by Erik Ristuben, Ryan Dembinsky, Jack Fadule, Russell Investments
- The stresses in the CRE market do not appear to pose a systemic threat to the global banking system
- One step regulators might take to lessen pressures on the system could be allowing banks to modify and then reclassify loans
- Tighter banking regulations could lead to more opportunities for private credit investors
On May 11, Chief Investment Strategist Erik Ristuben, Senior Research Analyst Ryan Dembinsky and Jack Fadule, Director, Investment Research, Private Markets, joined Morris Chen, portfolio manager at DoubleLine Capital, for a discussion on the commercial real estate market and its potential effects on the banking sector and the broader economy. Below is a recap of the key highlights from their conversation.
What’s happening in the CRE market?
Ristuben opened the discussion by noting that commercial real estate (CRE) debt has become a hot topic ever since March’s banking crisis, with concerns among investors that the entire market is under pressure—especially due to recent stresses among U.S. regional banks.
Dembinsky explained that in most sectors of the CRE market, these worries are likely overblown. The notable exceptions, he said, are the office and retail sectors. The retail sector isn’t as big of a concern, Dembinsky said, because while it’s still weak, a great deal of this weakness has already been digested by the market. The main concern is with the office sector, he noted, explaining that office buildings comprise 20% of all outstanding debt in the CRE market.
Chen agreed, stressing that this part of the CRE market does look the most vulnerable. That said, in Chen’s opinion, the overall threat does not look to be systemic. “From my vantage point, this appears to be much more of an idiosyncratic problem. I think that many buildings will be OK, but that there will be a few that will experience degradation. A lot of the problems with the most vulnerable buildings are centered around the owner of the building, versus the overall banking system,” he noted.
Dembinsky concurred, adding that many of the managers he’s been talking to have also expressed this opinion. “My assessment in the multiple conversations I’ve had is that the broad money manager community agrees that this is probably more of an idiosyncratic bank issue rather than a major systemic risk,” he stated.
What can be done to lessen the stress on the system?
Chen said that one option could be private credit, given that both investors and borrowers now see commercial mortgage-backed securities (CMBS) products as less attractive due to market volatility and the ongoing high-rate environment.” Once financial markets and capital markets stabilize, I believe demand for CMBS loan products will probably return—but in the interim, I think private credit could bridge this gap,” he stated.
Ristuben asked Chen what the playbook to solving some of these issues for banks and other lenders is likely to look like going forward—including the degree to which regulators might get involved. Chen noted that many regional banks are currently living one quarter at a time, and that it’s highly likely regulators will tighten lending standards for regional banks. He said one step that regulators might take is to allow banks to modify and then reclassify loans. “Think of this as amend and extend—with perhaps a regulatory move similar to the recent measures taken to support Silicon Valley Bank,” Chen said. This could give some relief to banks as it relates to capital reserve requirements.
As for how much of this has already been reflected in current market pricing, Chen said that a good deal of the weakness has already been priced in, but that there may be more to come in specific cases. Ristuben agreed, but added that overall, the market appears to have already thrown out the baby with the bathwater in many cases. “This could present some opportunities for investors,” he observed.
How are REITs likely to hold up in this environment?
The conversation shifted to the state of real-estate-oriented liquid markets—in particular, REITs (real estate investment trusts)—which have performed poorly of late. Dembinsky said that he believes that most of the weakness in retail REITs has likely already been priced in, while office REITs probably have further to fall.
“In my opinion, this probably strengthens the case for investing in CMBS, as I do think they have lots of value in terms of yield. If you’re a patient investor who can stomach the dismal headlines around CMBS, then from an active management point of view, we certainly believe there could be plenty of opportunities there,” he stated.
Is the changing landscape opportunity for real estate financing creating potential opportunities in private credit?
Circling back to the potential for private credit to bridge the gap in financing, Ristuben asked Fadule what private debt managers’ views on the woes of CRE are. “I believe they definitely see this as an opportunity to step in and fill the void,” Fadule stated, noting that there are a plethora of ways that private credit managers can help banks deal with their balance sheet issues—many of which might not be obvious to the average investor.
One of these options is the risk transfer trade, Fadule said. “Right now, the market views banks with CRE loans on their balance sheets as problematic. And if a bank sells its CRE loans at a discount, this hits its capital ratios in a negative way. A risk transfer trade allows a bank “transfer” the risk of some of these loans to a private credit lender without having its capital ratio impacted,” he explained. Amid today’s tightening regulatory standards, the risk transfer trade could be particularly appealing, Fadule said.
The bottom line
Ristuben, Dembinsky, Fadule and Chen wrapped up their conversation by reiterating that the stresses in the CRE market do not appear to pose a systemic threat to the global banking system. “CRE lending standards have meaningfully improved since the Global Financial Crisis, and the financial system as a whole—particularly in terms of loan and credit quality—is sound. However, the issues in the CRE market are serious and do need to be watched closely. Ultimately, I believe that if we do see continued idiosyncratic episodic bank failures due to CRE exposure, another regulatory response is likely in order to shore up liquidity,” Ristuben concluded.