In the 2011 movie Margin Call, Investment Bank CEO, John Tuld (Jeremy Irons), gathers his board together at 4 AM one morning after an analyst Peter Sullivan (Zachary Quinto) discovered earlier that evening that their entire company is in jeopardy if their invested positions fall in value by 25%. In his famous monolog Mr. Tuld explains that the only reason why he is the boss is that his job is to know when the music is going to play fast, or slow, or stop all together. He goes on to say that he doesn’t hear a thing, just… silence. (Watch monologue) Finally, he explains that the only way to win in the business on Wall Street is to do one of three things, cheat, be smarter than everybody else, or be first. He confesses that he doesn’t cheat and opines that although his team is very smart, they’re probably not the smartest. Hence, the only solution is to be first. If he is indeed prophetic, as in the movie, what does that mean if you are long on your bets in CRE?

Over the past few weeks, the Fed (Jerome Powell) has made it very clear that the music for CRE has slowed considerably and it is very likely that it may be several months before it revs up again; meaning interest rates are not going down any time soon. At ULI in New York this year the consensus – and resignation - from just about everyone was that rate cuts, if any, this year will likely be pushed out to the later summer or fall. If they do happen, it will be politically, not economically motivated. Wall Street seems to have priced in a strong economy and higher interest rates for the remainder of the year. Goldman Sachs, JPMC, Bank of America and other money center banks all have adjusted their modeling to include higher rates for longer. On the other hand, if you listen to the very well-known and well followed economist, Peter Linneman, he would tell you that inflation is really just over 2.0% (not the 3.5+% that is published by the BLM) and that unemployment is really 6.6% not 3.5% metric that the Fed tracks and that the Fed should and will initiate 3 or more rate cuts totaling 150-200 BPs by the end of the year.

Unfortunately, there is no horn blower out there who signals when the music stops, or when it starts up again. Perhaps the latest multibillion dollar deal by Blackstone purchasing the single-family rental company of AIR Communities is just such a signal. Has the music slowed, stopped - or is it just getting started again? There are hundreds of billions of dollars in capital waiting on the sidelines to pounce. FOMAM (fear of making a mistake) seems to be winning out over FOMO (fear of missing out; aka Greed) even though pricing is firming up as cap rates for high quality industrial and multifamily have come in by at least 50 to 75 bases points in major markets and are now trading again below 5.0%.

The Fed has no sympathy for the commercial real estate industry or any part of the 20% of the economy that is interest rate sensitive. They have their eyes set on the other 80% which, are frankly, insensitive to interest rates. So, why are they using a tool that is crushing value in 20% of the economy when it has little to no effect on the other 80% and relying on data to justify their actions that is highly subjective if not blatantly inaccurate? Perhaps Linneman is right, and the Fed is simply misguided. Or perhaps, they are acting politically. Or perhaps, we are in a new macro period of higher rates for much longer than anyone wants to admit.

Banks and many lenders have been content to “kick the can” down the road hoping for lower better interest rates and more liquid credit markets to drive pricing, but what if that does not happen any time soon? What happens if rates do stay higher for longer and capital remains illiquid? What is the relative risk profile of betting one way or the other? What is the likelihood of rates coming down significantly and cap rates following suit? The historical correlation of interest rates to cap rates is not consistent. Interest rates do not drive cap rates. Historical data indicates that the supply of capital and demand for risk adjusted returns drives cap rates. Values are facing and apparently will continue to face strong headwinds for some time to come. Indeed, the storm could get worse if inflation – or the fed’s interpretation of it, remains stubborn.

Mr. Tuld and Mr. Rogers (Kevin Spacey) and his team saved the company so they could keep dancing because they were first and cleared their balance sheet in one day. Yes, they took losses, but they saved the company to fight another day by “selling toxic assets to willing buyers”. Survival is always the first order of business. Perhaps survival is no longer a concern for lenders as it was after the GFC as the balance sheets of most banks, particularly the large money center banks, are now commercial real estate proof. And commercial real estate in and of itself is not toxic. It is just historically mispriced for a different capital markets environment. Also, this is largely a commercial real estate problem and not a residential problem. The value demise of CRE is exacerbated by the erosion of demand across only a few sectors, like office. This devaluation only affects some segments of the $4 trillion in commercial real estate loans, which in total are less than 1/3 the size of the $13 trillion the residential mortgage market, which has seen a significant increase in values. With adequate reserves, bank losses on commercial real estate are not an economic or political problem.

Considering the continued uncertainty across all sectors of commercial real estate and the capital markets which have produced a very inhospitable if reluctant lending commercial lending market, it is likely that transaction volume will remain quite anemic until the Fed relents its hawkish position. Perhaps this universal pessimism should signal a buying opportunity. No one, except maybe Blackstone - which purchased at an effective cap rate of 5.9%, is going to signal the bottom. Because most commercial banks, save for a few regional and community banks with high CRE exposure, do not need to clear the entire CRE loan book like Mr. Rogers did, and the assets are not toxic, it is likely the actual winnowing / sales process could be drawn out for years. The lenders have already written down the assets and taken losses. If you are the asset manager, you are motivated to hold assets if you can in the hope that value might increase, and you can book a profit – and get paid a bonus. Every asset class will play out differently. Despite current headwinds that have temporarily impaired values by 15%-20%, industrial, multifamily, some hospitality, self-storage and retail will weather this turbulence relatively well.

The real challenge will be office. Our last missive talked about the need to rebrand office. Look what rebranding did to industrial. Just by changing its nomenclature to logistics values skyrocketed as high as 4-5X in 24 months. Retail and hospitality both have multiple brand categories. So, why not office. Clearly One Vanderbilt, which word on the street say is getting north of $300 psf is not the same office as the commodity space in midtown NYC which garners $40-$50 psf. The owners of the trophy spaces in NYC have figured this out and are providing an amenity package that rivals 5-star hospitality resorts. In fact, they employ hospitality teams that are between the tenant and the property manager to address tenant needs or issues. They include the finest restaurants run by the most famous chefs and provide common area uses space that resembles a luxury resort. Perhaps we should be rebranding office into Ultra Luxury, Luxury, Business Class, Economy and No Frills - not unlike the airline or hospitality models.

We do not believe the music has stopped as Mr. Tuld professed, but we believe it has slowed considerably and it has changed significantly. For some, that means it’s time to learn a new dance. For others, it may be time to take a time out. For others, like Blackstone, it may signal a time to dance with gusto. Those who want to stay on the dance floor will have to rethink where and how they want to dance by targeting a service model that resonates with their tenant base to make them want to dance along with them.

Dancers live longer and prosper. If you are a dancer, then you will live through this and whether you are looking to exit or purchase or reposition an asset, Corion is here to help. We look forward to dancing with you.