Good morning, in today’s email: NYC landlords don’t know what to do about tenants selling weed under the table. Pension funds are pulling back on their commercial real estate binge as interest rates rise. Up to $52B in CMBS loans maturing over the next 2 years could be cutting it close. And despite WeWork’s fall from grace, coworking is still very popular.

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WORTH THE RISK?

After marijuana was essentially decriminalized in NYC, smoke shop operators welcomed the new foot traffic. But selling pot is still federally illegal, and many CRE landlords aren’t sure what to do.

Popping up: Smoke shops are a staple of the New York corner store, convenient spaces where you can snag a soda, a bag of chips, and a bong all in one place. But in just a few months, they've become some of retail's most prominent tenants after adding a lucrative new item to the menu: cannabis. And while customers value a convenient place to roll up, landlords aren't so enthused; others fear legal issues.

Hard to measure risk: “There’s a lot of gray area right now,” said Michael Robotti, a drug attorney who helped prosecute El Chapo. While selling cannabis without a license is still very much illegal, nobody has really been enforcing the law since NY decriminalized recreational cannabis at the state level last March.

THE TAKEAWAY

Lease now, ask later: The smoke shops that sell pot are capitalizing on the state's sluggish rollout of its dispensary program as lawmakers sift through hundreds of applications for dispensary licenses. To date, no storefronts for legal shops have been leased, so illegal ones are filling the void. And as the retail sector continues to recover in the city, CRE landlords want to retain steady tenants who can pay their bills, even if that means more risk.

LOST APPETITES

Pension Fund Appetite for Commercial Real Estate Is Fading Fast

As borrowing rates rise, pension funds are pulling back on their commercial real estate binge. The slowdown in funding comes as growing recession fears could prevent property owners from raising rents, putting increased pressure on the sector.

Tale of two halves: In H1 2022, pension funds gobbled up $32.6B worth of CRE, spread across offices, warehouses, hotels, and multifamily. Those investments were up 40% from H1 2021. But when interest rates shot up in H2, the once attractive inflation hedge became too costly for new capital. As a result, investors purchased $172.2B of CRE in Q3, 21% less than the same period in 2021, according to new data from MSCI.

Shifting environment: As of Oct. 20, real-estate funds managed by PE firms have raised $112.8B YTD from pension funds and other institutional investors globally, compared with $157.9B in the same period YoY, according to data firm Preqin. Last year, the market felt “we were coming out of Covid; inflation wasn’t going to last too long and interest rates were probably going to be manageable,” said Dave Lowery, Preqin’s head of research insights. “A lot has changed since then.”

THE TAKEAWAY

The bottom line: With fundraising slowing, CRE property sales are also declining placing pressure on prices. Pension funds and other big investors are reluctant to commit new capital now because they don’t know how far values will drop if there is a recession. “A deal today might be even cheaper tomorrow,” said Michael Stark, co-head of PJT Park Hill Real Estate Group.

STRESS TESTING

CMBS Borrowers Face $52B Hurdle For Low-DSCR Loans

NY-based data and analytics provider Trepp believes that CMBS borrowers may be in trouble as a portion of a $52 billion wall of loans set to mature over the next two years could fail an important stress test.

What’s DSCR and why does it matter? A loan’s debt service coverage ratio (DSCR) is a measure of how likely the borrower is to repay the debt. It’s calculated by dividing a property’s net operating income (NOI) by its debt service. If the DSCR is less than 1.0, it’s essentially a delinquent loan. DSCRs above 1.20 are safest.

“Close to the bone”: The “$52 billion wall” of CMBS loans all have DSCRs below 1.25, which means they’re cutting it close. And up to $17 billion (32.7%) of these CMBS loan properties have occupancy rates below 80%. “Some see this as a leading indicator of broader distress,” the Trepp report reads.

THE TAKEAWAY

Making the most of it: While increasing rates make it more likely that properties will fail the 1.20 DSCR litmus test, Trepp believes that most of the loans can be refinanced under more favorable interest-only conditions, which could result in a weighted averaged DSCR of up to 2.4–2.78 over the next 36 months, which is much better.

STAYING FLEXIBLE

Despite WeWork, Companies Keep Expanding Coworking Spaces

As office owners chew their fingernails because of high vacancy rates and uncertainty over future tenant demand, more and more companies are committing to flexible workspace investments.

The future of workspaces: JLL’s The Future of Work Survey 2022 revealed that 43% of 1,100 corporate real estate decision-makers plan to increase flexible workspace investments over the next three years. The key word here? Flexible. “What we are seeing…is that companies are increasing the share of flexible real estate that’s in their overall real estate portfolio strategy,” said Errol Williams, an SVP at WeWork (WE).

The phoenix rises: Speaking of WeWork, turns out it’s still very popular. WeWork’s total occupancy across its 641 global locations hit 72% in Q2. According to Yardi Matrix, which owns CoworkingCafe, coworking space usage jumped 25% nationwide in H1 2022. CBRE bought a 35% stake in Industrious and invested another $100M soon after. Even JLL has its own coworking arm, Flex by JLL, which is opening new locations.

THE TAKEAWAY

Guess he was right after all: After all the books and documentaries about why WeWork’s first IPO attempt failed, it seems Adam Neumann’s thesis was still correct. A lot of people like working around other people, and companies don’t need as much office space these days. Flexible workspaces are looking like the most sensible win-win solution.

📰 Editors' Picks

• Supply and demand: Apartment demand sinks to a 13-year low in Q3 as rents soar to some of their highest levels on record. No one should be surprised by this development.

• Meta in Manhattan: Beleaguered Meta (META), parent company of Facebook, leased 730K SF near Penn Station back in 2020. Now they’re finally getting ready to really use it.

• A new era in underwriting: Going forward, the FHFA will require lenders that use credit scores for underwriting to look at both FICO and VantageScore credit scores.

• Slowing growth spurt: According to the S&P CoreLogic Case-Shiller indices, home price gains slowed down in August, growing 13% compared to 15.6% in July.

• Money-printing properties: Real estate taxes are expected to account for $35B of NYC’s anticipated $65B in 2023 taxes. Last year, real estate taxes accounted for 54.1% of all tax collections.

🤝 Deals & Dealmakers

• The promised land: A $200M, 1.2M SF mixed-use “food innovation center” is breaking ground in south Phoenix, which is basically a food desert.

• Renter rewards: Bilt wants to help renters turn their monthly payments into rewards, which makes so much sense that the startup is already valued at $1.5B and recently raised $150M.

• LA luxury lifestyle: Geoffrey Palmer secured a 10-year, $120.1M refi loan from Wakler & Dunlop for the 526-unit Da Vinci Apartments in downtown LA.

• Pleasure doing business: Pasadena-based REIT Alexandria Real Estate Equities (ARE) bought a 4-acre site in downtown Austin for $108M from the Teacher Retirement System of Texas.

• Everything’s bigger: Houston-based Miday unveiled plans for Watermark, a 70-acre mix-use development that will include 650K SF of Class A office space and a 100K SF fitness facility.

📈 CHART OF THE DAY

Two Western Markets Together Lead the Nation in Industrial Leasing in 2022

😎 MEME OF THE DAY

💼 JOB BOARD

The CRE Daily Hiring Block

Looking for a new role? Or need to find top talent? The CRE Daily Hiring Block is a unique alliance of real estate professionals that connects talent and employers.

• Daily Writer (CRE Daily)

• Investment Associate (Greysteel)

• Asset Management Associate - Multifamily (Tides Equities)

• TPG Real Estate Finance, Analyst (TPG Real Estate)

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.