CRE Analyst

Here are the trends and events that we think will define commercial real estate in 2024.

Office mortgages: lifeless with a metallic aftertaste? Commercial mortgages can be a lot like wine, which could be a bad sign for office lenders. And, if history is a decent indicator, the pain and aftertaste could be worse than anticipated. ----- Vintage risk: wine ----- A lot goes into making a good wine. Region, location, climate, seasonality. But it largely comes down to grapes, and--more specifically--when a wine's grapes are harvested. ...which results in two counterintuitive takeaways: 1. Relatively BAD wines from a good vintage can be GOOD. 2. Relatively GOOD wines from a bad vintage can be BAD. And BAD wines from BAD vintages are terrible. ----- Vintage risk: CRE ----- There's a similar dynamic with commercial mortgages, as Moody's concluded in a pre-GFC study: "Moody's was granted access to a data base that offers the best of both possible worlds: Data that ranges over a full cycle that also has depth, in this case loan level details about leverage. This has enabled us to examine the role of leverage across the full cycle, which we believe to be the first work of this sort in our industry. A key conclusion is that the power of the real estate cycle trumps other variables." Moody's found that "risky" high LTV loans originated in strong vintages defaulted less (3.9%) than low LTV loans originated in weak vintages (5.4%), and high LTV loans originated in weak vintages experienced exponentially more defaults (30.7%). ---- Why does this matter? ---- Lenders have had an incredibly good run since 2010. Default rates have rounded to zero, and, although base rates were historically low, spreads were relatively attractive. Virtually no credit loss = profits. It would be hard to see an entire recent loan vintage mimicking the pre-GFC bad vintages or the 1980s bad vintages (i.e., 30% default rates). ...except in office, which is experiencing the clearest recessionary cycle in decades. If recently originated office mortgages follow the path of those more challenging historical vintages, i.e., if Moody's was right and cycle timing matters more than anything when it comes to mortgage credit quality, then office lenders could be in for a very painful reversion to the mean. Perhaps just as importantly, mortgage problems have historically played out over very long periods of time. Therefore, there may be no quick end in sight. Where do you land on this? A) This time is different. It won't be that bad. B) Brace for impact. C) Other

New direction with our annual New Year predictions: Rather than calling market trends, we bottled up insights and created a quiz to help you predict how you will compete vs. your peers in the new real estate cycle. More challenges and complications. Fewer tailwinds. More losses. ...but bigger opportunities for outperformers.

What a difference a year makes... One equity type shifts from red to green. More equity types to follow in 2025? Happy New Year!

Why predictions? Drafting thoughtful (-ish) predictions requires reassessment and investing thought into how CRE systems are evolving. Not a bad exercise. Some thoughts on last year's calls with the benefit of hindsight... ------------- 1. CRE sector will be better than expected in 2024 [✓] A year ago, calls for a 'real estate apocalypse' dominated headlines. We accurately thought it was uninformed hyperbole. 2. Economists will be wrong again [≈] Most economists called for a recession in 2023. We guessed they would be wrong again and that job growth would turn negative in 2024. We were 12K jobs away from being right in November when job growth came in at 12K jobs vs. consensus estimates of +100K. 3. Apartment problems exceed office problems [✓] This one was controversial, but the 2Q24 NCREIF report confirmed more multifamily properties falling short of DSCRs than office properties. 4. Fewer real estate jobs [x] Thankfully, we were wrong on this one. Hiring slowed to a crawl and there were many layoffs but nothing like prior cycles. 5. Brokerage revenue disappoints, led by CBRE [x] Brokerage revenue recovered quicker than expected. Glad to miss this one. 6. Apartment syndicators face the music [✓] Syndicator pain started in 2024. Well over $1B in defaults and restructures. Unfortunately for LPs, still early innings. 7. Loan sales > loan defaults [✓] Another relatively controversial call. Ended up being accurate, primarily due to very low levels of defaults. But we thought there would be more loan sales. 8. Life science loses its luster [✓] It's hard to believe that life science was still favored 12-18 months ago. Very tough year for the sector. 9. Data centers will surge but raise eyebrows [✓] Similarly hard to believe that not many non-data center people were talking about data centers (or their power drains) a year ago. It reached such a fever pitch this year. Big tech companies responded by putting nuclear plans in motion. 10. Open-end fund manager recaps [≈] There has been significant fund manager recap activity, but we were expecting at least one blockbuster, which never occurred. 11. Japanese investors will be a top U.S. investor [x] Totally missed this one. Japanese capital ranked 6th this year (so far). 12. More platform plays and spinouts [✓] Lots of secondary investment activity this year. And many anecdotal examples of mid-career professionals spinning out of established firms. More to come. 13. CRE executives talk a lot more about AI [✓] We surveyed a dozen REITs and found mentions of "AI" spiked by 50%+ this year. 14. Business schools: more about "business" than "school" [x] On one hand, we nailed this. Acceptance rates are higher, the traditional B school model is struggling, and their go-to click credential provider filed for bankruptcy this year. But we also predicted that MBA applications would decline this year, which was wrong. Stay tuned for thoughts on 2025.

“Passive income” seems passive when returns are extraordinarily strong but… We are entering a whole new world.

Millennials: “Thanks for the down payment mom and dad!” Gen Z: “We’ll never be able to afford a home.” Gen X: “One of my kids won’t ever move out!” Alphas: “Look at this TikTok!” Boomers: “Nothing to see here.” The volatility in this chart suggests that the year you were born likely has as much to do with your housing situation than nearly anything else.

"Youth is wasted on the young." It's impossible to overstate this shockwave... ...at home and at the office.

'Maturity wall' narrative vs. default research... ----- Narrative ----- Commercial real estate maturity wall $950B in 2024, peaks in 2027 "Rate hikes by the Federal Reserve and changes in post-pandemic behavior have put pressure on commercial real estate (CRE) borrowers needing to refinance loans coming due. The tally is nothing to sneeze at, with approximately $950 billion in CRE mortgages set to mature in 2024..." "Should borrowers fail to seek the necessary refinancing and default on their loans, banks would not only face losses on their loans but valuations in the CRE market could come under significant pressure. Origination data shows that maturity wall will grow to nearly $1 trillion in 2025 and ultimately peak in 2027 at $1.26 trillion, suggesting that the issue is unlikely to resolve soon." (Source: S&P) ----- Research ----- The bedrock longitudinal study of commercial mortgage defaults was driven by Howard Esaki of Morgan Stanley. Here's what Esaki and his peers found regarding the timing of defaults: "On average, the annual default rate was low within the year of loan origination, rose to about 1% in the first year following origination, then jumped to a range of 1.5% to 2.7% for the next six years. Default rates then declined to less than 1% for the next three years, and tailed off gradually. These results are nearly identical to the Esaki (2002) study. As in that study, THERE IS NO SPIKE IN DEFAULTS AT BALLOON DATES. Some research analysts have noted that loan restructures result in the appearance of low default rates in balloon years, but there is no evidence to support this in our study." "The default timing pattern for individual cohorts can vary widely from the average. The timing and total defaults of a cohort are highly dependent on its position in the real estate cycle. For almost all cohorts, however, the peak in defaults is in years three through seven after origination." Which approach will define performance: 'maturity wall' or historical experience?

Partner at top 25 law firm: “Our headcount will be 50% smaller in ten years.” One off instance or sign of the times?