A Double-Edged Sword for Banks

Good morning. With banks experiencing reduced revenues in Q1, the question arises: could increased commercial real estate lending be the solution to their balance sheet challenges? Meanwhile, private equity firms are poised to seize opportunities in the distressed CRE market.

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How Banks Can Turn Commercial Real Estate into a Viable Solution

Worries surround banks' commercial real estate lending, but not doing it could have its own problems. Could more CRE lending actually help the troubled banking sector?

What happened: During the first quarter, U.S. banks encountered a revenue issue. The yield earned on their assets increased at a slower pace compared to the interest rate they paid to fund those assets. As a result, banks' net interest margin, a crucial measure of profitability, was compressed.

Follow the trend: Banks faced a significant problem as they allocated a disproportionate amount of money to fixed-rate bonds like Treasuries or mortgage-backed securities during the pandemic. This offset the natural yield gains that banks typically experience with shorter-term or floating-rate lending, such as credit cards.

Problem meet solution: Commercial real-estate lending offers a promising yield for banks. The first-quarter data indicates that banks' earning assets yielded 4.92%, with nonresidential real estate loans yielding 5.4%. However, banks may face difficulties in offering new loans to certain borrowers, especially considering rising risks in sectors such as offices and multifamily properties. Balancing revenue concerns with potential credit risks becomes crucial for banks.

➥ THE TAKEAWAY

Bottom line: Banks must explore avenues to enhance their yields, particularly if deposit costs continue to catch up with higher interest rates. The availability of creditworthy loans remains a key question in addressing this challenge.

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📖 Read about how legendary real estate tycoon, Sam Zell, revolutionized the industry through his bold investments and transformative projects, leaving a lasting impact on the market.

🖥️ Watch as Shark Tank’s Barbara Corcoran discusses her take on residential’s rebound while she thinks commercial is facing a “bloodbath” partially due to changing workplace dynamics.

🎧 Listen to this episode of WSJ’s The Journal where they discuss Jay Gajavelli’s rise in Houston multifamily and why he’s front and center of one of the biggest CRE blowups in years.

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Private Equity Firms See Opportunities Among CRE Distress

With an estimated $1.5T in CRE debt maturing by the end of 2025, private equity firms are preparing to deploy their capital to seize opportunities in a time of distress.

Market dislocation: Amid market dislocation, the regional banking sector and downtown office spaces have experienced turmoil, causing investors to be cautious about the returns offered by commercial real estate (CRE). The pandemic-induced shift in office usage and the Federal Reserve's rapid interest rate hikes have contributed to declining asset values and higher borrowing costs. As a result, there is an imbalance between the demand for CRE debt and its supply, further complicating the situation.

Capitalizing on the distress: With banks scaling back their lending activities, private lenders are stepping up to fill the gap. Private capital currently accounts for 12% of the $6.3 trillion US commercial real estate (CRE) market and holds approximately $400 billion in available funds. These private firms have two main avenues to capitalize on CRE distress.

1️⃣ They can acquire distressed loans at discounted prices, taking ownership of properties with the goal of achieving substantial returns.

2️⃣ They can purchase performing loans from distressed sellers, securing properties at a significant discount.

The choice between these options depends on various factors, including asset quality, replacement cost, long-term demand drivers, and growth potential in specific markets.

Quality over quantity: Private capital is set to enter distressed commercial real estate (CRE) through diverse investment strategies, with funds targeting specific asset classes, debt funding ratios, and anticipated returns. Despite having available capital, the main challenges involve limited supply compared to demand and the necessity for cautious negotiations and risk management. For instance, Morgan Stanley seeks high-quality assets priced below replacement cost and offering significant discounts compared to 1Q 2022 prices.

➥ THE TAKEAWAY

Opportunity knocks: Private equity firms are exercising caution in the office sector due to the evolving dynamics of work and space utilization. Nonetheless, they find potential in mezzanine financing, preferred equity stakes, and recaps of assets initially financed at more favorable rates and higher values. Despite concerns about an upcoming downturn, these firms recognize opportunities amidst distress. The success of private lending in the distressed CRE market hinges on their skill in navigating negotiations, managing risk, and achieving strong returns.

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• Fair warning: Hillwood Chairman Ross Perot Jr. says developers are having a hard time getting construction loans, and warns of a recession for the industry if banks don’t start lending again.

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• Throwing in the towel: Many NYC developers are giving up on the Big Apple as the city’s office market has been hit hard by WFH. Bowling behemoth: Bowlero Corp is acquiring the Lucky Strike chain for $90M, expanding the bowling alley owner’s reach to major cities in the US.

• Cash in the bank: According to ADP, private payrolls increased by 278K in May, surpassing the 180K expectations and indicating a positive trend in job growth.

• Helping homelessness: Fairfax County is exploring various options to prevent evictions, as they contribute to the issue of homelessness in the area.

• Back to the drawing board: CRE brokers are adapting to the downturn in dealmaking and adjusting their strategies as sales and leasing volumes have dropped.

• Building Brooklyn: Carlyle is partnering with PMG to build two mixed-use towers for $100M on a Gowanus site.

• Collections to auctions: Sotheby's is buying the Breuer Building from the Whitney Museum for around $100 million. The iconic building will transition from hosting art collections to becoming an auction venue.

• For lease: Google (GOOGL) listed nearly 1.5M SF of office space in Silicon Valley up for sublease in an effort to cut costs.

• Fraud Alert: Lynn Stoner, the developer behind the Pixl Plantation project, has been arrested in South Florida on charges related to fraudulent activity and failure to repay loans.

• Mission Impossible: A Tishman Speyer executive has embarked on the challenging mission of revitalizing downtown San Francisco's struggling economy, despite facing a daunting $800M deficit.

• Now trending: Homeownership has reached a 53-year low as rising home prices and a competitive market make owning a home difficult while renting continues to climb.

• $22B in M&A: The real estate industry is experiencing constant turmoil, leading REITs to seek stability through mergers and acquisitions. In 2023, significant consolidations have already occurred as a result.

• Development of the day: L&L Holding is partnering with Columbia Property Trust for the redevelopment of Terminal Warehouse, a 1.3M SF office and retail destination in Manhattan’s West Chelsea neighborhood.

• Fresh funding: Veritas Investments intends to make a bid for its own outstanding debt, which amounts to approximately $1 billion, connected to two significant apartment building portfolios located in San Francisco.

Apartment List put out their June 2023 Rent Report, which shows that rent growth in the once hot Sun Belt metros like New Orleans, Las Vegas, and Phoenix is slowing down while Midwest markets have seen the fastest rent growth over the past year.