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New York CNN —
After decades of growth fueled by low interest rates and easy lending, commercial real estate has hit a wall.
Valuations of office and retail real estate have fallen since the pandemic changed how people live, work and shop, and the Fed's efforts to fight inflation by raising interest rates have also hurt credit-dependent industries.
The effects have been felt around the world, with banks in the U.S., Japan, Switzerland, Germany and elsewhere forced to write off billions of dollars in bad loans. Shares of New York Community Bancorp, hit hard by real estate losses, have fallen 66% so far this year.
But some analysts are beginning to see light at the end of the tunnel.
Tracy Chen, a portfolio manager at Brandywine Global, says she is starting to see signs of an upswing in commercial mortgage-backed securities (CMBS), which are bonds backed by pools of commercial real estate loans and secured by real estate such as office buildings, retail stores or apartments.
In fact, BBB-rated CMBS, as measured by an index compiled by Intercontinental Exchange and Bank of America, have outperformed Treasury bonds, corporate bonds and other types of loans so far this year, which Chen says is a good leading indicator for the rest of the commercial real estate market.
Before Bell spoke with her about finding signs of optimism in CRE.
This story has been edited for length and clarity.
Before the Bell: We hear a lot about how bad things are in the commercial real estate market and how that could have a devastating effect on the U.S. economy. Is that pessimism exaggerated?
Tracy Chan: I think that's true. The CRE market is very sensitive to interest rates. If interest rates peak and the Fed starts to cut rates, that would be very beneficial for the CRE market. Even a small cut in interest rates would do a lot to improve sentiment. I think the pessimistic sentiment around the CRE market is a little overdone.
The Federal Reserve looks set to keep interest rates steady for the time being, but will that be a problem for CRE?
This could mean that the CRE market will take longer to recover. It is highly sensitive to interest rates. It is highly leveraged and there is currently not enough transparency or deals. So, there will definitely be a need for price corrections (reductions) going forward.
What is the significance of commercial mortgage-backed securities outperforming government and corporate bonds?
There are a number of factors that could lead to outperformance in the CMBS market. First, most of the bad news is already priced in. Bank stocks are not completely down, but the CMBS market is more transparent. There are a lot of assumptions people make when they invest in the CMBS market. I think those assumptions are very rigid at the moment. So the pessimistic market sentiment is more reflected in the CMBS market than in the banking sector or the private credit sector.
The CMBS market also has a small share of CRE loans at just over 10%, while regional banks have the largest share. So while CMBS has a small share, it has been the most transparent when it comes to pricing in bad news. It has also seen a strong recovery and uptick year to date since shortly after the Fed paused its rate hikes.
I see this as a sign of a potential shift in the CMBS market from a sentiment perspective, which perhaps portends a recovery for the CRE market.
But do you expect regional banks like New York Community Bank to continue to struggle?
New York Community Bank has a unique problem that I don't think is prevalent in other parts of the CRE market. The bank was very focused on New York City apartment complexes that had rent control issues. I don't think this is representative of the CRE market.
In general, do you think these regional and smaller banks will continue to incur CRE-related losses?
I think some of the regional banks have very little reserves for potential losses, so they're going to see some pain down the road. But I don't think it's going to create systemic risk. It's going to take time to recover from the pain that's been with the CRE market. It's going to take years for these loans to pay off. It's going to be a very long road.
What should readers of “Before the Bell” take away from this information?
The CRE market is not all doom and gloom. There are bright spots in the CMBS market. Commercial real estate is not just office space. There are many types of real estate, some of which are doing very well. Suburban offices are doing well, Class A buildings, which are in short supply, are doing well, and buildings built after 2010 are in demand. I don't think you should shy away from everything related to the CRE market. You can certainly make a good return on your investment if you put in the effort.
So is there room for some optimism?
We are veteran investors in CMBS for quite a long time, over 10 years. We have been through a retail situation where 5,000 to 6,000 stores are closing every year. But look what is happening now. They are streamlining supply and at the same time people are still going to stores. Any retail that survived the COVID pandemic is a good retail, so people are confident in investing in retail properties. There is no reason why the same thing won't happen to offices in the future. There is a lot of hope for the future.
2024 was supposed to be the year consumers would come back to life.
After more than 20 months of rising inflation and borrowing costs, investors, economists and, ultimately, Federal Reserve officials say they expect the economy to soften this year, allowing the central bank to finally start cutting interest rates.
But hopes of a change in Fed policy continue to be postponed: Markets had initially expected six rate cuts this year since March, but that now seems unlikely.
Regarding the possibility of a rate cut at the Fed's January meeting, Fed Chairman Jerome Powell said, “I do not think it is likely that the committee will reach a level of confidence by the time of its March meeting that it would be able to determine that March is the time to lower interest rates.”
Some economists now believe the Fed will not cut interest rates at all this year.
The economy is not slowing down and some underlying measures of inflation are rising, Torsten Slok, chief economist at Apollo Global Management, said in a note to investors on Friday.
“The Fed will not cut rates this year and rates will likely remain higher for longer,” he added.
Federal Reserve Bank of Richmond President Tom Barkin reiterated his belief that the central bank may not cut interest rates this year.
“We'll see what happens,” Barkin said in an interview with CNBC on Friday morning. “I still expect inflation to come down. Once inflation normalizes, it will become clear why we want to normalize interest rates, but to me, inflation is the first step.”
OPEC+ members have agreed to extend voluntary cuts in crude oil production into the second quarter, the group announced Sunday, a move that's part of the group's permanent rebalancing strategy to stabilize oil prices by reducing supply, my colleague Eva Rosenberg reports.
OPEC+, the coalition of the world's biggest oil producers, announced voluntary production cuts of 2.2 million barrels per day in November. Sunday's extension eased some of the larger production shutdowns. Top producer Saudi Arabia will continue to cut by 1 million barrels per day, while Russia and Iraq will cut by 471,000 and 220,000 barrels respectively, down from the 500,000 and 223,000 barrels they initially announced.
Since November, Brent crude, the global benchmark, has risen nearly $2 a barrel to $83.46. Production cuts and the subsequent rise in regular oil prices could also push up retail prices at gas pumps.
But while U.S. drivers are seeing higher gasoline prices and AAA expects prices to spike during the spring break travel season, analysts say a surge in oil prices is unlikely, in large part because strong U.S. production has kept oil prices in check, which is part of the reason OPEC+ extended its production cuts in the first place.
Goldman Sachs in December cut its forecast for the average price of oil this year by 12%, saying increased U.S. oil drilling would keep Brent crude from reaching its initial estimate of $92 a barrel. Analysts at the bank now see Brent crude averaging $81 in 2024.