For the past two years, while largely nonchalant with broader price levels, the Fed has been warning about two particular asset bubbles: that of easy lending particularly in junk bond, and of a commercial real estate bubble. Following the recent rout which has seen the biggest HY selloff since the financial crisis, especially in the energy sector, it is safe to say that the junk bubble has burst - the only question is how much worse it will get before it bottoms (UBS had some unpleasant thoughts on that matter).
As for the commercial real estate bubble, as Morgan Stanley writes this morning, it bottomed in January 2010 after falling 40%. In the six years since, commercial real estate prices have risen 96% and now sit 17% above pre-crisis peaks, substantially underperforming the residential real estate market.
That, too, however is now set to pop as the Fed is about to get its wish of "renormalizing" prices in this last bubbly space, which means that one of the few relatively isolated sectors from the energy collapse over the past year is about to see a sudden and acute capital exodus, and lead to yet another wave of "unexpected" secondary contagion effects.
Here is Morgan Stanley's Vishwanath Tirupattur explaining why anyone still long commercial real estate may want to quietly take advantage of the next OWIC.
A Tale of Two Markets
Whoever said that real estate is all about location, location, location didn’t really have to worry about financing. Of course location matters for real estate investing, but the post-crisis evolution of the US real estate markets – both commercial and residential – says a lot about the role of financing, or more broadly, financial conditions in markets. In fact, the moral of this tale of two markets has broader ramifications for the economy.
The role of the real estate bubble in what became the Great Financial Crisis (GFC) is now too well known to be rehashed. It is worth highlighting that though prices of both US residential and commercial real estate fell hard, the post-crisis recovery that followed evolved very differently. Residential real estate recovered much later and more slowly. Commercial real estate bottomed in January 2010 after falling 40%. In the six years since, commercial real estate prices have risen 96% and now sit 17% above pre-crisis peaks. On the other hand, residential real estate didn't find a bottom until over two years later in February 2012 after falling a more modest 27%. Since that bottom, residential real estate prices have only climbed 31% and are 5% below pre-crisis peaks.
The residential real estate recovery faced three major headwinds. First, the crisis created a large supply of distressed properties from the spike in mortgage delinquencies and foreclosures. At their peak, our estimate of ‘shadow inventory’ – properties that faced the prospect of being sold by lenders and not at the discretion of owners – got as high as 10.8 million units. Second, the regulatory environment for residential mortgage lending changed dramatically, imposing onerous new restrictions on lenders. Third, lenders faced an onslaught of fines, settlements and litigation related to different aspects of pre-crisis mortgage origination, securitization and foreclosure processing. We estimate that for the industry as a whole, related payments to state and federal regulators, investors, the GSEs and others since the crisis now exceed US$250 billion.
The combination of these three factors resulted in an extremely tight residential mortgage lending environment in the US, with mortgage credit availability restricted to borrowers at the very high end of the credit quality spectrum. The private label RMBS market, which accounted for over a third of all mortgage lending pre-crisis and specifically catered to less creditworthy borrowers, currently constitutes less than 1% of lending volumes.
On the other hand, lending to commercial real estate didn’t have to endure many of these headwinds and certainly not to the same extent. This was mainly because of the so-called ‘big boy’ rule, meaning commercial real estate lending was to experienced and sophisticated borrowers who knew or should have known the issues in pre-crisis commercial mortgage lending. The muted focus on incremental regulation and the much lower litigation issues related to pre-crisis commercial real estate financing sparked a revival of lending by banks and insurance companies to commercial real estate as the post-crisis recovery began to take hold. The private label CMBS market made a successful comeback, albeit at more modest levels compared to pre-crisis. The point here is that the lending landscape for commercial real estate during the post-crisis recovery was very different from that of residential real estate lending. This difference is a major contributing factor to the very different pace of recoveries we have seen over the last several years between these two large and crucial real estate markets.
Fast forward to the present and yet another change may be in the offing. There is a growing sense of tighter financial conditions, particularly to the commercial real estate sector. Late last year the regulators issued a joint statement on Prudent Risk Management for Commercial Real Estate Lending and the latest Senior Loan Officer Opinion Survey (SLOOS) shows that banks tightened their lending standards to commercial real estate meaningfully in 4Q15. At the same time, they are showing signs of easing lending standards to residential real estate. To be clear, residential real estate lending remains tight but the change in tone and directionality from the SLOOS is noteworthy. Furthermore, the headwinds to residential real estate financing described earlier are fading, on the margin – distressed inventories have whittled down to around 2.7 million units, lenders have gotten used to new regulations and residential mortgage litigation is increasingly in the rear-view mirror. The growing sense of gathering clouds in terms of tightening financial conditions to commercial real estate translates into a more challenging road ahead for US commercial real estate. The move in the opposite direction makes us more constructive on the prospects for US residential real estate markets.
If there is a moral to this tale for the broader economy it is this. Tightening financial conditions are a key part of the transmission mechanism for ‘challenging technicals’ to become ‘weak fundamentals’. The dramatic widening of corporate credit spreads and the constrained capital market access to a growing number of high yield borrowers signal a meaningful tightening of financial conditions in the broader US economy. As our US economist, Ted Wieseman, noted in his commentary earlier in the week, given the relatively precarious state of the US economy – after 1.8% GDP growth in 2015 and 0.7% in 4Q15 and tracking under 1% thus far in 1Q – the starting point is not exactly a robust economy better able to withstand a major hit from financial conditions.