Welcome to Part III of our recession planning series. Toby Mathis, Esq. and Stefan Whitwell, Founder and Chief Investment Officer of Whitwell & Co., LLC, are back to discuss the facts, statistics, and future trends they see happening in the crumbling commercial real estate market. There are great investment deals out there, but you need to look at facts and numbers. Don’t fall for the bargain investment “story.” Enlist the assistance of a pro to make sure you don’t get in over your head.
- Commercial real estate – current stats and trends
- Interest rates are doubling
- Commercial building has slowed or stopped- increasing demand, but over 10 years
- Is the residential market next?
- REIT and risks
- Looking at numbers, not the story: history, past cycles and performance
- Invest with an advisor’s assistance, and don’t get greedy!
Full Episode Transcript:
Toby: Hey, guys. Toby Mathis here, and I’m joined again by Stefan Whitwell, CFA, fiduciary, and a financial expert. I’m going to use a quote that you sent over to me. It was Tesla’s CEO, Elon Musk. Everybody knows who Elon is. He says, “Commercial real estate is melting down fast. Home value is next.”... Read Full Transcript
What’s going on in the commercial real estate market? What are the facts? And what can you do to protect yourself?
Stefan: Three or four facts. Fact number one, the way that we are using commercial real estate is changing. The average occupancy in office space is now 50%. We all know that a lot more people work from home.
Retail is going online very quickly. Do we need as much retail space? Probably not. How do we use the retail space that we have? It’s becoming more experiential. (a) Things are changing. (b) Interest rates are now more than double, where they were when a lot of people first bought a lot of that commercial real estate. When loans come up to renew, it’s a different world entirely.
Toby: In commercial, it’s usually five years. They do this thing called a five-year balloon on a 30-year amortization. Everybody thinks it’s a 30-year loan, but it’s not. It’s a five-year loan, but it’s based on mortgage projections out over 30 years.
Stefan: That’s right.
Toby: How much money are we talking about that is going to need to be refied because it’s in this five-year window? Just think about this. What has it been about? A year-and-a-half, two years? Since we are at our bottom of interest rates. We have about another three years. If anybody refied during that period of time, they’re sitting on a ticking time bomb, right?
Stefan: Yeah, it’s a problem. Not only is your interest going to be much higher if you can get the loan, but the banks are likely to tell you, well, gee, we’re not going to roll the whole thing, you’re going to need to put up another substantial amount of cash equity for us to approve that loan.
Toby: Because they’re doing a loan to value. If values are down in commercial, this happened during the recession. I remember this clearly, because it was a friend of mine who runs a production company.
He owned his property, and it never missed a payment. The bank did a cash call on him saying, well, your property has gone down, your loan to value is 70%. Therefore, you need to come to the table with several hundred thousand dollars of cash. He was like, where the hell am I going to find that? We’re in the middle of a recession. That’s what banks were doing to people. You see that happening again?
Stefan: It is happening. We’re seeing it both in small size and in large size. There have been several hundred million dollar deals in San Francisco recently, where assets are trading at 25% of what their value was four years ago.
Toby: You’re seeing a major impact in the commercial marketplace. I’m just going to use one of your facts, I think it’s $1.5 trillion worth of commercial mortgage debt that is coming due by 2025.
Stefan: That’s right. A lot of that, again, was put in place on Wall Street, benefiting from super low interest rates that have now more than doubled.
Toby: The cost of that debt has doubled. It’s no different than in the consumer market. All of a sudden, the median house, you saw the interest payment on that loan doubled in the last two years. In the commercial market, all that’s going to do is it’s going to make people let go. They’re going to say, I’m done, I’m out. You’re going to see pooled funds say, that was great, we’re done. We’re cutting our loss, we’re out. What is that going to do with the market?
Stefan: What you’re going to start seeing is a lot more deals being marketed to you as a good deal. This is a 20%, 30% reduction. All you need to do is reposition this, lease it back up, do this, do that, and then you’re going to be making a lot of money. My advice to you is to discount or to be very, very careful about assuming some of those good things happening.
I think the way to buy real estate is based on current cash flow. If you can make a good return based on what it is today, that’s attractive. If you’re buying it for a price that only makes sense, if you do this, if you get this higher rent, if you can get it leased up, if you reposition it and put all this money into tenant improvements, and then you’ll be able to fill up the building, you’re taking a lot of risk.
Toby: Huge amount of risk. Here’s one thing that’s offsetting some of that. They’re not building commercial right now. We saw this with the residential market, because I do want you to address Elon’s comment about residential real estate being next. I still don’t see it.
They’re sitting here in a situation where they’re like, we’re worried that we’re overbuilt. So they stopped building. What that does is it drives up demand. We’re not replacing. We’re not bringing new commercial property to bear. Is that going to help this situation? Is it going to alleviate? Because they’re not building. It’s way down.
They’re like, they see it. Hey, we got too much commercial real estate. We’re going to stop building commercial real estate. You still have commercial real estate every month going out of commission. It’s aged out, it’s not going to be used. It’s going to be torn down. All of a sudden, that’s out of the marketplace. Is that going to help?
Stefan: It helps, but that helping is over a 10-year period.
Toby: Yeah, it’s going to be a while.
Stefan: And by the way, over a 10-year period, there are significant improvements you still have to think about. Technology is changing to where modern tenants want HVAC systems that can be controlled from their phone, that have intelligent monitoring to lower the usage while you’re not there, to be more ESG-friendly. Well, you know what? Some of the old systems don’t do that. The investment to make your property competitive for things that modern tenants want sometimes requires—
Toby: Be careful then. If you’re investing in those things where they’re saying, hey, there’s going to be a turnaround project, just base it on half. If you’re going to have half the tenancy, you’re just going to have to do a really high vacancy rate when you’re plugging in your numbers. Is that what you’re doing?
Toby: And you’re just making sure that you can’t get hurt. How does somebody take advantage of some of the opportunities that are coming into play? You’re going to see that.
As you see, the commercial market get kicked in the teeth, There are going to be great opportunities as people walk away. How does somebody participate? Is that something like Joe Schmo or a guy like me can go participate in? Or do you have to know somebody? Do you have to be a part of a fund?
Stefan: You got to know somebody. It’s like any other industry. If you’re trying to break into Hollywood, break into any line of business, you got to know somebody. Some of the best deals are often not publicly marketed. The best investment, distressed funds, they’re not available.
In fact, one of the funds that’s done very, very well for clients that we’ve invested in it, they only work through RIAs, and only then firms that have the expertise to understand what they do, because they’re taking advantage of it by buying these assets at distressed prices, or buying the paper from the banks at big discounts, working through these issues, and then making money from it.
Toby: You got to find somebody that has an in on some of these funds and that has an expertise in this particular area. Let’s shift gears a little bit. Residential. Do you think that Elon is right that the residential market is next?
Stefan: I don’t, but I think there’s a different set of concerns. I think your home is the new office for a lot of people. I think the reality is that residential is probably one of the best sectors out there. However, I think there are a lot of people that got a little bit lazy over the last 20 years and got used to declining interest rates, buy a house for anything, benefit from appreciation, refinance it, pull money out. It was the magic formula.
Going forward today, although I don’t think Elon’s right, I don’t think we’re going to see a meltdown in residential, I don’t think we’re going to necessarily see another melt up for a little while because interest rates are going to stay high. Homes are already now at a much higher level of price than they were five years ago. I’m not worried about a meltdown, but I just don’t think I’d walk into it assuming you’re going to have an automatic melt up and leverage yourself to the chin, assuming that it’ll be just like the last 20 years.
Toby: I’ve done a bunch of videos on these, and I always bring facts to bear. We still have half equity. In 2008, houses were underwater. They had negative equity. People were walking away. Here, throw the bank the keys after they steal all the cabinets and all the copper out of the place. If you were in Vegas, that was your modus operandi. Let’s drain the place of anything that we could take and hand it back to the bank.
I don’t see that because there’s just too much equity. Its average just last year, $200,000 of equity. You have, as a percentage of debt, adjustable rate debt. The private sector is about 11%. It’s even less when you look at mortgages. This is the opposite of what’s going on in commercial. Commercial were being forced to refi at higher rates.
Stefan: That’s why I think Elon is wrong. You’re right. The balance sheet of individuals today is actually pretty strong.
Toby: We’re great. Actually, as a percentage of our household debt, the percentage of your income is really low. It’s historical. People still don’t realize that because all they do is they look at credit card debt and they go, it’s going up.
Stefan: But even credit card debt, what’s interesting is I think people have to look at it a little bit below the surface. On the surface of it, they see that even recently, the usage is way up. But what they’re not realizing is, that’s all paid off, or a lot of that has paid off. The usage is up, but a lot of it is being paid off. Why? Because guys like me, want to earn my 3% points on it.
Toby: We’re using it more.
Stefan: It’s not a financing of last resort because like you said, Toby, the balance sheets of individuals today in America are pretty strong.
Toby: Very strong. The debt, as a percentage of income, is really low. The adjustable rate debt, which killed us in 2008, because that’s what was getting people, the same thing that’s happening in the commercial market was what was happening in the residential market in 2008. What’s going on today in that commercial market reminds me of that. You have people who, if it didn’t adjust, they’d be perfectly fine. You’d still be making money. But it is going to adjust, and they’re going to pay twice as much.
You went from having a payment on a commercial building of $20,000 a month, now it’s going to be $40,000. When you’re at $20,000, you made $10,000. When it’s at $40,000, now you’re negative and you’re losing $10,000. It’s not going to be sustainable. You’re going to force some of those folks to have to dump their properties, and you’re going to end up seeing this glut.
That does not exist in the residential marketplace. In a residential marketplace, we’re still underbuilt. We still have very low supply because who wants to sell their house when they have a 2½% mortgage?
Stefan: Nobody, and don’t pay it off early, by the way.
Toby: Yeah, you’re nuts. Those same folks may be looking at it saying, I have cash, what do I do with it? Talk to Stefan and go put it into one of these funds is what you do, and go take advantage of the marketplace as it exists because there is a need. It’s not taking advantage of a person, it’s taking advantage of the opportunity because the fact of the matter is, the banks are tight.
They’re not lending nearly what they were because their balance sheets are looking like crap, because so many people are moving deposits. You’re going to have to go fill that marketplace. And then there are going to be people that are not going to continue. There’s going to be a meltdown in commercial, and they’re going to dump their properties.
Stefan: I do think one of the risks we haven’t talked about is the risks in the publicly traded real estate, so in REITs.
Toby: How do you know whether your REIT’s exposed?
Stefan: I was looking at this the other day after one of our conversations in a little more detail. It comes back to basics. I was looking at a whole bunch of different REITs and how they are doing. You want to look at things like, how much leverage do they have? There are some REITs that have a lot of leverage.
Toby: Stay away from those. Stay away if you’re over levered because it’s adjusted.
Stefan: You know what, though, it’s very misleading, because some of those REITs that have the highest leverage are right now paying the highest dividend. They have a very high dividend yield, so people go, oh, wow, this is great, I’ll get 5%–6% yield.
Toby: But they’re going to get adjusted. They’re going to get adjusted in the next two or three years, and they’re going to get kicked in the teeth. It’s that same scenario where, hey, I was paying 20, and I was able to make money. But if I’m paying 40, I’m not. If I’m paying 20, I’m paying you 10. If I’m paying 40, I’m losing 10.
Stefan: I’ll confess, I’ve made that same mistake. I think all investors have. All I’m doing right now is reminding you, be careful, and don’t fall in love with that high yield until you really do your research and understand where that’s coming from. If there’s a lot of debt on that, walk.
Another interesting thing that I looked at was, and again, this is so basic, I know you’re going to get it, but is their revenue growing? There are some REITs where if you look at the last five years, their revenue is consistently growing. Don’t you want that?
Toby: They’re in a position to take advantage of the marketplace. What you want is to buy that, folks that are in a situation, they have dry powder, they have access to capital, to where they can capitalize on the opportunities that present themselves. You want to not invest in the guys that can’t and that are going to be subject to having to liquidate some of their assets. How do you know, though?
Stefan: I think it helps if you have an advisor or a fiduciary that you can talk about this with and get to help you do this research. Thankfully, today, there’s more information. It’s good and bad. There’s more information than ever available on the internet. The bad news is, there’s more information than ever available.
Toby: I also look at history. I say, hey, did these guys go through this before? How did they do? I’m one of those guys that looks at their dividends that they paid out over the years and if they’ve been increasing them for 20–30 years. They’ve gone through some cycles, they’re probably going to be okay.
I tend to avoid the newfangled stuff because I’m like, you haven’t gone through the fight yet. You don’t have dirty nails. You don’t have the bruised knuckles. I want to see the guys that have been through this and see how they performed. If they did okay, then I’m probably looking at them closer.
Stefan: I’ll share one other secret, and that’s look at the numbers. I can’t tell you how many times I’ve started reading a research report. I’m reading the narrative and the story. I’m like, oh, that’s really compelling. That looks really good. Then I look at the numbers and I’m like, whoa, wait a minute, these numbers don’t look very good.
Toby: Numbers don’t lie. Numbers don’t care about our feelings. Facts don’t care about our feelings.
Stefan: Look at the picture that the numbers tell, rather than getting too sold on the story.
Toby: All right. Is it fair to say that what we’re going through right now in the commercial market, it’s not going to resolve itself in the next 18–24 months?
Stefan: This isn’t going to be a two- or three-year workout period. It’s going to take time. That’s both good and bad. I don’t ever want to see America be faced with these horrific radical adjustments in three- or four-month periods. That’s hard on us as a country.
Toby: This is a train wreck that’s going to be going on for a while.
Stefan: This is a slow moving train wreck, which is better for the country, but you need to be careful that you’re not lulled into a false sense of comfort too soon.
Toby: We’re diving at opportunities, here’s what I would say. This is 2008. If somebody went out there and said, houses are down 30%, I’m buying everything, and then it went down to 75%, you’re kicking yourself. Do not be that person that dives in. It’s almost like dollar cost averaging. You’re looking at a long horizon. Don’t go diving into everything thinking, hey, this is going to be my get-rich-quick.
Continue to invest prudently. Invest through an advisor. I would just plug for this. Invest through a fiduciary and make sure that you’re looking at these as opportunities, but that you’re not getting greedy. If you feel yourself getting greedy, that’s when you really need to be talking to somebody and keeping yourself from making mistakes. That’s what they’re there for. That’s why you have good people.
Stefan, speaking of good people, thanks for coming in here and enlightening us some more.
Stefan: That was good catching up. Thank you, Toby.