As we analyze commercial real estate (CRE) capital allocations this morning, we can’t help but draw similarities to last night’s second season opener of Westworld – in our opinion, one of the best television shows ever produced. A common rubric on the show is the Romeo and Juliet quote, “These violent delights have violent ends” and it fitting to any bank’s CRE analysis. As community banks, we can’t stay away from CRE, but we know it is dangerous at some point. Similar to both the humans and robots in Westworld, in this article, we try to be more self-aware. We turn to a recent April survey by JP Morgan of 64 of the largest institutional real estate investors to include banks, insurance companies, pension funds and asset managers to get their perspective of the current state of the CRE market.
Breaking The Loop
The bulk of survey respondents (85%) believe we are now late in the cycle or at the peak, while some CRE investors (15%) now see us already in an early correction phase – a first for this cycle. However, if you break the sentiment down further, you get a little rosier view. 39% still find the asset class “Attractive” and 43% term their sentiment as “Neutral.”
While many investors we believe we are late in the cycle, the details behind that show that new investments are continuing to be made keeping the loop of increasing value going. More investment brings more capital which brings more investment.
How the loop will end is not clear, but 61% of the respondents are concerned with external credit shocks to the economy that would impact commercial real estate such as lower international investment, while 21% see the risk coming from within the sector such as oversupply.
What Is Real
Episode 1 of the second season of Westworld asked the mind-bending question, “What is real?” The question is surprisingly answered by, “That which is irreplaceable.” That answer, if you think about it, is even more mind-bending. We are not sure if the current values in CRE are “real,” but like the humanoids in Westworld, it is hard to argue they are not when they perform to “real” standards and become sentient.
Having gone through some downward pressure, CRE values are back again and largely on the rise. Hospitality, retail, and office have so far performed better than the 4Q models predicted. Both probability of defaults and loss given defaults are better than expected thereby lending some credence to where we are seeing tightening loan pricing. On a risk-adjusted basis, CRE loan spreads have been higher than average. Where community bank loans used to average a 13% risk-adjusted ROE, 15% or greater has been the average so far for April.
By sub-sector, most survey respondents rated industrial properties as still having the best value and the highest capital allocation followed by multifamily and offices in core sections of metro areas. “B” or “C” class malls followed by suburban office buildings and limited service lodging were deemed areas where investors were looking to lighten up and not take on any new exposure.
Putting This Into Action
Credit risk for banks in CRE is at or near their record lows. Those banks that are still trying to get 3% margins will continue to struggle with their reality as they have not adjusted their risk premium. This allows banks that do monitor credit risk to earn the less risky deals. The late cycle trends of CRE demand banks increase their vigilance and consider tightening credit spreads to move up in credit quality.
We are not sure how long the sector has to run, but the survey results indicate that investors are slightly more bearish than last year. The season premiere of Westworld asks the rhetorical question, “Have you ever had to stop and think about your actions? The price you would have to pay if there was a reckoning?” That question is hitting too close to home as most bankers remember what that price was for CRE during the last downturn.
Submitted by Chris Nichols on April 23, 2018