CHG Issue #167: Asset Duration is Shortening

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In CHG Issue #164: Real Estate in a Rising Rate Environment we introduced the idea that real assets benefit in a rising rate environment, but we've only discussed residential real estate so far leaving out the commercial real estate and commodities markets. The two charts below show a commodities index, and a commercial real estate REIT index overlaid with the Secured Overnight Financing Rate (SOFR). Clearly both markets have struggled in a rising interest rate environment so this week we are going to jump into why this has happened and why our earlier statement about real assets and rising rates still holds true.

The first thing to point out is something we continually talk about which is that market prices and fundamentals are not the same thing. In both cases the market expects higher rates to be harmful to commodities via lower growth and commercial real estate via higher financing rates and lower property values, but the true fundamental outcome still lies in the future. Interestingly, we have recently seen commodity prices perk up as growth has continued to be resilient, a soft economic landing in the US has become the consensus expectation, and China has launched several large stimulus measures.

Commodities suffered for over a decade after the GFC as low aggregate demand combined with high supply due to cheap capital kept prices low and diverted marginal investment dollars towards high growth investments like technology stocks. On the other hand, commercial real estate benefited from the low-rate era as financing costs stayed low and low cap rates supported property valuations. Both outcomes were contrary to consensus expectations coming out of the GFC which was for real estate investments to suffer and aggregate demand for commodities to increase due to zero interest rates and expansionary fiscal policies.

The CRE market experienced a V-shaped recovery after the GFC, and commercial banks made a big push into CRE lending which provided cheap and abundant capital to the market allowing the CRE market to build up significant amounts of leverage. According to Trepp, the universe of commercial mortgages outstanding stood at $5.9 trillion at the end of Q1 2024; more than double the level it stood at just prior to the GFC. CRE debt continues to grow today, despite higher interest rates and the broad pullback in lending by commercial banks with Multifamily leading the pack growing at 6.5% year-over-year as it continues to benefit from demographic trends and low-cost financing support from the GSEs.

However, it is this high level of aggregate leverage that presents the problem for commercial real estate today. Existing properties that were underwritten in a low-rate environment face increased costs for new financing and lower margins from rising expenses. Certain property types like offices are facing idiosyncratic demand shocks which necessitates a deeper deleveraging for that sector. Transaction volumes have dropped sharply as rates have risen, property values have dropped, and property owners defer sales in hopes of a stronger market in the future.

New construction faces rising land acquisition costs, higher cost of equipment and materials, and higher financing costs all of which puts pressure on project returns. We are in a quirky environment today where cap rates, while higher, are below financing costs. Project returns are also lower than the cost of capital for new construction which can be beneficial in the short term because low cap rates keep exit valuations high, however, with the general yield-on-cost (a development return metric that compares the expected cash flow from a project to the total project cost) for multifamily projects hovering around 6-7% and interest rates closer to 8-9%, these projects suffer from negative carrying costs. In other words, you are sinking a $1.00 into the ground today only to get back $1.30 in 2-3 years IF cap rates don’t rise. You can finance a project with a WACC higher than the project return only if you expect to be able to sell it at a premium once the project is complete. While that has generally been the case over the last forty years, higher rates and higher project costs are making it increasingly difficult today. Cap rates could and should rise above financing costs as transaction volumes pick up or the supply of distressed properties weighs on the market.

The level of distress in commercial real estate continues to increase as borrowers with loan maturities struggle to refinance or sell their properties. However, we must differentiate between fundamental distress and financial distress. Outside of the office sector, the broader CRE market is only experiencing financial distress due to too much leverage. Said differently, there are plenty of high-quality, yet over-levered assets in the CRE market today. As these properties restructure their debt, prices and rents will reset to a level more in balance with current land values, construction and operating costs. After years of not having to even think about operating expenses, owners will remember how to manage expenses and will no longer be facing expense growth outpacing revenue growth. It is easy to lose sight of the tailwinds for commercial real estate during this deleveraging, but as we move through it, the reality of increasing land values and increasing rents will become apparent.

In inflationary and rising interest rate environments investors value the physical more than the financial, which is the primary reason why real assets do better in these environments. When rates and inflation are low, it is easier for stories to take hold of investors' imaginations whereas during inflation and rising interest rate environments consumers tend to hoard commodities and investors want near-term returns; in effect, the asset duration of the broader economy shortens. Commercial real estate used to be viewed as a bond-proxy type investment because you would build a project and collect rent over a long period of time as your primary source of return. That changed over the past 40 years where investors were able to realize equity-like returns by investing in real estate and selling at progressively higher valuations. Many billionaires were created during that cycle with one of them a current presidential candidate. While the general economics of real estate investing are undergoing change, the CRE market will continue to provide plenty of opportunities for wealth creation.

?Commodities and other “hard” assets once held allure for their inflationary protection attributes, but after forty years of disinflation commodity prices have tended to move more in line with aggregate growth. The disintegration of the USSR and the emergence of China as a major goods exporter created a supply shock for the world with cheap commodities and goods readily available for the world. As these economies have moved from marginal producers to marginal consumers the increase in supply has leveled off but demand has continued to grow, and we have moved from abundance to scarcity which is the germ of inflation.

It is important to recognize the potential for these secular changes which will have simple, but far-reaching impacts on investors and the global economy. We tend to do what has worked most recently which makes turning points like this difficult to navigate, but by being aware of the potential for change and indicators that signal change is taking place makes it easier for us to adapt and benefit from the change.

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