"We Have to Be Aware of the Risk": The Dynamics of the Commercial Real Estate Market
Charles Davidson: Welcome to another Economy Matters podcast. I'm Charles Davidson, staff writer for Economy Matters, the Atlanta Fed's digital magazine. I'm here today with Brian Bailey. Brian is a subject matter expert in commercial real estate in the Atlanta Fed's Supervision, Regulation, and Credit Division. Brian, thanks for your time today.
Brian Bailey: It's great to be here, Charles. Thank you for having me.
Photo: David Fine
Davidson: Yes, sure thing. What Brian does—Brian is out amongst the folks in the commercial real estate industry, so he gets a real feel for the industry by talking to a lot of people. So he does a lot more than just pore over the numbers, though he certainly does that, too. So Brian, let's jump into it here: with the economy on solid footing as it is—but there are certainly some signs of concern out there—we still see a lot of construction cranes around Atlanta, and certainly in other metro areas in the Southeast. Is that something we should be concerned about?
Bailey: Well, it's fun to be out and about in the market and hear them describe all of these cranes as the "state bird of Florida," or the "state bird of Tennessee has returned." Obviously, there is a lot of economic activity, and you can easily see it in a crane that towers over the skyline, whether it's Nashville, Chicago, New York City, Dallas, or Atlanta, Tampa, etc. So certainly we've seen the return of commercial real estate building—now, not being done quite as robustly as we saw in the mid-2000s. So I think certainly there are some dynamics. If you look at the size of the commercial real estate market—ballpark, it's roughly about 3 percent of gross domestic product of the national economy. So certainly it's an important factor—it's probably $500–$600 billion in economic activity per year.
Davidson: That's a pretty huge number.
Bailey: It's huge, absolutely. You look at some of the organizations that follow it—for instance, Nareit: they've estimated, based on CoStar data, that there's somewhere between $14-17 trillion of commercial real estate assets. So certainly that's not a trivial matter. You know, I'd like just a little bit of a sliver if I could own part of that.
Davidson: Sure. And Brian, just to be clear: CoStar is basically a market research firm that studies and analyzes commercial real estate, right?
Bailey: Absolutely. So you have a significant piece of the overall economic engine of the U.S. in commercial real estate. Some of the trends that are affecting that right now: certainly, population growth is huge, and job growth—two of the main drivers in commercial real estate. You're also combining that right now with very significant amounts of capital available, whether that's domestic-based capital or whether it's foreign-based capital. And as you're well aware of, there are a number of countries right now outside the U.S. with negative-yielding sovereign wealth debt. Well, certainly our commercial real estate has benefited from that dynamic as people have sought positive returns.
The other thing we've got to look at is construction. It's not as robust as it was in the mid-2000s, but certainly there is an element of timing. A lot of people have talked about the length of this economic expansion, and it continues on—which is great. At the same point, we know that it takes, for some of these towers—if you have permits in place—two, maybe even upwards of three years to build. And that's a long time to absorb that risk of a potential shift in the marketplace.
Davidson: Right. So from the time you start a building, things may be great. Three years down the road, things could change pretty dramatically.
Bailey: Absolutely. There were a number of firms who started buildings in 2006 and 2007, and that didn't end well when they got to completion at 2008 or 2009 when the market was completely different, and we saw that firsthand. I think the other thing we're seeing right now is we are 10-plus years removed from the downturn, and in that 10 years or so—more than 10 years—we've seen significant evolution in technology, we've seen costs come down. Commercial real estate is a slow, late adopter of technology, but that technology has even begun to permeate the commercial real estate field. For instance, you see more telecommuting. You see more information available, and so people are able to make better decisions, better-informed decisions, on financing. You also have seen e-commerce. Obviously, Amazon has grown significantly in those 10 or 15 years. We also see it in the use of commercial real estate space. You think about the square feet per person right now, per FTE. So if you have—
Davidson: What's FTE?
Bailey: FTE is "full-time equivalent."
Davidson: Okay, so a person who works in an office, basically.
Bailey: So a person who's working in an office environment. And so we've seen that amount of square feet per person—per office-using worker—come down, and the trend continues downward today.
Davidson: That's because people are working at home more, or working remotely more, and therefore they're not in the office as much, or...?
Bailey: So some of that is having an impact, but also you've seen occupancy costs rise, and so employers are trying to squeeze out the costs and be as efficient as possible. And so really from a densification standpoint, more workers in the same or less square footage allows them to pay more for some of the prime real estate, and we've seen construction costs go significantly upwards. So yes, you really have kind of a tradeoff per se, in that costs have gone up significantly, employers have actively worked to manage their costs, and so they've dialed down the amount of square footage per worker.
Davidson: Well, Brian, are there areas where we're seeing overbuilding perhaps, or concerns about potential overbuilding?
Bailey: Right, that's a good question. Obviously, we have built a significant amount of luxury apartments within the last decade, and certainly, this was probably the first recovery in the last five that wasn't led out of the downturn, as far as commercial real estate was concerned, by office buildings. This one was led by the construction of multifamily. And so the multifamily developers came in, were able to secure the prime locations, were able to lock in their costs before they began to jump, and hence we saw a wave of multifamily buildings. And really, that carried across the nation. First it was in the gateway markets of Chicago and New York and San Francisco, but then we began to see that permeate down all the way to the Atlantas and the Tampas and the Orlandos that were later in recovering than some of the gateway markets. And so that wave of apartment building, of luxury apartments, has kind of been—we've seen it over a significant number of years.
Now, it reached pretty significant levels in 2016 and 2017, and you did see in some of those markets on the upper end, we became oversupplied. And so it began to take longer to lease up the buildings that were coming online. The landlords of buildings had to provide more concessions to get that done, and so really we saw a stagnation through 2016, 2017, and 2018, really. It was just a flat rental growth rate of 1 percent to 3 percent. Recently that's begun to tick upwards again, so I'm beginning to think that we're seeing some of that excess clear. But another area to look at right now is industrial. If you're an industrial developer, it really seems like nothing you do can go wrong.
Davidson: That's largely driven by the growth of e-commerce, is that right? These big, giant warehouses that are super-efficient?
Bailey: It is. There is a huge race right now to flesh out the capability of the last mile, and certainly we'd be remiss in not using Amazon as an example, but you look at how—
Davidson: When you say "last mile," Brian, you mean to someone's house—the last mile to get something to your house?
Bailey: Yes, getting it to their house. And so you've seen those facilities, more from 40-foot clear height. Amazon's latest version is now at a 75-foot clear height.
Davidson: That means how high the ceiling is?
Bailey: How high it is. They're putting in second and tiered storage, they're accelerating the throughput of product through their buildings, and so really we're still changing how, and still trying to figure out how, to best optimize and be as efficient as possible with some of the last mile capabilities. So certainly it's fascinating to me to hear Amazon quote the statistic that they will have a distribution system that has one square foot for every American in their system by 2022, so you think about over 300 million square feet—just a staggering number.
Davidson: Brian, earlier you mentioned the vast pool of capital that's available right now to commercial real estate developers and builders—a good thing if you're a developer, I suspect, but are there any concerns there that they might get a little less careful than they need to be?
Bailey: In my career, I have never seen a time where there has been this much capital available, and certainly as a reformed developer—I spent many years out in the private sector—from that standpoint, it's a very strong dynamic to get capital and make it available to the development community. At the same point you have to watch it, because historically when you have the combination of heightened values, too many lenders, too much capital, or lots and lots of capital, available—when you begin to combine those points and connect the dots, historically that's not ended terribly well.
And so certainly we have to be aware of the risk associated with that right now. When there's a lot of capital available, there tends to be a lot of competition. And we've seen it—you have the banks, you also had the rise since the last downturn of the segment of nonbank lenders—so life insurance companies were always lending, but they've certainly put an additional emphasis on commercial real estate. You've seen more pension money come into the space, as there's been a greater recognition of commercial real estate as an investment class. You've seen private equity money, hedge fund money, high net worth individuals. On top of that, we've become more efficient from a global perspective in capital flows, the flow of capital. So it's easier to move capital from Europe to America, easier to move it from America to Asia, etc. And so what that's caused to happen is that has brought capital to areas where there were higher returns, where there was the perspective that the environment, in the case of the United States, was a flight to safety—a more safe environment, less volatility.
And so we've seen a lot of that capital come in. It came in as equity from 2012, through even today. But really the equity component began to back off in 2016, and it focused more on debt. And so there are vast amounts of capital from the sources that I just talked about that's available for debt. And certainly, why have they kind of shifted away from equity and more toward debt? There is some concern that we may be in the latter stages of this economic expansion. Certainly, there's been concern about heightened pricing levels, and so there are a number of dynamics. So I think from my point of view, yes, there are some areas of concern. To single a couple out: certainly right now you see CRE/CLO—commercial real estate, collateralized loan obligations—and the structure is that money goes from a bank or a pension fund to a lender, and that lender then makes commercial real estate loans, and then repays the organization that they borrowed the money from by securitizing those loans and chopping them up, selling that investment grade paper, or noninvestment grade—
Davidson: So these entities are basically borrowing large sums of money, and then relending it, essentially? Okay.
Bailey: That's correct, yes, but they're securitizing it into investment grade or noninvestment grade. You look at the underlying assets that those loans are based on.
Davidson: Brian, with all these dynamics—a lot of capital out there, a lot of different funders, let's say—if that's the proper term—or financiers, the hedge funds, private equity funds, pension funds, even I think earlier you mentioned sovereign wealth-type funds from other countries that are basically sort of like national, government investment pools—getting into the commercial real estate game in the U.S., what does that mean for our commercial banks? How does this affect them?
Bailey: Well, I think that certainly there has been...in some segments of the lending world you see greater competition. So in the nonbank space, my understanding is that there is very significant competition on loans less than $30 million. We know that is prime territory for a lot of the community banks to play in as well, and so certainly if you see greater competition, greater capital available, heightened values, it potentially means that there is growing risk in that space.
Davidson: Because they're going to be able to accrue less interest on their loans, right? The more competition there is?
Bailey: It's funny you've mentioned that, because we get some of the greatest structuring data out of the CMBS space, and we've seen—
Davidson: Commercial mortgage-backed securities?
Bailey: Commercial mortgage-backed securities, thank you. All of those loans and the structures are public information, and we've seen an uptick in the use of interest-only structures and partial interest-only structures. So right now, in some instances...you take office space: 90 percent of the loans that are originated right now either use interest-only or partial interest-only structure. You think about that, there is some crossover at some point, whether it's—
Davidson: Brian, I want to stop you for a second. So for those who aren't experts in this field, what does that really mean? "Interest-only structure," compared to what?
Bailey: Well, you can think about, if you're just paying interest compared to an amortizing loan where you're paying interest and part of the principal, then from a lender's perspective that's a less risky loan. So if you're using interest-only, it's better for the developer or owner because there is less cash out the door, as far as you're not making a principal payment, so then your return essentially is greater. At the same point, to the lender there's more risk because you're not making any principal payments over the term of that loan if you're using an interest-only structure.
Davidson: Right. So for the banks then, does this start to become a concern or is it something we need to—as a regulator—to keep an eye on?
Bailey: Absolutely have to keep an eye on it. From a standpoint of CMBS, the loan-to-values have been relatively modest: roughly about 60 percent, which is a decent level. At the same point, the nonbanks—and some of the banks—have seen an uptick in those loan-to-values.
Davidson: And "loan-to-value" means: if a building costs $100 million, if I lend you $100 million, that's 100 percent loan-to-value?
Davidson: Okay, got it.
Bailey: And we know that the probability of the loan running into trouble, there is a direct correlation between the higher that percentage is, the higher the loan-to-value, and the potential for the bank to run into trouble with the loan itself. So you think about what we saw back in the mid-2000s. We saw loans with higher loan-to-values, loans that used interest-only structures, and those loans had a higher probability of creating challenges for the banks. So certainly we're keeping a pretty close watch on that dynamic. I don't think it's pervasive across the lending space right now, but certainly we're seeing more and more instances of that right now. We know that lenders who fared pretty well during the downturn moderated the amount of loans with higher LTVs [loans-to-value] with interest-only—some of those other dynamics as well.
Davidson: I know you're not Sigmund Freud here, but I did want to ask you a question about the psychology of all this. The farther removed we get from the Great Recession, memories tend to fade. Does that at some point become a concern, or do the people who lived through it, do they still recall just how tough that was and so it's going to temper just how adventurous they might be tempted to get?
Bailey: I think you have a combination of that dynamic right now. So we're 10-, 12-plus years removed from that, and so certainly some of that institutional knowledge has moved on and retired, and we've brought up new talent in the industry, which wasn't impacted by the Great Recession—at least, in the professional sector. We know, again, that loans with higher LTVs that utilized interest-only structures didn't fare so well. The other thing we know that didn't fare well is when we begin to stretch on the amount of construction cost financing. So like you said, if we go 90 percent or 100 percent of construction cost financing, we saw a greater proportion of those loans run into trouble. What's fascinating to me—and certainly I'm not Sigmund Freud, and you're taxing my abilities right now [laughter]—but it's fascinating to me that those loans, the loans that were 90 to 100 percent of construction costs: a significant number of them ran into trouble and had very significant losses associated with them.
And today in the marketplace I have been hearing about, and talk to, people whose firms are now originating construction loans that are 90 to 100 percent of construction costs. Why do we need to be concerned? Well, if you think about the structure of a project that's under construction, in a lot of ways at 90-plus percent, the developer is actually able to pull money out of the project. So it kind of comes back into the underlying notion: how much skin in the game do you have? And the less skin in the game you have, the more propensity that the lender may experience some problems.
Davidson: Right. Well, Brian, thanks so much. Fascinating information, and obviously this is stuff we're going to continue to keep an eye on.
Bailey: Thank you for having me back, Charles. I had a wonderful time. Thank you.
Davidson: All right. Thanks for listening, and please come back to frbatlanta.org for future Economy Matters podcasts. Next month we'll have Mike Johnson on. Mike is the head of the Bank's Supervision, Regulation, and Credit Division, and he's going to talk about developments in bank examinations and what that may mean for banks in the Southeast. Thank you for your time.