Master your fundamental research. Join 79,627 investors who trust our platform and content.
Save 54+ hours of fundamental research with free access to Stock Card.
We only ask your name and email address.
|
If you mix these three ingredients:
The real estate sector is killing the banks again! We saw a glimpse of this situation last week. New York Community Bancorp reported a surprise $252 million earnings loss and $552 million in loan losses, a 790% jump in loan losses compared to the previous quarter. In today’s post, I'll explain what's happening with commercial real estate and regional banks. Share interesting investment opportunities, and duscusd two REITs to consider buying now to take advantage of the situation. Let’s talk about them!  I'm Hoda Mehr, founder, and CEO of Stock Card, and on this blog and its accompanying YouTube channel and Podcast show, I share detailed fundamental analyses and interesting investment stories.
This post is part of our educational series to help you hone your fundamental investing skills. Catch up with past blog posts on How to Invest Like Buffett? How to Invest Like Charlie Munger, or how to Find the Highest-Returning Stocks? Remember, this content is for education and sharing ideas and not advice to buy or sell any securities. Sign up for a free account on Stock Card to get notified of these blog posts, YouTube videos, and Podcast shows every week. We only ask your name and email address when you sign up. What's Happening In the Commercial Real Estate Sector?First, let's discuss what's happening: New York Community Bank stock fell almost 60% in the last few days after Moody's dropped its credit rating to junk. The company also had a miserable quarterly earnings report with surprising earnings loss, loan losses associated with two apartment and office building loans, and a 70% cut of its dividends. It's a perfect storm for one company but a giant signal for the broader regional banking and real estate market. Let's step back and understand the context behind this situation: There are three types of banks based on their asset size in the United States:
Smaller and regional banks specialize in small business lending and local community development. If you are a real estate developer or a property owner, you'll be better served by regional banks. Jill Castilla, CEO of Citizen Bank of Edmond, on the Bloomberg Surveillance show, explains the advantages of regional banks in local markets: These local banks understand the local market better and can better assess the risk associated with a specific property. What Jill explains makes sense. According to Goldman Sachs, 80% of the commercial real estate loans in the U.S. are held by smaller regional banks. Hold that information aside for a few minutes. Now, let's talk about commercial real estate and office buildings. To understand the scale of the market, commercial real estate is a $25.37 trillion market in the U.S. That's ten times bigger than the $2.53 trillion residential market in the U.S. Commercial real estate includes office buildings, hospitals, warehouses, retail stores, manufacturing facilities, large residential buildings, etc. Office buildings are a big part of this market and represent 16% of commercial real estate. Let's hold this second piece of information aside again and discuss the third ingredient: the commercial real estate loan situation. Commercial real estates are rarely bought or developed by paying cash. And here's something very peculiar about these loans that I learned from Howard Marks, co-founder of Oaktree Capital: Nobody ever repays their loan. They just refinance it. Commercial real estate investors typically refinance their loans to get a longer-term or a longer amortization schedule and increase their monthly cash flow. Or if they hold a term loan, and the loan is coming due, they refinance the loan instead of repaying it. $2.8 trillion of commercial loans will come due between 2024 & 2028, and many were issued when the interest rate was low. When they get refinanced, they will face a significantly higher interest rate and monthly payments. The question is, can they afford higher payments? If a developer or an investor owns an office building, it may generate less revenue than before. Due to the work-from-home or hybrid home-office working model post-Covid, they are collecting less rent than before. As a result, chances are they won't be able to afford a higher interest rate for their loans, and they may even default on their loan. Now, let's bring it all together: Regional banks own 80% of commercial real estate loans in the U.S. A giant portion of commercial real estate loans are coming due in the next three to four years. Most of these loans are expected to be refinanced, as is customary in the commercial lending market. No one pays back their loans. They refinance it. On the other hand, office buildings are 17% of the commercial real estate market. The demand for office buildings and, therefore, the associated rent income is lower than it used to be thanks to the work-from-home and hybrid work model after the COVID era. Some properties have lost a significant portion of their value because there isn't enough demand. And with the higher interest rates, the new borrowing cost is much higher than what developers and real estate investors are used to and can afford. These borrowers may be unable to afford higher monthly interest payments, or what they owe may be higher than their property's value. Banks holding such loans may end up with either revenue loss or bad loans that can never be paid back. That has happened with two properties at New York Community Bank recently, causing the stock to lose 60% of its value. I've heard somewhere that banking problems are like cockroaches. There is never only one of them (ugh). It's fair to assume more banks will collapse due to similar bad loans in the next few quarters. How Is The Commercial Real Estate Crisis Different From The Great Financial Crisis?Things get scary when the word "collapse" comes before banks or real estate sectors. The important question is whether more regional bank failures due to commercial real estate challenges will have a broader impact on the economy. The broader risk of regional bank failure is that businesses that depend on these regional banks for funding and growth will lose access to funds and banking. However, there is a reason regional banks are NOT in the so-called too big to fail category. There are more than 4000 regional banks in the U.S.; if a few fail, it won't be a systematic risk to the broader economy. Moreover, these bad commercial loans are not coming due simultaneously, and the problems are easier to anticipate. Just because we are talking about them now means there is an expectation in the overall financial system that some banks would fail. The last point is that not all regional banks are exposed to troubled commercial real estate, specifically office buildings. Jill Castilla explains many regional banks focus on relationship-based banking and have already taken the steps required to avoid disastrous outcomes. Therefore, most regional bank are not at risk. Final note on risk: Before we move to stocks you may consider investing in now to benefit from the regional bank challenges, I want to warn you that there is still a risk to the broader economy due to this commercial real estate and high interest cost. As they say, risk is what's left after you've thought about everything. Today, we thought about possible ways the real estate sector may impact banks and concluded it would be manageable for the broader economy. But there is always the risk of us not seeing other dependencies in the broader economy. Be mindful of the unforeseen risks, always. How To Invest & Benefit From Commercial Real Estate CrisisIf not all regional banks are doomed because they have done a good job at their due diligence, and similarly, if not all commercial real estate and specifically office buildings are in trouble, this means there are investment opportunities for all of us at a reasonable price in the commercial real estate market. Luckily, stock market investors don't need to buy commercial real estate to benefit from the market opportunity. We can find the right fund or a Real Estate Investment Trust (REIT) that is reasonably priced or undervalued. Cathy Marcus, Global Chief Operating Officer of PGIM Real Estate with $208B in assets under management, gives us some clues into such commercial real estate investment opportunities in her conversation with Barry Ritholtz on the Masters of Business show. First, we have many companies that are back to the in-person model. And a bigger portion of companies allow a hybrid model. In both cases, companies use their office quality to attract talent and employees into in-person collaboration. This means only a certain type of office building will be in demand. According to Cathy Marcus, those are Class A buildings with wellness and ESG attributes that have higher quality than employees' houses, encouraging them back into in-person setting. Anything lower than that isn't in demand and has a hard time generating rent income. That means REITs focusing on Class A buildings may offer interesting investment opportunities. I searched for Office REITs on our company's website, stockcard.io, and a few names grabbed my attention: Alexandria Real Estate Equities, ticker ARE, is one good example. It focuses on Class A office buildings in the life sciences sector. According to financial analysts, the stock has more than 13% upside compared to its current price and pays more than 4% in dividends. Boston Properties, ticker BXP, is another one. This REIT focuses on premium, Class A offices in Boston, New York, San Francisco, and Washington DC, with more than 11% upside, according to financial analysts, and 6.2% in dividends. Consider researching those REITs as a part of your portfolio. Talking about good stocks to buy now, last week, I discussed how to find quality stocks at a reasonable price and shared a few stocks to buy now following such an investment methodology. If you missed it, reading it now is good. I'll see you next time! Comments are closed.
|
Categories
All
Archives
March 2024
|
RSS Feed