The largest commercial CRE tech event on the east coast blew my mind a couple weeks back. Granted, I’m not the road warrior I was a decade ago at Zillow, but the truth is it was CREtech New York was one of the best events I’ve ever attended: fantastic food/refreshments, efficient networking, and an unbelievable space (Dock 72 in Brooklyn). And no shortage of smart innovators, including Resident, Spruce, Livly, Doorkee, and Mint House.
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The bar has been raised. Props to Michael Beckerman and Ashkan Zandieh (and the entire team behind you): you nailed it. I’m looking forward to being back in New York next year.
During the initial wave of the banking crisis in March, I published “Truist: Immense Unrealized Bond Losses Threaten Core Equity Stability.” At the time, Trust Financial Corp. (NYSE:TFC) had suffered the most significant drawdown among the top-ten US banks. Roughly five months ago, I was among the few analysts with a definitively bearish outlook on the bank, while many had viewed it as a dip-buying opportunity. My perspective was that although TFC’s “bank run” risk was low, the vast extent of its off-balance sheet losses left it with little safety for a potential rise in loan losses. Further, I expected that growing net interest margin pressures would substantially lower the bank’s income over the coming year, potentially compounding its risks.
Since then, TFC has declined by an additional ~11% in value and recently retraced back near its May bottom, associated with the failure of the Federal Republic. I believe the most recent wave of downside in at-risk banks is a notable signal that the market continues to underestimate systemic US financial system risks. Of course, following TFC’s most recent bearish pattern, I expect many investors to increase their position, viewing the company as significantly discounted. Accordingly, I believe it is an excellent time to take a closer look at the firm to estimate better its discount potential or the probability of Truist facing much more significant strains.
Estimating Truist’s Price-to-NAV
On the surface, TFC appears to have considerable discount potential. The stock’s TTM “P/E” is 6.3X compared to a sector median of 8.7X. Its forward “P/E” of 7.7X is also below the banking sector’s median of 9.3X. TFC’s dividend yield is currently at 7.2%, nearly twice as much as the sector median of 3.7%. Finally, its price-to-book is 0.66X, considerably lower than the sector median of 1.05X. Based on these more surface-level valuation metrics, TFC appears to be around trading around a 25% to 35% discount to the banking sector as a whole. Of course, we must consider whether or not this apparent discount is pricing for the bank’s elevated risk compared to others.
Importantly, Truist is one of the most impacted banks by the increase in long-term securities interest rates, giving the bank huge unrealized securities losses. Based on its most recent balance sheet (pg. 12), we can see that Truist has about $56B in held-to-maturity “HTM” agency mortgage-backed-securities “MBS” at amortized cost, worth ~$46B at fair value, giving Truist a $10B loss that is not accounted for in its book value. That figure has remained virtually unchanged since its Q4 2022 earnings report through Q2 2023; however, it will rise with mortgage rates since higher rates lower the fair value of MBS assets. Truist’s Q2 report also notes that all of its HTM MBS securities are at due over ten years, meaning they’re likely ~20-30 year mortgage assets that carry the most significant duration risk (or negative valuation impact from higher mortgage rates).
Significantly, the long-term Treasury and mortgage rates have risen in recent weeks as the yield curve begins to steepen without the short-term rate outlook declining. See below:
From the late 2021 lows through the end of June, the long-term mortgage rate rose by around 4%, lowering Truist’s MBS HTM assets fair value by ~$10B, while its available-for-sale securities lost ~$11.9B in value (predominantly due to MBS assets as well). Accordingly, we can estimate that the duration of its securities portfolio (almost entirely agency MBS) is roughly $5.5B in estimated losses per 1% increase in mortgage rates. Since the end of June, mortgage rates have risen by approximately 35 bps, giving TFC an estimated Q3 securities loss of ~$1.9B. Around $1B should show up on TFC’s balance sheet and income, while ~$900M will remain unrealized based on its current AFS vs. HTM portioning.
For me, we must value TFC accounting for both. Total unrealized losses and estimated losses based on the most recent changes in long-term interest rates. That said, should mortgage rates reverse lower, Truist should not have that $1.9B estimated securities loss in Q3; however, should mortgage rates continue to rise, the bank should post an even more considerable securities loss. At the end of Q2, Truist had a tangible book value of $22.9B. After accounting for unrealized losses, that figure would be around $12.9B. After considering the losses associated with the recent mortgage rate spike, its “liquidation value” is likely closer to $11B. Of course, Truist has a massive ~$34B total intangibles position due to goodwill created in its acquisition spree over the past decade. Although relevant, I believe investors should be careful in accounting for goodwill due to the general decline of the financial sector in recent years.
While much focus has been placed on unrealized securities losses, the risk associated with those losses is vague. Truist can borrow money from the Federal Reserve at par against those assets, partially lowering the associated liquidity risk. However, the Fed’s financing program is at a much higher discount rate (compared to deposit rates) and only lasts one year, so it is not a permanent solution. Further, the unrealized securities losses are on held-to-maturity assets, meaning it will recoup the losses should the assets be held to maturity. Of course, that means it may take 20-30 years, and Truist may need that money before then.
Further, Truist has a substantial residential mortgage portfolio at a $56B cost value at the end of Q2 (data on pg. 48). Those loans had an annualized yield of 3.58% in 2022 and 3.77% in 2023; since the yield did not rise proportionally to mortgage rates, we know the vast majority of those loans are likely fixed-rate long-term. Since they’re not securities positions, Truist need not publish their changes in fair value; however, should Truist look to sell its residential mortgages, they would almost certainly sell at a similar total discount to its MBS assets, considering its yield level is akin to that of long-term fixed-rate mortgages before 2022. I believe the unrealized loss on those loans is likely around $10B.
The rest of Truist’s loan portfolio, worth $326B at cost, is predominantly commercial and industrial ($166B), “other” consumer ($28B), indirect auto ($26.5B), and CRE loans ($22.7B). Excluding residential mortgages, all of its loan portfolio segments have yields ranging from 6-8% (excluding credit cards at 11.5%), with those segments’ total yields rising by around 3-4% from June 2022 to 2023. Accordingly, it is virtually certain that most of its non-mortgage loans are either short-term or fixed-rate since their yields rose with Treasuries, meaning they do not likely face unrealized losses based on the increase in rates.
Overall, I believe that if Truist were to liquidate its assets, its net equity value for common stockholders would be roughly zero, technically $1B. That figure is based on its current tangible book value, subtracting known unrealized losses on securities (~$10B), estimated recent Q3 realized and unrealized losses (~$1.9B), and estimated unrealized mortgage residential loan losses (~$10B). While the bank does have some MSR assets, worth ~$3B, that are positively correlated to rates, I do not believe that segment will offset unrealized losses in any significant manner. Together, those figures equal its tangible book value and would lower the total book value to about $34B. However, in my view, intangibles are not appropriate to account for today because virtually all banks have lost value since its 2019 merger, making its goodwill an essentially meaningless figure.
From a NAV standpoint, TFC is not trading at a discount and is most likely trading at a significant premium. Further, based on these data, Truist is, in my view, seriously undercapitalized. Although TFC posts a CET1 ratio of 9.6%, which is also relatively low, its common tangible equity would be essentially zero if its loans and securities were all accounted for at fair value. To me, that is important because most of its losses are on ultra-long-term assets so it may need that lost solvency sometime before those assets’ maturity. Further, even its 9.6% CET1 ratio is close to its new regulatory minimum of 7.4%, so a slight increase in loan losses or a realization of its estimated ~$22B in unrealized losses would quickly push it below the regulatory minimum.
Truist Earnings Outlook Poor As Costs Rise
To me, Truist is not a value opportunity because it is not discounted to its tangible NAV value. Even its market capitalization is around 65% above its tangible book value, which does not account for its substantial unrealized losses. However, many investors are likely not particularly concerned with its solvency, as that could not be a significant issue if there are no increases in loan losses, declines in deposits, or sharp NIM compression. If Truist can maintain solid operating cash flows, that could compensate for its poor solvency profile.
Of course, TFC cannot continue to try to expand its EPS by increasing its leverage since it is objectively overleveraged, nearly failing its recent stress test. On that note, poor stress test results are essential, but “passing” is somewhat inconsequential, considering most of the recently failed banks would have passed with flying colors, as the test does not account for the substantial negative impacts of unrealized losses on fixed-income assets. That is likely because, when “stress testing” was designed, it was uncommon for long-term rates to spike with inflation as it had, and banks had much lower securities positions compared to loans. Thus, it is quite notable that TFC nearly failed a test that does not account for its substantial unrealized losses.
Looking forward, I believe it is very likely that Truist will face a notable decline in its net interest income over the coming year or more. Fundamentally, this is due to the decrease in Truist’s deposits, total bank deposits, and the money supply. As the Federal Reserve allows its assets to mature, money is effectively removed from the economy; thus, total commercial bank deposits are trending lower. Truist’s deposits are trending lower in line with total commercial banks. I expect Truist’s deposits to continue to slide as long as the Federal Reserve does not return to QE. As Truist competes for a smaller pool of deposits, its deposit costs should rise faster than its loan yields. Today, we’re starting to see the spread between prime loans and the 3-month CD contract, indicating that bank NIMs are declining. See below:
Truist’s core net interest margin has slid from 3.17% in Q4 2022 to 3.1% in Q1 2023 to 2.85% in Q2. Truist’s deposits (10-Q pg. 48) have generally fallen faster than its larger peers, so it needs to increase deposit costs more quickly. Over the past year, its total interest-bearing deposit rate rose from 14 bps to 2.19%, with the most significant rise in CDs to 3.73%.
Notably, Truist has increased its CD rate to the 4.5% to 5% range to try to attract depositors. However, the bank continues not to pay any yield on the bulk of its savings account products, causing a sharp increase in customers switching toward the many banks which pay closer to 5% today. Over the past year, the bank saw around $10B in outflows for interest-bearing deposits and about $25B from non-interest-bearing deposits, making up for those losses with new long-term debt and CDs. Problematically, that means Truist is rapidly losing more-secure liabilities to more fickle ones like CDs and the money market. While this effort may slow the inevitable decline of its NIMs, it will also increase Truist’s solvency risk because it’s becoming more dependent on less secure liquidity sources as people move money between CDs more frequently than opening and closing savings accounts at different banks.
Truist also faces increased expected loan losses due to a rise in late payments last quarter. That trend is correlated to the increase in consumer defaults and the sharp decline in manufacturing economic strength. See below:
Consumer defaults remain normal, but I believe they will rise as consumer savings levels continue to fall and should accelerate lower with student loan repayments. The low PMI figure shows many companies face negative business activity trends, increasing future loan loss risks on Truist’s vast commercial and industrial loan book. Of course, Truist also has a notable CRE loan portfolio, which faces critical risks associated with that sector’s colossal decline this year.
The Bottom Line
Overall, I believe Truist has become even more undercapitalized since I covered it last. I also think Truist faces an increased risk of recession-related loan losses and has a more sharp NIM outlook. Even more significant increases in mortgage rates recently exacerbated strains on its capitalization, while its low savings rates should cause continued deposit outflows. Further, its increased CD rates should create growing negative net interest income pressure.
If there was no recessionary potential, as indicated by the manufacturing PMI, then TFC may manage to get through this period without severe strains; however, its EPS should still decline significantly due to rising deposit costs. That said, if Truist’s loan losses continue to grow due to increasing consumer and business headwinds, its low tangible capitalization leaves it at high risk of significant downsides. If its loan losses grow or its deposits decline, it will need to realize more losses on its assets, quickly pushing its CET1 ratio below its new regulatory minimum. Personally, I strongly expect TFC’s CET1 ratio will fall below the 7.5% level over the next year and could fall even lower if a more severe recession occurs.
I am very bearish on TFC and do not believe there is any realistic discount potential in the stock besides that generated by speculators. Since there is a significant retail speculative activity in TFC and some potential for positive government intervention due to its larger size, I would not short TFC. Although TFC downside risk appears significant, many factors could create sufficient temporary upside that it is not worth short–selling. That said, I believe Truist may be the most important financial risk in the US banking system due to its solvency concerns combined with its size and scope. Accordingly, regardless of their position in TFC, investors may want to keep a particularly close eye on the company because it may create more extensive financial market turbulence than seen from First Republic Bank should it continue to face strains.
In our latest real estate tech entrepreneur interview, we’re speaking with James Segil from Openpath.
Who are you and what do you do?
I’m James Segil, and I am the president and co-founder of Openpath, an LA-based startup which creates smart, secure physical access systems for the modern office. I’m an entrepreneur with proven experience having built and sold three successful technology companies.
I run day-to-day operations and business development at Openpath, where we are helping companies reduce common touch points and make a contactless user experience as part of a new, healthy post-pandemic environment.
What problem does your product/service solve? My fellow co-founders Alex Kazerani, Samy Kamkar, Rob Peters and I had the idea for Openpath when we grew tired of forgetting our office keys at home and were frustrated with having to carry multiple badges to get into buildings. We were also worried about security at work given the state of the world today. We started Openpath in 2016 because saw an opportunity to really improve the office access and the keyless-entry experience by making it more frictionless and secure. We saw that we could use our phone to open the doors instead of having to carry a keycard.
Our solution combines hardware and enterprise, cloud-based software to improve the experience for people accessing buildings with hands-free access and mobile credentials, all through a beautifully designed product. Openpath’s access control platform helps companies across a range of sectors including commercial real estate, manufacturing/industrial, offices, retail, schools, gyms and places of worship, and supported over 5 million unlocks a month.
What are you most excited about right now?
Getting America back to work safely with Germ-Free access to your building and office. We are currently laser-focused on helping building owners, managers and tenants to provide employees and visitors secured access without touching any physical surfaces.
We just announced our “Wave to Unlock” feature, through which users can wave their hand in-front of a reader from a safe distance in order to unlock an entry, removing all surface contact. The patented Triple-Unlock technology works over WiFi, LTE, and Bluetooth, and guarantees a fast and reliable connection, which is critical for efficient and safe access. This is part of our offerings to help companies facing demands to update workspaces for returning employees to work.
We’re hearing from building owners, tenants, city planners, architects, and security consultants that this touchless solution is calming some employee concerns about returning to the workplace as a touchless, hands-free, germ-free experience.
What’s next for you?
Beyond the COVID-19 response, we are looking for new ways to improve the day-to-day work experience of every worker in the world through frictionless access. Our obsession on user experience drives us as we want people to experience the built world in a more personalized and secure way.
What’s a cause you’re passionate about and why?
I’m passionate about reducing homelessness, which is how I became very involved with The Giving Spirit, a grassroots charity that assembles survival kits for the homeless here in Los Angeles. We have helped over 40,000 homeless since we started and continue to focus on helping those who are the most in need during this difficult time.
Thanks to James for sharing his story. If you’d like to connect, find him on LinkedIn here.
We’re constantly looking for great real estate tech entrepreneurs to feature. If that’s you, please read this post — then drop me a line (drew @ geekestatelabs dot com).
Geek Estate is about celebrating entrepreneurship, focused on the real estate tech (residential and commercial). The REACH program, backed by the National Association of Realtors and Second Century Ventures, is a big part of the broader ecosystem. Today, they announced their entire 2020 class.
The eight companies selected for the REACH Class of 2020:
Earnnest: secure, electronic escrow fund transfer platform
Kangaroo: affordable, DIY smart home and small business security solutions
RealX: America’s first online property rights exchange
Ylopo: end-to-end, cross platform, digital marketing
PunchList: all-in-one closing repair solution
Transactly: simple, streamlined platform for real estate professionals and transaction coordinators
CartoFront: software-as-service (Saas) based flood insurance tool for Realtors®
Modus: secure, modernized title and escrow platform
The eight companies selected for the REACH Commercial Class of 2020:
Obie: insurance and portfolio management for small-to-medium CRE investors and owners
EPR2: clean energy solutions for commercial property owners
Pear Chef: private chef and culinary services for the multi-family housing market
The real estate investing landscape has changed dramatically since the big bust of 2008. Confidence is still not what it once was, and for smaller investors, the risks seem to outweigh rewards. However, an article I read from Forbes back in the summer of 2017 shined a light onto diversified investments into commercial as “the way.” With this in mind, news from an innovative social platform for real estate investments called “iintoo” led me to request an interview with the company’s Managing Director, Shoshana Winter.
Here is the gist of our Q & A session.
Phil Butler: Can you outline briefly an ideal/characteristic iintoo deal or investment?
Shoshana Winter: Iintoo is designed to remove every possible barrier to entry for investors who are interested in exploring alternative asset classes to help diversify their portfolios, but don’t want to take the time to develop the expertise necessary to choose the right deal. The ideal investment for iintoo is, therefore, one that makes it through a long and rigorous vetting process which is designed to weed out less opportune deals. Our platform leverages AI as well as the expertise of our team to identify those deals that meet the core standards in our methodology: commercial-grade, income-generating (value-add capital improvement projects for senior living, student housing and multi-family, etc.), in B and C geographies, and in short exists (no later than 36 months). These criteria have historically demonstrated positive returns for investors, even through economic downturns.
Our goal is to deliver double digit returns on each investment and to do so in short timelines so investors can either roll their returns into another deal or be able to use that yield to fund home improvement projects, vacations or special occasions like a wedding. This vetting process has resulted in iintoo offering only 53 projects to investors out of the 4000 plus deals they’ve seen over the past 4 years. This strategy has returned a 16.78% average annual yield across the 11 exits completed. iintoo’s vetting of these projects does not end with the offering – our team of analysts and business development professionals stay involved in every step of the project ensuring that the developers they are working with stay on time and budget according to the business plan of each project. iintoo will be in contact with the sponsor, do site visits and deliver quarterly reports to its investors to provide complete transparency on progress through the life of the project.
Phil Butler: What’s the benefit that iintoo provides to investors looking to capitalize on the CRE market?
Shoshana Winter: Iintoo provides easy, direct access to curated, premium commercial grade real estate deals designed to drive maximum yield in short time frames. That means that many investors can enjoy these yields in a very immediate way. For example, if they want to see their retirement funds deliver higher returns than traditional products (IRA’s), they can invest a portion of their retirement fund in iintoo through the use of a custodial trust that we make available to them, which allows them to invest without the tax penalties of withdrawing their retirement funds early. iintoo takes a lot of the guesswork out of the process by only offering deals that are designed to deliver the highest potential yields. This means that investors do not need to be real estate experts to make these investments. In addition, iintoo offers investors the industry’s only Equity Protection Investment Community (Epiic) platform which protects them against a loss of value of real estate projects. Epiic adds a two-layer protection benefit for investors who are seeking the safety of principal protection for their initial investment.
Phil Butler: How does iintoo help investors limit risk?
Shoshana Winter: Iintoo does everything it can throughout the process to ensure the best possible investor experience. Though no investment is risk free, iintoo’s methodology is based on a proven model, a highly rigorous criteria-driven vetting process, hands-on management of the investment, and equity principal protection. (See above)
Phil Butler: I’ve taken note of the fact iintoo does not offer investments for those interested in the luxury market. How can your platform/service be helpful to these investors?
Shoshana Winter: Iintoo’s model is based on over 30 years of historical performance of commercial grade real estate investments across multiple geographies. The reasoning for focussing on B and C grade geographies and commercial grade projects (vs. hotels and retail) is they have proven to deliver better yields even through economic downturns. iintoo is looking to capitalize on what is delivering returns vs. other criteria; our analysts and business development team continue to evaluate deals across the spectrum and if new opportunities present themselves that serve our goal of maximum potential returns than we might expand our offerings to include those kinds of deals. But, the guiding principle is always about insuring the most positive outcome for our investors.
I asked the iintoo executive about her company’s successes/profits for investors, which she expressed in terms of a 16.78% average annual yield for our 11 exits. According to Ms. Winter, by using the iintoo platform, accredited investors can now access commercial-grade real estate opportunities without the normal barriers to entry smaller investors usually face. iintoo specializes in grouping investors from all over the country into bigger, multi-million dollar positions and investing that in commercial grade real estate like hotels, student housing, storage facilities, as well as multifamily complexes.
Phil Butler is a former engineer, contractor, and telecommunications professional who is editor of several influential online media outlets including part owner of Pamil Visions with wife Mihaela. Phil began his digital ramblings via several of the world’s most noted tech blogs, at the advent of blogging as a form of journalistic license. Phil is currently top interviewer, and journalist at Realty Biz News.
VTS, a New York-based company has announced they’ve raised an additional $90 million in Series D funding led by Brookfield Ventures. In total the startup has gleaned $187.4 million since it’s entry seven years ago. According to the company, this funding round makes VTS the largest software venture in CRE history.
According to the Wall Street Journal, the Series D funding values the company at over $1B, which makes one of the 20 or so “unicorn” startups valued at $1B or more.
Other investors in this round included GLP and Tishman Speyer, as well as Fifth Wall, along with others. VTS’ Saas business model innovation has had revenue growth of 70% year on year in 2018, according to the company’s press. VTS says its software empowers landlords to convert leads into leases 41% faster with data-led strategies. Josh Raffaelli, Managing Director, Brookfield Ventures, offered this:
“VTS has been one of the most impactful technology platforms we’ve incorporated into our organization and we are excited to be playing a part in their future. VTS’ market-leading technology platform has transformed the way the industry operates, and we’re incredibly excited to partner with them in this new capacity.”
Back in 2016, VTS and competitor Hightower merged to grow square footage of office, retail, and industrial assets managed from a combined 2 billion to 10 billion by the end of 2018. The proptech company now boasts of over 35,000 users which include brands like Jones Lang LaSalle and Blackstone. Nick Romito, Co-Founder, and CEO of VTS offered this via press release:
“There’s no truer validation as a founder when your customers invest in your product and we’re thrilled to welcome Brookfield Ventures and GLP as our partners, alongside return investor Fifth Wall, as we enter the next phase of growth. This funding will enable us to accelerate the pace at which we build the best technology for commercial real estate landlords, brokers, and tenants, as we arm them with the sophisticated solutions they need to win in a rapidly changing environment.”
The new funding will be used to enhance the VTS platform, according to the company press. VTS also plans to accelerate the launch of its commercial real estate (CRE) marketplace, Truva, slated to go live later this year.
Phil Butler is a former engineer, contractor, and telecommunications professional who is editor of several influential online media outlets including part owner of Pamil Visions with wife Mihaela. Phil began his digital ramblings via several of the world’s most noted tech blogs, at the advent of blogging as a form of journalistic license. Phil is currently top interviewer, and journalist at Realty Biz News.
[Note from the editor: Originally published on Thomvest’s Blog]
Today we’re releasing an updated version of our commercial real estate technology market map. The full list of companies is available here, and a high-resolution version of the map can be accessed here. This market map includes more than 220 technology companies operating across every aspect of commercial real estate, and range from seed stage businesses to public companies. If you’d like to suggest a company to be added to this market map, please submit them using this form.
Broadly defined, commercial real estate (CRE) includes any property owned to produce income. In total, more than 100 billion square feet of space in the United States is devoted to commercial use. Because commercial property is acquired for investment purposes, it differs from its residential counterpart in several important ways:
Commercial real estate is a diverse asset class that can take on many forms: office buildings, retail stores, malls, apartment complexes, homes, hotels and more.
Every property is analyzed for its ability to generate income. In most cases, there is a leasing component to commercial property ownership (which is the main revenue-generating activity), whereas in residential real estate properties are often owner-occupied.
Commercial properties are actively managed by teams responsible for leasing, routine maintenance, improvements and amenities to ensure that the building is suitable for occupants.
As the map above indicates, there are hundreds of technology companies across every aspect of the commercial real estate lifecycle, from property search and financing, to leasing and ongoing management. You’ll notice that several companies are included in more than one section — this is due to the fact that many of these businesses have expanded their product areas to capture multiple phases of the CRE lifecycle. For example, VTS recently launched a listings marketplace offering to compliment its suite of leasing and asset management tools. As such, we’ve included VTS in both the “Find Property” and “Manage Property” sections.
Assessing the Impact of COVID-19 on Commercial Real Estate
It’s no secret that the pandemic has dramatically altered our ability to utilize commercial real estate. The pandemic has impacted every CRE segment (office, hospitality, retail, etc.) and every phase of the asset ownership lifecycle (leasing, financing, utilization, etc.). The pandemic will likely continue to influence occupiers and end users of real estate in unprecedented and unique ways, which will have implications for the entire CRE industry.
This is particularly true in the office segment, as the abrupt change in the way we work has required mass remote working. Interestingly, as companies have transitioned from office work to remote work, many employees are reporting no meaningful impact on productivity. Even as lockdowns are slowly eased, as many as 75% of employees prefer to work from home out of caution or convenience. This has caused many in the industry to ask: Is the office as we know it dead?
Given these lingering existential questions, we’re witnessing the reimagining of office environments designed to anticipate what the “next normal” will look like. Tenants and landlords are working hard to determine an approach for re-entering the office, and the impact of remote work on future space needs. While there are many questions we’ve yet to answer, we anticipate the office category evolving in several important ways, and expect technology companies to play a central role in that evolution:
Emphasis on Safety:As new case volume persists, businesses have been cautious to re-open offices. In an August survey of 15 employers that collectively employ about 2.6 million people, 57% said they had decided to postpone their back-to-work plans because of recent increases case volume, according to the Wall Street Journal. Employers are also developing safety measures to facilitate a smooth re-opening, including redesigned workspaces and temperature checks. We expect additional safety standards to be developed, including staggered employee schedules, space plans to promote social distancing, safe hygiene practices, cleaning protocols, and guidance on using elevators. Technology is a key component of ensuring that both tenants and landlords abide by these emerging safety protocols.
Flexible Work Arrangements:The pandemic catalyzed a massive work-from-home experiment. In many cases, employees actually prefer remote work as it provides flexibility, reduces (or eliminates) commute times and enhances productivity. More than 75 percent indicate they would like to continue to work remotely at least occasionally, while more than half — 54 percent — would like this to be their primary way of working, according to IBM. The forced shift to operating remotely has led to nearly 40 percent of employees indicating they feel strongly that their employer should provide opt-in remote work options when returning to normal operations.
Flexible Space Needs: As offices reopen after COVID-19 shutdowns, we will likely see a mix of new use cases. Some companies will require more office space to further space out employees and reduce potential transmission, while others will move to permanent work-from-home arrangements or a hybrid of home, co-working, and office spaces to minimize commutes and maximize social distance. This will create more demand for flexible office space, including co-working space offered by companies like WeWork and Industrious. According to JLL, 67 percent of corporate real estate decision-makers are increasing workplace mobility programs and are incorporating flex space as a central element of their agile work strategies. JLL “expects 30 percent of all office space globally to be flexible in some form by 2030” (up from about 3% today).
In every industry, technology is an important enabler of not only process efficiency, but also of customer satisfaction and growth, and real estate is no exception (particularly during this pandemic). We’ve already seen technology companies step up to offer useful solutions for landlords and tenants. For instance, companies like Envoy are offering safety-focused tools including employee registration, touchless sign-in, wellness checks and capacity management to employers preparing to re-open their offices. We also expect accelerated adoption of digital solutions related to property and building management, leasing and transaction management. Working on furthering the adoption of technology in real estate? We’d love to talk.
Like many of you, we are seeing a significant increase in commercial real estate (“CRE”) loan workouts. The magnitude of the swell in distressed CRE loans remains unclear, although one thing is certain: appreciating the options and remedies for CRE participants, particularly lenders and borrowers, has never been more critical.
A Changing Landscape
Under contemporary commercial real estate finance practices, many CRE loans are typically structured as nonrecourse interest-only loans with balloon payments at maturity. In times of low interest rates and booming property values – the case over the last decade or so – borrowers were generally able to refinance their loans with relative ease.
Unfortunately for borrowers, times have changed dramatically, and the current real estate lending environment has thrown the traditional playbook out the window. In response to persistently high inflation, the Federal Reserve has raised interest rates by 500 basis points since March 2022 (with additional hikes expected this year). Rate hikes, combined with declines or threatened declines in real property values, have resulted in a challenging environment for CRE refinancings.
Borrowers eager to refinance will face higher borrowing costs, and banks, skeptical that property values will recover soon, have grown reluctant to issue new loans. Additionally, many properties (particularly in the office sector) cannot support the carrying costs associated with higher-interest alternative credit providers.
What Lies Ahead
A spike in real estate foreclosures, deeds-in-lieu, and CRE loan modifications is therefore looming (if not already here). Until values stabilize, CRE may become a “hot potato,” with borrowers whose equity values have evaporated uninterested in expending additional resources to retain their properties and lenders reluctant to take them over.
If history is any indication of what’s ahead, we expect the increased activity in loan workouts to result in a mix of mortgage and mezzanine foreclosures, bankruptcy filings, deeds-in-lieu, loan modifications, loan sales, and property short sales.
CRE Loan Workout Outcomes
From “amend and extend” strategies to deeds-in-lieu. there are many potential paths that a loan workout may take. There are tax implications to each outcome that will have to be considered and may drive many of the decisions in a loan workout. Those include cancellation of debt income for recourse loans, capital gains treatment for nonrecourse loans, and a material loan modification being treated for tax purposes as an exchange of debt.
Amend and Extend: In most cases, we expect to see agreements between borrowers and lenders to modify CRE loans permitting the borrower to continue to own and operate property under more favorable loan terms. This “amend and extend” strategy became popular after the 2008 financial crisis when experts expected property values to recover quickly, which ultimately came to pass. It remains to be seen whether lenders will show the same flexibility in the current climate.
Loan modification agreements come in many different flavors. They may simply extend maturity dates on the same terms and conditions. By extending out loan maturity dates to 2025 or later, lenders and borrowers are betting that the additional term will allow sufficient time for interest rates to fall, occupancy rates to rise, and property values to recover enough to allow for a more successful sale or refinancing. Loan modifications can also be used to adjust interest rates, loan covenants, the cash management waterfall, defer capital expenditure requirements, provide additional liquidity, allow for the entry of a new equity partner, and otherwise waive existing defaults. In many cases, to obtain these concessions form the lender, a borrower or its sponsor may be required, in addition to fees, to reduce principal or invest new equity for capital improvements or as a carried interest reserve.
Foreclosures: CRE loans are underwritten based on the value of the underlying collateral. A real property loan is collateralized by a mortgage on the property itself, whereas a mezzanine loan (and sometimes preferred equity) is collateralized by a pledge of the sponsor’s equity in the entity that owns the property. After a loan default, the lender has several enforcement options, including foreclosure. Generally, a successful foreclosure extinguishes all junior liens and encumbrances and removes them from the property’s title.
The foreclosure process differs from state to state and by the type of collateral. Foreclosures of mortgages, leasehold mortgages, or deeds of trust on real property can be judicial or non-judicial. That threshold question will typically determine the duration of the process. A judicial foreclosure takes months or years, depending on the defenses raised by the borrower. A non-judicial foreclosure can be completed in a matter of weeks. Although more common in judicial states, most mortgage loans contain provisions that entitle the lender to the appointment of a receiver early in the case to take control of the property. This remedy may also be available in non-judicial states where the lender commences an action in state court for the appointment of a receiver. A judicial foreclosure provides a borrower that wants to delay or contest the lender’s enforcement of its remedies with a forum to raise defenses and create triable issues of fact. In non-judicial states, the burden is on the borrower to commence an action in court to enjoin or stop the foreclosure. That presents a higher bar to overcome.
In contrast, a foreclosure on a pledge of the membership or partnership interest in the mortgage borrower, either under a mezzanine loan or as additional collateral securing a mortgage loan, is always a non-judicial process. Equity interests in commercial entities are personal property. Thus, a pledge of an equity interest is governed by the Uniform Commercial Code, which expressly contemplates non-judicial foreclosures provided that they are conducted in a commercially reasonable manner.
Unlike the mortgage lender, which can foreclose on the borrower’s fee interest, a mezzanine lender forecloses on the equity interest in the fee owning entity. This means that the mezzanine lender is taking ownership and control of an entity and all of its debts and liabilities, including the mortgage loan. This prospect of having to assume the mortgage loan and provide a replacement guaranty, if any, may deter some mezzanine lenders from foreclosing on their loans.
Bankruptcy: Many CRE loans have been structured as non-recourse, meaning that the lender’s recourse is limited to the property itself. To discourage borrowers (who may have invested relatively limited equity in the property) from filing for bankruptcy protection in an effort to halt foreclosure proceedings and then to try to cramdown their lenders, commercial real estate loans often require a credit-worthy guarantor to provide a springing recourse guaranty (known as a non-recourse carve-out guaranty). Personal liability under the guaranty for the entire loan balance springs into existence – becoming a recourse loan – upon the happening of specified “bad” events, such as a bankruptcy filing by borrower.
The advent of the springing recourse guaranty puts the guarantor in the position of having to repay the entirety of the loan in full if the borrower files for bankruptcy (or triggers certain other defaults). As a result, borrowers generally avoid filing bankruptcy except where: (1) the property’s value exceeds the amount of the guaranty and whatever other obligations may need to be paid in bankruptcy; and (2) the guarantor is insolvent or is itself prepared to file for bankruptcy protection as well, such that the liability exposure under a springing guaranty is less of a threat.
Deeds-In-Lieu: For a variety of reasons, borrowers may prefer to give the property to the lender via a deed-in-lieu, rather than delay the inevitable by forcing the lender to conduct a foreclosure. For borrowers and guarantors, a deed-in-lieu of foreclosure may include a release that will extinguish or reduce liability under any existing guaranties and loan documents (although such releases will typically exclude environmental indemnities). For lenders, a deed-in-lieu should expedite the transfer of the property and allow for a more seamless transition.
A similar method to consensually transfer ownership and control exists under Article 9 of the Uniform Commercial Code. This is known as a “strict foreclosure” and allows for the sponsor to transfer its equity interest in the fee owner to the mezzanine lender.
One complexity here is that the borrower cannot force its lender to take the property. While it may seem counterintuitive, once the default actually occurs the lender may be unwilling to take ownership of the property due to the expenses associated with it, required capital expenditure projects, and cost and time to manage it. The property may also have potential successor liability issues, such as environmental issues, that often deter lenders from accepting title. If the lender has control of the rents through a lockbox and cash management arrangements, a borrower will not be able to cutoff the flow of funds without triggering recourse liability under a springing guaranty. Thus, the lender can continue to receive the cash flow without having to assume the risks of actual fee title ownership. On the other hand, if cash flow is not sufficient to cover the operating, repair and maintenance costs of the property, a lender may have to move quickly to assume ownership and control to preserve the value of its collateral. In that case, a deed-in-lieu of foreclosure may be a desired approach.
A deed-in-lieu may present other issues if a mezzanine loan or loans also exist. In certain cases, depending on the terms of the mezzanine loan documents and any intercreditor agreement between the mortgage lender and mezzanine lender, the consent of the mezzanine lender may be required before a borrower could convey the property to the mortgage lender. That requirement will give the mezzanine lender an opportunity to extract its own concessions in return for its consent.
Other Possible Variations
While beyond the scope of this introductory article, there are numerous other potential paths that a loan workout may travel. For example, the lender may decide to sell its loan to an opportunistic buyer that is willing to exercise remedies to acquire the property.
The borrower and lender may also agree to convert all or a portion of the lender’s loan into equity of the borrower (or a new joint venture), while bringing in another investor to inject needed funds into the project.
The possibilities are numerous, and creative thinking (and counsel) are a must.
2023 Goulston & Storrs PC. National Law Review, Volume XIII, Number 201
Wells Fargo is taking bigger precautions on its office building loans, setting aside more funds to cover potential losses as the sector continues to deteriorate.
The office market “continues to be weak” in many cities, Chief Financial Officer Michael Santomassimo said Friday. But he also argued that general trends can be misleading, and said the bank has been doing a property-by-property analysis to see where its specific risks lie.
The warning from one of the country’s largest banks hints at signs of trouble that smaller banks may share as they start reporting earnings next week. Office loans make up about 3% of Wells Fargo’s total loans, but many smaller lenders have bigger concentrations.
Wells, which has $1.9 trillion of assets, continued to conduct a deep dive into its office loan book in the second quarter, which prompted it to set aside more reserves to absorb potential losses later on.
After stress testing its commercial real estate loans, the bank’s allowance for credit losses in the CRE sector jumped to $3.6 billion in the quarter — up 64% from a year earlier. Office vacancy rates have climbed as remote work has shown staying power.
Wells Fargo executives, who also boosted CRE loan reserves in the first quarter, didn’t rule out adding more reserves as conditions evolve. But they said their current analyses covered just about every risk they can see at the moment.
“We’ve gone through a number of stress scenarios and feel like at this point, we’re appropriately reserved,” Santomassimo said on the bank’s second-quarter earnings call.
JPMorgan Chase also bumped up its reserves during the quarter due to office loans, though its executives cautioned against reading too much into the buildup, given the bank’s limited exposure to the office sector. JPMorgan Chief Financial Officer Jeremy Barnum said the company wanted to get “ahead of the cycle,” but he noted that most of the bank’s CRE portfolio is tied to loans backed by multifamily buildings.
Wells Fargo and other large banks have manageable exposures to office buildings and other commercial real estate, said CFRA research analyst Kenneth Leon, pointing to the resilience those banks showed in this year’s stress tests. Leon credited Wells executives for displaying strong “credit risk control” and closely monitoring its CRE loan portfolio.
Wells Fargo’s CRE team is focused on “surveillance and de-risking,” Santomassimo said. The bank highlighted diversification in its portfolio, with an investor presentation showing that office loans make up 22% of its CRE book.
Loans backed by apartments, a sector that Santomassimo said is performing “quite well,” account for 26% of Wells Fargo’s CRE book. Warehouse, hotel and retail loans make up smaller chunks.
Nearly a third of Wells Fargo’s office loans are in California, and the remainder are spread across several other states. San Francisco, where Wells is headquartered, has been a source of worry in the office market, given that tech companies have embraced remote work more than many other firms. One office building there has reportedly seen an 80% drop in its value.
Asked about office-related risks in California, Santomassimo said that worries are not “isolated to California” and “you see weakness in a lot of cities these days.” He also cautioned against focusing solely on geography.
“Even in California, we’ve got as many examples where clients are actually reinvesting in buildings, even if lease rates are low or even empty in some cases, as they are going into a workout,” Santomassimo said.
Wells CEO Charlie Scharf said it’s “a very big mistake” to think that a building’s geographic location is the only factor that will determine whether losses occur.
“We have examples in cities that are struggling where the structure of our loan is quite good — the underlying property has very high lease rates for an extended period of time,” Scharf said. In markets that are doing well, specific properties may be at more risk due to a large amount of upcoming lease terminations, he added.
“That’s the level of detail that we’ve used to come up with what we think the appropriate level of reserving is,” Scharf said. “We’ve tried to be as diligent as we can.”
The winners of the 2020 Real Estate Tech Awards, which we covered earlier this year, have been announced. The awards are organized by the team at CREtech.