're going to have some challenges. Some of the other challenges that we'll continue to see in 25 is the inflationary pressure on the expense side of the equation. So we spent a lot of time talking about distress and delinquency and the predominant factor being maturity defaults and other things. One of the other really challenging things for owner operators now is that it costs them a lot more to operate their buildings than it did two years ago. So we put out a research report a few months ago where we looked at office properties in particular, and we looked at their primary expenses. We looked at property taxes, we looked at insurance, and we looked at repairs and maintenance.

There are still jurisdictions across the US that are increasing property tax assessments on office properties. Even with all the headlines, even with all the challenges they're seeing increases in their property tax burden, insurance across all property types, but in particular office and multifamily, seeing a huge uptick in insurance costs to the tune and submarkets of over 30% on a year over year basis for insurance. So now you have an office that traditionally was 95% occupied, that's now sitting at 80% occupancy, and oh, by the way, your taxes are going up. You're getting less rent and your insurance has gone up 30% year over year. That's a challenge. And then repairs and maintenance is up for everybody. Supply chain issues, cost of labor, cost of goods, all of those things are being rolled into this increased operating inflation environment that we're in. So it's really putting some pressure on some of these operators, people that are not well capitalized, office owners in particular.

If you're building 60% occupied, you still have to fix the elevators when they break. You still have to renovate the lobbies and the bathrooms. You still have to keep your building in condition that people would want to lease there, and you don't have 95% occupancy to absorb some of those pass through expenses. So as the owner offices become much more capital intensive, they've always been capital intensive, but they're just realizing how capital intensive they are at this point, higher delinquency risk. So I think for my just general outlook for 25, I think 2025 will carry on where we are in 2024. I think you're going to see continued issuance. The market movers, Blackstone, Brookfield, these other really big players have kind of put a stake in the ground and said, we think the worst is behind us, and we're going to start transacting on things at scale.

So Blackstone, just in the last call it three months, has probably done 20 billion worth of publicly announced deals that we all can track. Brookfield, as we mentioned just over the last couple of weeks, a couple billion dollars worth of deals. They effectively have the ability to be a catalyst to move the market if they start buying those properties at that scale. It gives incentive and confidence to other people to start transacting. So I think you're going to have this seller capitulation finally happen, or the bid ask spread reduces. People actually start to transact and people start to deploying more capital back into CRE if you get some rate relief. If the Fed continues to lower rates, that could just turbocharge those efforts. And 2025 could be primed for a really great year. Maybe not the same as 2021 when the Fed pumped all the money in the market, but a really, really strong year.

If you want to take a negative perspective of that, if Trump comes in and acts some of his inflationary policies with tariffs and other things and it drives inflation back up and the Fed has to stop and maybe reverse on the rate where they actually increase rates. Again, you could see a completely different 2025 where everything tightens back up and nobody really does anything. So I'm optimistic. I'm an optimist. I'm hoping for the positive 2024 and I think we'll get it, excuse me, positive 2025, just like 24. And I think we'll get it, but I think there is a slight chance that some of these things do prove to be inflationary that we might see a slight pull back in 2025.

Lisa Knee:So I'm going to ask you to, I know I've heard you talk about this and so there's a lot of talk, the office conversions to residential and the feasibility. I see you're smiling already about it, the feasibility and the likelihood of it happening. We've been seeing some large headlines on that recently with some capital being deployed and the city of Yes, certainly supporting some of that with zoning. So just to take your thoughts on how that's going to fare 2025 versus what you had maybe anticipated.

Lonnie Hendry:Yeah, so I definitely, I was kind of not supportive of this office to residential conversion in the macro, and I don't know that I've changed my perspective wholly on that. I do think anyone thinking that office to residential is going to work at scale, I think is not going to happen. Where my thought process has shifted some is that for an individual fund or developer or someone that wants to target four or five particular markets, for them to make that a worthwhile business endeavor for them, they may only need to convert five office buildings and they have a really great setup. And I do think in that type of micro scale where you might have some funds that raise a couple billion dollars, they target to do 50 or a hundred buildings, the really big players, smaller players, maybe five or 10 buildings. I do think that at this point you're finally getting office values on the buy side to where it maybe makes sense in certain markets and some of these net and migration transit oriented type of markets where there's some positive momentum.

I definitely think you can make a pitch that that will work. I still don't think it solves the challenge of where we're at with just the office distress. I mean, I pulled, I didn't have it in the slide deck, but I had to put together a presentation a few weeks ago. If you look at new loan origination cap rates for offices leading up to 2023 deals, were still getting done at five and a half to 6% cap rates for office buildings. Now looking back on that now you would say that's crazy. No one's lending on a suburban office at a five cap rate, but in 2019 they were doing it left and right and no one was thinking twice about it just because that's what the market was. That was the same 1980s functionally obsolete office building in 2019 as it is today. Our behaviors just changed, but lending was running rampant at those low cap rates.

So it's not going to fix all of that issuance that took place over the last 10 years. But I do think for some markets like Dallas is one, San Francisco's one, there's a few others that I do think there's some real possibility for them to do these office to resi conversions on the city of yes stuff. Obviously a huge supporter of that. I think we need more housing that the data suggested. If you want to make housing more affordable, you want to make housing more attainable. The solution, not a solution. The solution is build more housing, that's the solution. Create more denser neighborhoods, get rid of single family zoning, all this stuff where you can actually build enough units to people have affordable housing options in the city of Yes proposal, they're targeting 80,000 new housing units. So I'm not super great at math, but in a city the size of New York with the challenges that they have, 80,000 units, I don't know that it moves the needle.

I'm hopeful that they hit that goal and it just is a snowball that goes down the mountain and it starts building momentum and 80,000 turns into 800,000. I'll be shocked if we get to 80 just because the administrative nonsense that comes with these things. But if they do great on them, I love that they put this into practice. Florida's another one where they created a law called Live Local that allows for much denser development. It's gotten a slow rollout similar to what the opportunity zones did after 2017 when they passed. Now sitting here in 2024, there's a lot of opportunities on development. It just took five or six years to get it going. Maybe live local in Florida, maybe the city of yes here in New York. Those things will help progress this narrative. It all looks great on paper. I just hope that we can actually get people to execute on it. I did have one more slide here I wanted to get to, and then if that's okay, then we can take any other questions if that. All right, Lisa.

So Grace, so for those that are on, we put some QR codes here. You can sign up for some of our free content commentary, a trip. We live, eat, sleep, breathe, commercial real estate 24 7. It's what we do all day every day. We want to bring this information to the market. So as Lisa mentioned, we have a podcast, I'm lucky to be co-host of that podcast. It's a weekly show. We've had 1.7 million listens to date. We're approaching our 300th episode. We'd love for you to give us a listen and check that out. And then you can scan the QR code for our daily newsletter. It's called the CRE rundown. It's about a 10 minute read. It comes out every single morning. And then we put some ways for you to get in contact with us. I'm obviously on LinkedIn as well, if you want to connect or Twitter, my handle is just at Lonnie cre. Happy to interact with you guys, however we can and bring some more insights into the marketplace.

Lisa Knee:I absolutely, I'm already an avid listener, so I urge everybody to do it there. It's, it's a good listen and it's really helpful for the weekly insights. So I will give you a testimonial.

Lonnie Hendry:I love it. And we keep 'em to 45 minutes in length and we keep 'em lighthearted. Unfortunately, my Southern accent is there every week. I've tried to get rid of it. It doesn't go anywhere, but we try to keep it lighthearted and fun, but really cover some cool week to week interactions of what's taking place in the marketplace. And this has been a great experience for me today. I really appreciate the interaction. I do think maybe we had one more question here that came in around high vacancy and antiquated office buildings. Yes, we talked a little bit about that. So does it reduce office supply? Yeah, so if you can see office to residential conversions, it is a twofold solution there. It solves the need for housing. It also reduces some of that antiquated inventory on the office side, which takes that out of the denominator, which hopefully increases office occupancy and the appeal for some of the office stuff. So, hey, look, if we could get a hundred office buildings in every state converted, that's a win for everybody. I hope that we can, I'm not rooting against it, I just don't know that the math works at scale.

Lisa Knee:Wonderful. So unless there's any other, oh, there's one more. Yes, we will be sharing today's presentation, so everybody will be looking for that in their email, thanking them for attending today, and there will be a copy of the presentation attached. So I think with that, I want to thank you. I thought this was, I enjoyed it. I thought it was wonderful. Thank you for sharing your insights and the TR data with EisnerAmper and our clients and prospects and colleagues, and it was a real pleasure for me to sit and interact with you. So thank you.

Lonnie Hendry:We're thankful for the opportunity, so thank you so much.

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