The quarter in review
The first quarter marked an eventful start to the year, as evident from the performance of the FTSE EPRA NAREIT Developed Rental Index which rose by 9.39% in January and declined by -4.54% and -3.52% in February and March, respectively. Inextricably tied to the benchmark’s performance is the deteriorating macroeconomic backdrop, rising borrowing costs and the recent banking turmoil seen in Europe and the United States of America (USA).
The best performing listed real estate market for the quarter was Singapore, which recorded a total USD return of 5.59%. Europe (ex-UK) recorded the lowest total USD return of -5.94%. On a property subsector level, Storage was the best performing sector as it appreciated by 12.30% during the quarter. Lab Space was the laggard as it declined by -12.94% over the same timeframe.
In Europe, the second largest bank in Switzerland, Credit Suisse was sold at a price of $3.2bn to UBS (the largest bank in Switzerland). This came as a result of myriad challenges that Credit Suisse has been contending with for the past few years, chief among which is the recent $119bn withdrawal of funds by the bank’s customers amidst the bank having reported its biggest annual loss since the 2007/2008 global financial crisis (GFC).
Similarly, in the US, Silvergate Capital, a California based community bank that primarily lends to the crypto industry, announced in early March 2023 that it was winding down operations and liquidating its bank after reporting net losses in the fourth quarter of 2022 and seeing outsized withdrawal requests following the collapse of FTX (the now bankrupt crypto currency exchange).
Furthermore, Silicon Valley Bank (SVB), a California based regional bank was shut down by the California Department of Financial Protection and Innovation after the bank sold its bond portfolio at markedly pronounced losses following the recent rise in rates. This incidentally led to a rapid wave of deposit withdrawal requests which the bank was not able to meet as it did not have enough cash. The panic among depositors in California spilled over to the east coast of the USA via the New York based Signature Bank, which also saw outsized depositor withdrawal requests and consequently shut down.
In this report, we will unpack the potential impact of the recent banking turmoil on private and public commercial real estate. We will also highlight how we, at Catalyst Fund Managers (Catalyst), are underwriting the risk associated with the recent banking crisis and lastly, we will highlight insights on occupational fundamentals across the sector.
Potential impact of the banking crisis on the commercial real estate industry
According to Citi Research, US banks hold circa 48% of the $5.6 trillion of multifamily (MF), and commercial real estate (CRE) outstanding loans. The lion’s share of the 48% is attributable to income generating CRE, such as offices and retail property. Multifamily real estate (commonly known as Apartments) and owner-occupied CRE each make up 22% of the overall outstanding loans, and the balance is construction loans on CRE projects.
Source: Citi Research, Morgan Stanley Research
*Other: include Agency and Government Sponsored Enterprise portfolios, Life Insurance Companies, CMBS, CDO and other ABS Issuance, Mortgage REITs etc.
The first-round impact of the recent disruption in the US banking sector is expected to be in the form of increased regulatory scrutiny among community and regional banks that have a sizable portion of their assets in CRE. This will translate to even tighter lending standards for CRE loans, which will exacerbate the already challenging cost of capital environment as refinancing risk increasingly becomes front and center for commercial real estate companies and investors alike. Consequently, as we have seen from the recent rapid interest rate hikes, higher debt costs weigh heavily on earnings particularly among companies with stretched balance sheets.
That said, it is important to separate the public real estate market from the private real estate market when unpacking the potential impact that the recent banking crisis may have on the real estate sector. The private real estate segment is generally more levered than the public market, and this is where we think refinancing risk is more pronounced. To put it into perspective, leverage in the private real estate market is typically 50-70% which is in stark contrast to the public market at circa 33% among companies within our coverage universe.
As can be seen in the chart below, the US public real estate market, which is the biggest market in our benchmark, has around 22% of its overall debt maturing over the next three years. Admittedly, there are sectors that have outsized debt maturities in the near term, notably Lodging/Resorts and Regional Malls.
Source: Morgan Stanley Research
Lodging/Resorts have the highest proportion of debt maturing over the next three years, which can be alarming at first glance. However, triangulating the size of the debt maturing in the near term with the average in-place debt rate of 5.6% which is comparable to our estimated marginal cost of debt for the sector within our coverage universe, indicates that the potential impact on cash flows from operating (CFO) activities is not alarmingly outsized as displayed on the chart below.
Source: Morgan Stanley Research
Additionally, it is imperative to highlight that circa 86% of the US public real estate companies’ total debt is fixed rate debt. This provides an additional layer of protection against rising cost of debt for the US public market.
Source: Morgan Stanley Research
While the recent collapse of Credit Suisse and the three US banks warrants a watchful eye, we are encouraged that delinquency levels remain muted among US Banks’ CRE loans relative to historical average levels. Furthermore, the Fed, the US Treasury and the Federal Deposit Insurance Corporation have been swift in their efforts to allay systemic risk concerns. That said, leverage risk cannot be dismissed as it can pose a serious threat to company earnings. To that end, it behooves us to remain vigilant of the potential risks that may transpire on the back of recent events.
How are we underwriting the associated leverage risk?
At Catalyst, one of the two core themes that our research focuses on is fundamentals and trends impacting asset pricing and capital markets. Our intrinsic valuation methodology has always demanded a sizable premium for financial leverage risk and shorter duration debt. Our financial leverage risk premium considers the companies’ overall leverage, near term debt maturities (refinancing risk) and the proportion of debt that is secured (vs. unsecured).
To that end, our methodology has always guided us towards companies with relatively healthier balance sheets. We believe that companies with robust balance sheets will be well positioned to be opportunistic in acquiring assets at discounted values in a scenario whereby the continually rising refinancing risk translates into assets being brought into the market by asset owners with weaker balance sheets.
The second theme that our research methodology focuses on is fundamentals and trends impacting real estate supply and demand, vacancy rates, and changes in market rental growth. As such, our methodology tends to govern us towards companies with relatively healthier operating fundamentals that support and boost the resiliency of underlying cash flows. Sectors that currently fit this mold include US Industrial, European Towers and US Manufactured Housing:
- US Industrial
While construction completions are expected to modestly outpace the net take-up of industrial property space over the next five years, development starts are slowing. The slowing development starts in conjunction with the sector’s buoyant demand (driven by various companies’ efforts towards building optimal inventory and supply chain resiliency and enhancing ecommerce delivery efficiencies) is expected to support continued rental growth in the intermediate term. This places the US industrial sector in a favorable position to continue to capture outsized embedded growth through compelling releasing spreads. Moreover, US industrial companies have relatively healthy balance sheets with low refinancing risk.
- European Towers
Demand in the sector is supported by mobile network operators’ continual efforts to remain competitive and uphold market share through allocating capital towards building out 5G wireless networks and expanding coverage given the omni-present usage of mobile data. Ericsson estimates that data consumption in Europe will more than triple over the next several years. This is expected to be supportive of continued growth within the sector.
- US Manufactured Housing
The sector is supported by myriad structural tailwinds including the expanding affordability gap between manufactured homes and other alternative housing options, aging baby boomers looking to downsize etc. The supply side of the equation is constrained by gating factors such as “not in my backyard” (NIMBY), stringent zoning regulations and financing constraints. Lastly, Manufactured Housing boasts an average loan to value of 25% with only 6.6% of overall debt maturing over the next three years.
In contrast, there are sectors and companies with tepid or slowing operating fundamentals and relatively weaker balance sheets. These include European Office, US Net Lease and European Malls.
- European Office
The Office sector continues to wrestle with cyclical and structural headwinds in the form of recessionary pressures and the work from home theme which is translating into reduced office space utilization. While we recognize the bifurcation between below-average quality office assets and best-in-class office space, the demand outlook remains weak. The sector’s average loan to value is 32%, which is in line with our broader Global Real Estate coverage universe.
- US Triple Net Lease
The triple net lease sector is uniquely set up such that the tenant assumes the burden of operating costs such as taxes, insurance and common area maintenance in exchange for lower rents, significantly lengthy lease terms and the ability to customize the leased space. As a result, Triple Net Lease landlords primarily rely on external growth (mostly via acquisitions) to drive earnings growth. While the sector enjoys a healthy cost of capital, a potential rise in credit losses on account of the deteriorating economic backdrop is a notable concern in the intermediate term.
- European Malls
The sector’s relatively outsized leverage profile is concerning, notably the loan to value estimate for the sector is 46% compared to the broader European average loan to value of 36% across our coverage universe. Unibail-Rodamco Westfield (URW), the largest European owner and operator of Malls is wrestling with deleveraging challenges given its considerably elevated leverage ratio, reported at 47% (including hybrid bond facilities). Consequently, URW remains strategically focused on deleveraging their balance sheet principally through asset disposals, which we believe is an unfavorable position to be in given the deteriorating economic and challenging cost of capital environment.
The banking turmoil seen in the first quarter of 2023 may be interpreted by some as an unassailable indicator of what we noted as the “most anticipated recession in history” in our Q4 2022 report, and the “million-dollar question” of whether it will be a “hard, soft, or no” landing scenario remains. The truth is that no one really knows, which is why we at Catalyst believe that it is ever more important to have a robust and through-the-cycle tested investment process to help investors navigate through this period of markedly heightened uncertainty.
As such, we will continue to be judicious and disciplined in following our long-standing and robust investment process that has been tested over numerous market cycles and periods of dislocation. As active, specialist listed real estate investors we are likewise fortunate to have an extensive opportunity set spanning a variety of sub-sectors and companies with unique underlying economic drivers. While these will not be entirely immune to the ebbs and flows of the broader economy and stock markets, it does provide us with the tools to construct portfolios for varying economic conditions to better enable the management of risk and return over the long-term.
The estimated forward funds available for distribution (FAD) yield for the sector is 5.38%. For investors with a similar long-term time horizon, the sector appears fairly valued with more attractively priced opportunities for astute active managers to generate superior risk-adjusted returns.
