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Good morning. The Fed's Financial Stability Report on Monday raised concerns over rising interest rates and potential credit crunch in commercial real estate and other sectors. Wealthy families are capitalizing on institutional exhaustion by moving into NYC offices, while defaults on a specialized mortgage bonds for apartment purchases are increasing.

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The Fed is Keeping a Close Eye on CRE Landscape

On Monday, the Fed's bi-annual Financial Stability Report revealed that the commercial real estate (CRE) market is the fourth-largest financial stability concern, citing worries over the sector's strain and possible spillover effects on the broader economy.

Risky business: A survey of 25 professionals from broker-dealers, investment funds, research and advisory organizations, and universities revealed that many of them saw real estate, particularly in the commercial sector, as a potential source of systemic risk. Concerns were raised over higher interest rates, valuations, and shifting end-user demand. Additionally, some participants believed that banking sector stress could emerge due to underperforming commercial real estate assets, posing a risk of instability.

What they're saying: The Fed is closely monitoring commercial real estate CRE loan performance due to concerns raised by the report. Tom LaSalvia of Moody's Analytics doesn't anticipate CRE challenges leading to broader economic fallout, noting that stakeholders can use their capital and income to delay refinancing or find alternative solutions. Although he predicts a drop in value and an increase in delinquencies, LaSalvia does not see a CRE-triggered financial crisis on the horizon.

Small but mighty: According to the Fed, CRE loans are a small slice of total assets held by banks. But these loans represent 20% of total assets for the smallest banks, with some having more exposure than others. The Fed also acknowledges a blind spot in assessing the market's health—while banks hold around 60% of CRE loans, there's little information on how the loans held by non-bank entities are performing.

➥ THE TAKEAWAY

Slowing down: The Fed's consecutive interest rate increases have created a challenging borrowing environment for the commercial real estate industry, and a correction to office and downtown retail properties could affect many banking institutions. Loan losses will depend on the leverage of property owners, and a decrease in CRE property valuations could lead to increased loan-to-value ratios.

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Development is one of the most varied, dynamic, and challenging fields in commercial real estate. For investors looking to make their first foray into development or existing development firms expanding their pipelines, having access to an expert developer’s insights and advice is invaluable.

In this conversation, we catch up with Bullpen contract professional Matthew Ticknor, who has led the development of hundreds of units of multifamily projects on the West Coast.

Matthew shares his answers to questions like:

• What really makes a great developer a great developer?

• Project deadlines hit hard and fast. How do you stay on top of them?

• How do you level up as a multifamily developer?

• What is the hardest part of Bay Area development?

Interested in bringing Matthew onto your development team? Get in touch with Bullpen here.

Wealthy Families Flock to NYC Office as Institutions Say “No Thanks”

Institutional buyers are shying away from NYC offices after pandemic setbacks, but high net-worth families and smaller developers see a chance to bargain hunt in top neighborhoods.

New buyers: Rising borrowing costs have prompted many office owners to sell at a discount, allowing family offices to seize opportunities for lower-priced properties. While large institutions and real estate firms dominated NYC office acquisitions in 1H22, the trend shifted in 2H22 with wealthy individuals, families, and smaller developers making up 7 out of 11 acquisitions. This trend is likely to persist as NYC office prices have fallen by 26% from their 2017 peak in 1Q23.

The price is right: During downturns, institutional investors tend to stay away, creating opportunities for others to take advantage of discounted prices. Empire Capital Holdings CEO Josh Rahmani sees a "temporary dislocation in pricing" as an ideal chance for affluent private investors to invest in commercial real estate and bet on the city's recovery with patience.

International interest: Wealthy investors worldwide see real estate as an opportunity to make money over the long term. Global investors have long flocked to NY real estate as a gold standard. And now, they no longer have to pay "trophy" prices. A survey of more than 500 global private bankers, wealth advisers, and family offices found that about 46% see real estate as a top opportunity to increase their wealth.

Caution ahead: Institutions and smaller buyers still have reason to be cautious. The outlook for office remains bleak, and NYC office properties, particularly, are facing a potential $50B reduction in value spurred by remote and hybrid work. So it's hard for some family offices to bet on such a pricey market with that kind of long-term uncertainty.

➥ THE TAKEAWAY

Opportunities abound: A recent real estate deal in New York City highlights the shifting landscape as Columbia Property Trust sold a Madison Avenue building to Enchanté Accessories at an $11 million discount. Metro Loft Developers also seized a chance to purchase JPMorgan's former offices and convert them into luxury apartments. With the market expected to self-correct in 3-5 years, these opportunities are rare for investors looking to buy in the city.

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Defaults on The Rise For Apartment-Backed Bonds

Collateralized loan obligations (CLOs)—mortgages packaged into bonds and sold—are primarily used to fund apartment building purchases. Now they’re under stress as the rental market slows down.

What’s in a CLO? CLOs trace their roots to the aftermath of the GFC, as banks became more conservative. These exotic instruments helped fill the void for investors looking for an alternative source of capital.

Who wants a CLO? CLOs became popular with bond investors for their higher yields while interest rates were low. Owners are also drawn to mortgages tied to CLOs since they can take on more debt with less equity than a traditional bank mortgage. Shorter terms and floating rates also offer owners more flexibility to sell or refinance.

What's the problem? CLOs are also risky since they’re far more vulnerable to changes in interest rates. And as the apartment market soared, so did CLO issuance. According to Trepp, apartments accounted for 67% of CLOs issued in 2021 and 81% in 2022. CLO issuance rose to a record $45.4B in 2021, up from just $8.7B in 2020. Trepp estimates nearly $88B in securitized mortgages are at risk of default, with 42% backed by apartments. CLOs make up most of these at-risk loans in which the buildings barely cover their debt payments.

Funding the Sunbelt: CLOs helped fuel the rise in housing costs across Sunbelt states like AZ, TX, and NV, where owners saw the most opportunity to raise rents. One of the biggest buyers of CLOs was LA-based Tides Equities, which purchased $1.7B in Sunbelt properties in 2021. Now, Tides faces lower profits as rising rates and falling rents hit their portfolio. With such a drastic change in the market, Tides and other owners are at risk of default.

➥ THE TAKEAWAY

Tight spot: Borrowers are facing multiple challenges with the expiration of rate caps, rising interest rates, and construction and insurance costs. This is making it difficult for owners to refinance projects, and CLO lenders are at risk of losses if defaults rise.

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• Lending on the rise: CRE lending by banks saw a $20.7B increase in April, with nonfarm nonresidential properties accounting for half the increase.

• Legal battles: New York landlords are seeking to challenge the state's rent laws in the Supreme Court, claiming they are unconstitutional.

• Price cuts: A 22-story office building in San Francisco’s Financial District sold for a 75% discount to its 2020 asking price, causing more concern for the city’s battered downtown.

• Rising rents: SFR rents rose 6% YoY in Q1, but properties stayed on the market an average of 43% longer during the same time period.

• Ace in the hole: Northwind Financial purchased the $68M distressed loan on the Bowery Hotel in Manhattan, giving them leverage in the hotel's financial struggles.

• Luxury living: Take a look at some desirable luxury properties that have been listed and sold across five major US markets.

• Losses looming: According to Moody’s annual stress tests, bank CRE losses could reach 8%.

• Got scripts? Hollywood landlord Hudson Pacific Properties (HPP) plans to slash its dividend as a result of the writers’ strike.

• Bidding war: Media mogul Rupert Murdoch paid $35.2M, nearly 20% over asking to win a bidding war for a Central Park South co-op.

• Risk management: Charles Schwab (SCHW) started hedging against interest rate risk by using derivatives, a move aimed at reducing the impact of potential losses on their balance sheet.

• Power play: New Jersey power broker George Norcross says he’s easing back from politics as he faces scrutiny over his role in the state's tax incentive program and business deals.

• Budget shortfall: Georgia saw a 15.5% decrease in April revenue as both income and sales tax plummeted.

Demand for self-storage remains strong despite YoY rent growth continuing to be negative for most markets. Charlotte, Raleigh-Durham, and Nashville were the only markets with annual rates for 10×10 non-climate-controlled units rising.

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