September 23, 2020
Seven Economic & CRE Risks heading into Q4 2020
This week’s WIN is the part two to last week’s insights that outlined the “Seven Guiding Economic and CRE Metrics heading into Q4 2020.” As a quick recap, those seven metrics from last week were: i) COVID-19 Cases - Monitor the case rate in the bordering states to your north, south, east and west to appreciate how cross-state border economic activity will be affected in Q4; ii) Employment – Job cuts by the likes of Challenger-Gray is the forward-looking indicator to what happens to employment in Q4; iii) State Budgets and Local Government Fiscal Health – absence of a 4th fiscal stimulus/rescue bill or CARES 2.0 will shift more of the fiscal strain to state and local governments that have already seen revenues decline by an average of 29%; iv) Small Business Failures - YTD there have been more than 325,000 business bankruptcies, and Alabama ranks 8th with more than 11,800 - and behind California(#1), Florida, Illinois, Georgia (#4), Ohio, Texas and New York (#7); v) Property Taxes – Although this item is more of an issue in states like California, New York, Illinois and Florida as Alabama has the lowest property tax rates in the country, it is going to be an area of appeal and lost revenue for all hotel and retail properties in 2021; vi) Transportation Metrics – TSA Passenger Count, Rail Traffic and port of Mobile expanding TEU counts are what to monitor. All are recovering and heading in the right direction for Alabama; vii) CRE Debt Pie - We entered 2019 with the banks having another CRE concentration problem holding nearly 55% of the $4.3 trillion dollars of CRE debt. That remains with a 51% ratio and the banks have yet to really address the market value impacts on MF from rent forbearance and hotel assets from payment deferral programs. CRE-concentrated face challenges in Q4 2020 and 1H 2021 when support programs like rent forbearance and payment deferral programs end.
Seven Economic and CRE Risks heading into Q4 2020:
1. Corporate Earnings: We have evidenced a $10 trillion rally since the respective market indices lows in April 2020 and we are starting to see the bifurcation (tech, work-remote, and eCommerce vs. the other L&T (leisure & travel), Big-Box and mall retail, restaurants, financial services, etc.) and partial unraveling with no CARES Bill 2.0. What will industry segments and companies tell us about the state of the consumer, workforce and CapEx plans without additional fiscal support in Q4 and the election uncertainty 40 days out. Q3 earnings will reveal the wrinkles in the economic fabric and where recovery is stalling out by sector and geography. The banks start first in three weeks and then we get into manufacturing, and retail sectors heading into the final 2 weeks of the presidential and congressional election on November 3, 2020.
2. CRE Credit Metrics: All is not well with the CRE Debt Pie. Banks hold more than half of the $4.0+ trillion in total CRE debt and have yet to begin to recognize impaired loans. Hotel and restaurant loans have been on “payment deferral programs” - and recognition of valuation diminution has not commenced with reappraisals. The bank regulators are behind on this one, again! Q1 2021 could see the restart of bank failures that have large CRE or leisure & travel industry exposure. The Life Companies are in good shape with just 3% hotel CRE concentration in their portfolios. Declining urban office leasing and sales activity, along with MF and the reality of rent forbearance programs ending in Q1 2021 are the risks for Institutional capital sources. Why? These two property types account for approximately half their CRE exposure. CMBS is going to stay constrained and messy as hospitality and retail drag performance and credit metrics down, metrics such as loan delinquency and LTSS (Loans Transferred to Special Servicers)
3. Appraisals and CRE Values: Periods of what bank regulators define as “Material Change,” along with a dearth of transaction activity make market valuation updates challenging in periods like this. Cost approaches are practical as there is difficulty in estimating “external obsolescence” from COVID-19 and government intervention with things like occupancy restrictions. A lack of transactions makes a sales comparison approach an exercise in the dreaded fourth approach to value – the Averaging Approach. Averaging the recent universe of sales transactions is a statistics exercise rather than a valuation method. The Income Approach and a refreshed DCF is what lenders and investors rely upon; but where does one extract market support for the inputs, like vacancy, credit loss, absorption and market rent? The answer is corporate earning reports and 10q filings with the SEC for public companies. Unfortunately, few appraisers and bank appraisal review departments use them - or even know how to read them. These corporate earnings reports reveal what companies are expecting and planning for the next one to three quarters, even if they don’t proffer forward guidance. What are companies for the tenants in your buildings doing with CapEx spend? What percent of their assets have slow rent payment or rising receivables? What are workforce and staffing plans? These earnings reports also answer questions like why public builders that are having stellar profits (Lennar for example) are not ramping up production of new homes. Get ready for messy valuations and prepare to challenge these valuations with results form corporate earnings.
4. Uncertainty Risk: We are already seeing this in the stock market and we are seeing this in slowing of CRE transaction activity. Is this risk a precursor to a broader market disruption (Fed Chair Powell seems to think it is with lots of work ahead justifying his confidence in communicating low interest rates for many quarters – maybe years), or something that is temporary in nature that will pass after the elections and maybe passage of a CARES 2.0 Bill in early 2021? How are investors responding with metrics like Cap Rates or underwriting of NOI? Calls with industry participants the past two weeks suggest Cap Rates are holding steady due to liquidity form the Fed, but debt and equity sources are being much more conservative in their underwriting of NOI. Risk manifests itself in our industry via the Cap Rate. Recall, a Cap Rate is the inverse of a stock multiple. The higher the perceived risk in the market, the higher the Cap Rate. The other way this manifests itself is the “I” piece of the “IRV” valuation formula (Income divide by Cap Rate results in Value). More conservative underwriting of NOI has the same impact as raising the Cap Rate.
5. Zoom and Remote Work: We are not going back to the way we worked pre-COVID-19. That is not my opinion; rather it is the opinion of nearly 70% of CEOs recently survey by KPMG. A few quotes from this latest office and work study by KPMG of note to encourage you to be rethinking office CRE include:
- The rapid shift to working from home might have been rocky at the outset of the pandemic, but after months of overseeing their remote workforce, 77% of CEOs said they will increase their use of digital collaboration and communication tools, according to the survey conducted in July and early August 2020.
- Out of 315 CEOs answering the survey published in KPMG’s “2020 CEO Outlook: COVID-19 Special Edition,” 69% checked the “We will be downsizing office space” box.
- 6. GDP Composition by State and MSA: Where we once produced the majority of our GDP is changing. Be thinking about the following graphic from Visual Capitalist and asking yourself if these same states and MSAs will be the dominant economic powerhouses of pre-COVID producing the largest portion of our GDP. A new VisualCapitalist analysis of US GDP revealed how just 10 metros account for nearly 1/3rd of the GDP for the dominant global economy - the US. These rankings and top 10 list will change post COVID-19. Who do you think will ascend into the top 10 as NE & West Coast MSAs slip?
- 7. November Elections: It is not just who will be President; rather what happens to the composition of Congress and whether the Republicans retain the Senate for important decisions like Supreme Court confirmations. And there are lots of local elections that will determine things like redistricting post the 2020 Census. The “dot” that has not been connected is how migration out of dense and urban cities to other states will impact the Electoral College. What has left New York for Florida or North Carolina that might make these type states more or less Red or Blue is the real question? The pollsters do not know and are not even trying to assess. Assume nothing, and be prepared that we will not know who is President, or who controls Congress, come November 4, 2020 - or maybe even December 4th or January 4, 2020. Study the Constitution over the Thanksgiving holiday to learn how a newly seated Congress in January 2021 could end up deciding the Presidency if the challenges by both candidates can’t be resolved by the courts. If you thought the “hanging chad” in Florida was a mess in the Bush vs. Gore presidential election almost two decades ago in December 2000, you may learn a lot more about our election and constitutional process from this November’s elections.
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