WS1890 Trends in Commercial Real Estate | Highlights Brian Bailey

In today's highlight episode, we've compiled some incredible insights from our esteemed guest, Brian Bailey from the Federal Reserve Bank of Atlanta. Brian shares a wealth of knowledge that I'm confident will be invaluable to our listeners, especially those involved in commercial real estate.

Brian provides an overview of the current state of the economy, touching on the resilience of the U.S. economy despite the headwinds and tailwinds it's facing. He discusses the impact of the Federal Reserve's interest rate hikes and how they traditionally lead to a slowing economy. However, he points out the robust job growth and the deceleration from previous years.

We delve into the accuracy of commercial real estate values, with Brian expressing that they are more challenged today due to various factors, including job growth, population migration, and consumer spending. He highlights the overbuilding in the luxury multifamily segment, which contrasts with the shortage in workforce and affordable housing.

Lastly, Brian and I talks about the potential impact of decreased property tax revenues on municipal services and how this could affect commercial real estate owners. We also cover the significant increase in insurance rates and the strategies operators might employ to mitigate these risks.

Thank you for tuning in to today's episode. Remember to like, subscribe, and share The Real Estate Syndication Show with your friends. For those looking to build wealth in real estate, head over to lifebridgecapital.com to start investing today.


Click the links below to listen to the full episodes and gain valuable insights from Brian Bailey on the current state of the economy, commercial real estate values, the health of banks, increased expenses, and more!


https://lifebridgecapital.com/2023/09/28/challenges-and-opportunities-in-commercial-real-estate-lending-brian-bailey/

https://lifebridgecapital.com/2023/09/29/the-impact-of-insurance-and-property-taxes-on-real-estate-investments-brian-bailey/

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Transcript

Whitney Sewell: This is your daily real estate syndication show. I'm your host, Whitney Sewell. Today, we've packed a number of shows together to give you some highlights. I know you're going to enjoy the show. Thank you for being with us today. Brian, welcome to the show. I'm honored to meet you and have you on. I was listening to some things about you, some keynotes that you've done in the past. And it's honored to have, have somebody on the show with your level of experience and knowledge. I know the listeners are going to learn a lot from you over a series of shows that we're going to do here. And so I know in the very beginning, you need to share a disclaimer. I want you to knock that out so we can dive right in and then we'll share a little bit about, or you share a little bit about your background and let's do it.

Brian Bailey: Great. Absolutely. And Whitney first, thank you for the invitation to be on your show. Appreciate the opportunity to share a few thoughts today with the listeners. No good show would be without a disclaimer. I certainly need to plug our attorneys, but from a transparency perspective, I want to be forthright in that these are my opinions today and not necessarily those of my colleagues at the Federal Reserve Bank of Atlanta, nor the Board of Governors. And just to be clear, we're recording this the first week of September as we have an FOMC meeting that's a little bit over two weeks out.

Whitney Sewell: Brian, I thought maybe I was just thinking about this, but right at the beginning here, maybe you can just give us kind of an overview of some thoughts on the current state of the economy, even, and maybe back up a little bit, the last six months, some things you could highlight that's affecting the economy right now and specifically commercial real estate. And then let's kind of move forward to what you expect in the next six months as well. And we'll dive into some, I want the listener to know we're gonna dive into a number of specific things. And, but yeah, I want you to give us just kind of an overview of some thoughts and we'll dive in after that.

Brian Bailey: Sure. Well, my thoughts on the economy, we could probably have a month's worth of shows, but let me boil it down pretty quick. I, I think that there are both head and tailwinds right now. I think that we are seeing. We've seen a very sizable increase in the Fed's funds rate, courtesy of the Federal Reserve, as we've worked very hard to fulfill our mandate of price stability. And from that standpoint, as you have Increasing rates. Traditionally, you have a slowing economy. Our economy has been very, the U.S. economy has been very resilient. We've had job growth well in excess of what we need for natural population, for the natural population rate. So we're creating on average in 2023, roughly 200,000 jobs a month, which is well in excess of what we need to keep up with population growth wise. At the same point, we've seen that number begin to decelerate a little bit. And it certainly has decelerated from the results in 2022, where we had over We had an average over 400,000 jobs a month created, and in 2021, bouncing back from the pandemic effects, we had roughly 600,000 jobs, give or take, created every month in 2021. We're seeing that slowing. At the same point, we've benefited from energy prices coming down up until the last 60 days or so. We've benefited significantly. So I think there are both head and tail winds right now that are impacting the economy. One I know that we will talk about later is obviously the implications in lending right now as the higher rate environment coming out of a higher rate environment from a low rate environment has created greater uncertainty, has created challenges with accurately gaining, accurately assessing, pardon me, what commercial real estate property values are. There've also been issues with higher costs. So on the, on that front, I think that there are a number of both positive and headwinds that have been impacting the economy, but we've been fortunate that the economy continues to be a resilient, healthy

Whitney Sewell: Yeah, no, I appreciate that very much. Yeah. I would love to talk about the, are commercial real estate values accurate? How, how you see that right now, just at where we're at in the cycle. Do you feel they're accurate? Maybe speak into that a little bit.

Brian Bailey: I think commercial real estate values are more challenged today. If we look at the underlying dynamics, so we've got, we talked about job growth. Obviously some markets are positively impacted by population growth, the Sunbelt, some of the Rocky Mountain States, some of the Southwest, South Central, have been impacted by the migration of population to those areas, which More migration, more in-migration means that there is some basic need for commercial real estate. The consumer continues to spend. We have seen an increase in their propensity to take on debt, which we need to watch. We know that the addition of debt may signal that their budgets are more challenged. And from that standpoint, they continue to spend, but at the same point, there may be a little bit more risk. In the near future, we know that there are changes coming, i.e. the restart of student loan payment. And on that front, I think the median payment is $225 to $250 a month. Obviously not the end of the world, but it's certainly if your budget is already been heavily impacted by rising costs associated with inflation or whatever, from that standpoint, another $200 a month could very well create challenges. And if that's the case, the consumer may pull back, which may impact retail. So I think there are some areas that impacting commercial real estate If we kind of take it down a level to the specific types of real estate, which I know you wanted to talk about, retail continues to do very well on that dynamic. Our friends in the press talked about the, the retail apocalypse for many years. And on that front, I think that sediment, that negative sediment drove a lot of developers and a lot of lenders to think very conservatively regarding the building, the construction of new retail. From that standpoint, because of the times the press talked about the retail apocalypse and e-commerce was taking over the world, I'm exaggerating just a hair, but in essence, That dynamic that sediment really pushed a lot of that newer retail to the sidelines, and so we build nationally we built somewhere between 25% and a third of the. amount of retail that we had built over the preceding 20 years. So from that standpoint, we have a lower amount of retail that's been built in the last 10 years. And on that front, I think we don't have this huge oversupply in the retail space. Where we do have some oversupply, multifamily. Interesting, I can say that in a time where we have a housing shortage. I'm sure we'll have some listeners kind of scratching their heads. There is a housing shortage. At the same point, we do have oversupply in the multifamily space because most of the projects that have been built in the last few years have been aimed at the luxury high-end segment versus where the shortage is, and the shortage is in workforce and affordable housing, to be clear. So we are seeing vacancy rates going up in a lot of those higher-end multifamily projects.

Whitney Sewell: I think that's a valuable point to be made there. So, so many people, oh, actually even earlier talking about even in the retail piece, how all the headlines and the over and over kind of scare everybody as a whole, right? It's kind of how perception becomes a reality to some degree, right? But I think when you're talking about multi-family now, everybody's talking about this oversupply or we're talking about a housing shortage, right? Housing shortage. But it's interesting. Well, when you dive down, like you said, the building, the oversupply has been in luxury, right? That's been where it's been built. While I feel like some, a lot of people are building luxury while using that statement of the housing shortage to kind of fund the deal, right, and make the story happen when the shortage is in a different class of multifamily, right?

Brian Bailey: You bet. I mean, we've seen building costs grow significantly. And I think from that standpoint, what I've been told is that only the luxury premium projects right now are the ones that are financially feasible. It's interesting when you think about the perception A couple of things come to mind. One, had a good friend in 2021, who's heavily engaged in the multifamily space. They have a portfolio. He's a CEO of a large REIT, a large ownership company, a multifamily. They in essence said, over my 30 something years of experience, 2021 is the most the best year in the last 30 for effective rent growth. What we've seen though is we've seen that slowing occur, and now we're seeing concessions, which were virtually non-existent in 2021, grow to somewhere, depending on the market, two to six weeks of free rent right now. So it's fascinating on that front as far as the perception still have a significant amount of those luxury units under construction right now. So I do think that for some period of time, we will have, it's essentially an affordability. You've got an affordability issue on the luxury end while you have this shortage on the lower, shortage of housing on the lower ends.

Whitney Sewell: Yeah. Yeah. Yeah. You nailed on down there a little bit or brought that out. What about, well, let's for time sake here, I want us to jump into just the health of the banks a little bit. And I know we'll talk about interest rates and some of those things, but just what's happening with banks right now, or maybe some recent regulatory changes that investors or operators need to know about. And let's dive in there a little bit.

Brian Bailey: Sure. First and foremost, the banking system is healthy and well-capitalized. As far as the large banks are concerned, annually they have to go through the Comprehensive Capital Assessment Review, CCAR, which are the Fed's stress tests. The Fed gives them assumptions and they have to show how it impacts their capital. From that standpoint, they are well, well capitalized. I think what we have seen is we've seen more uncertainty enter the banking, the lending, the commercial real estate lending environment right now. And part of that driven by the increase in rates, part of it driven by When we think about what's going on in commercial real estate, we talked a little bit about this overbuilding and affordability issue and multifamily. I think we've got some overbuilding that's going on. We're in the early stages in the industrial sector. On the other end of the spectrum, we have a change in use, the change in the way we're using office space right now. Yes, it's impacted by work from home, but we're also Now that employers are focused on it, they're looking at not only the crowd that works from home, but also the crowd that travels. From that standpoint, if you travel a significant amount, you may be better suited. It may be better. It may be more efficient for the employer to generate some kind of telling process. And that way. A couple of folks or group of folks can share space that are not in the office every day, or maybe they're in the office once or twice a week. From that standpoint, we are changing the way that we use space. We've had remote work back to the 1960s. And on that front, every five or 10 years, the amount of remote work has doubled. The challenge is we got to the pandemic and the pandemic growth in remote work grew five fold over that very short period of time. So we accelerated work from home. We've got some studies now we've got coming out of the academic environment where in essence, people who work from home full time are not as productive. as those who work kind of a hybrid schedule. So on that front, I want to say I'm in the camp that we will be back in the office. There will be a hybrid model. I don't know, two days a week, three days a week, four days a week. It kind of depends on the nature of the business. depends on the industry. But on that front, I think there is going to be a hybrid model that will be mostly be more adapted than, say, five days a week back in the office.

Whitney Sewell: Yeah, I can see that for sure. I've been a remote worker for a long time. I was also a federal employee for a number of years and I was even remote then. And so I can, I can see that people are more productive when they're at the office more at least as opposed to never, right? In the FaceTime with other employees and the interaction that happens and in our, our business right now, we're all remote. There's no office where any of us really are together. But we try to do that virtually right where we are having kind of interactions or even have something we call a water cooler meeting. There's no agenda. It's just like, Hey, how you doing? Just so there are some of those interactions, but man, it's, it is something that I don't think it can be replaced. Right. Having some in-person time.

Brian Bailey: I think as a society, we've undervalued that transmission and transfer of knowledge to the younger generation. So I think it has been undervalued. You asked me to talk about the health of banks. Let me take us back. So I think the large banks are, because of the CCAR stress test, From that standpoint, they are well capitalized. I think looking at the smaller and regional banks, which account for 40 to 50% of commercial real estate originations, certainly we've seen, we saw some liquidity events pop up earlier this year, which I think is part of the dynamic coming out of the added uncertainty. associated with the change in rates. And I think commercial real estate is a byproduct of that. Being a capital-intensive industry, from that standpoint, as the cost of capital changes, it hits those capital-intensive industries squarely. And I think that's what we're seeing in both commercial and the residential environment right now. So on that front, I think banks are a little bit more hesitant right now, as far as lending is concerned. At the same point, they remain healthy.

Whitney Sewell: Yeah, it is a challenge, no doubt about it, right? Finding debt that helps, makes the deal work right now, right? Everybody I'm interviewing is saying the same thing, right? Well, we can't make deals work right now where there's no deal flow that are really debt that can make, makes a deal happen, right? It's too expensive or obviously with interest rates, uh, What are your thoughts about where interest rates are now or maybe expectations of interest rates, the path for that moving forward and how that affects the commercial real estate industry?

Brian Bailey: Let's show that question for a minute and back up to kind of, I love your comments where your folks are saying, Hey, it's hard to get capital right now. And one of the areas I think, thinking about that, why is that? Well, one is the value. We're uncertain. The industry is uncertain about where values are today. I think that part of that has manifested itself in that there's been a flight to quality. If you look at what's trading, to use an example, think about fast food. There are lots and lots of folks. I'm one of them that love Chick-fil-A. From that standpoint, I think the Chick-fil-A, Chick-fil-A has continued to trade, they continue to trade low cap rates. But, and I'm not going to name the fast food establishment because I'll get in trouble, but think about one that's a little bit lower on the quality, lower scale. From that standpoint, those are probably not trading. And from that standpoint, I think that uncertainty around what the actual cap rate is, value has created some pause with the lenders. Additionally, we've seen lenders, because of the uncertainty with liquidity, with the uncertainty in commercial real estate, all of a sudden they've said, hey, we're gonna tighten our underwriting standards. So from that standpoint, loans that were made in the past that were perfectly conservative, all of a sudden may not meet the current underwriting standards. And from that standpoint, Value may not be there. You may, in essence, you don't need the cash. People kind of chuckle about the cash out refi, which is popular in commercial real estate, but this may very well turn into the cash in refi as because of increased debt service costs, because of declines in value, loans may not meet the conservative underwriting standards that banks are setting. And from that standpoint, they may require equity to be put in the deal. I think third challenge is that lending has changed. So your normal lenders, the banks, et cetera, capital continues to remain available. But some of the areas where we've seen tremendous growth, i.e. some of the non-banks are not actively engaged in commercial real estate lending to the rate that they were historically. So if you have a loan with one of those non-banks and they're not active, that puts greater pressure on you to go to a bank or another lender that continues to remain active, which may have different underwriting standards at that point. So I think that there has been some changes in the lending environment, in today's lending environment from where we were 12 or 18 months ago, whether it's value, Whether it's higher underwriting standards, I think there have been changes and that may make it harder. I think it is making it harder for borrowers to get capital.

Whitney Sewell: Yeah, no doubt about it. No doubt about it. I love the, even the thinking through the, the Chick-fil-A comment versus a different brand that may not be known as well, or maybe, but assumed as lesser quality potentially on how that influences things. But. that this, you said this may turn into the cash in or refi time. I'm seeing that happen, right? I've talked to a number of operators that I know and even had on the show that that's what's happening, right? And they're hoping at this point that they have the capital, right, to make that happen and are not having to do capital calls or or turn the property over, right, to the lender. And I know that's starting to happen a little bit. And I think a big expectation, it seems, is that's going to be happening a lot more over the next six, 12 months. Would that be your expectation as well?

Brian Bailey: I think so. One of the things that's kind of on our radar screen is there's a significant wave of commercial real estate debt that's maturing over the next five years. Not insurmountable. We have certainly scaled these levels of maturities before, but certainly in an environment where where there's more uncertainty, whether it's accuracy value, whether it's underwriting standards increasing, whether it's the number of lenders that was lending 12 months ago has pulled back. So there's been a curtailment of lending. From that standpoint, I think there are a number of headwinds to get us over that may create challenges refinancing this $2.5 trillion in commercial real estate debt that needs to be refinanced over the next five years. I think that potentially, again, it depends on kind of the area of the lender. When you think about next year, 2024, there was about a hundred plus billion dollars that was originated from investor driven funds, hedge funds, private equity, et cetera. You think about kind of the typical MO of hedge funds, private equity, they traditionally take more risk. They probably offer a higher loan to value. They offer more proceeds, but you have to pay for that. From that standpoint, if they are not lending, then in a sense, you may have to go to a bank, which does a conservative, more conservative profile loan. Certainly the regulators are watching and they don't want to spend more time with me. And from that standpoint, I think that then you may have to have the cash in rebuy. So I do think that lending is changing right now. partially driven by the segments of lenders where your loan was originated.

Whitney Sewell: Listeners joining us again today, back with our guests, Brian Bailey. Brian, welcome back to the show. I'm honored to continue the conversation. I hope the listeners will go back and listen to yesterday's segment. If you didn't hear it, Brian elaborated on so many things that I know you have questions about right now about the economy and are the commercial real estate values accurate and what's happening with the banks? Are they healthy? Are they not? We dove in deep on a number of those things yesterday. We're going to continue today. Brian, I know you need to put that disclaimer out and let's do that. Knock that out and let's jump right back in.

Brian Bailey: Absolutely. Thank you. Thank you, Whitney. So just for transparency purposes, these are my thoughts and not necessarily those of my colleagues from the Atlanta Federal Reserve Bank or the Board of Governors. And we're recording this show on September 7th.

Whitney Sewell: Awesome. Again, Brian, I'm grateful to have you on the show and be able to share your expertise with the listeners. And so a lot's happened on the operations front as well, right? With operators, the expenses specifically, there's a number of things happening with the increased expenses. I know we're going to talk about a few of those, but why don't you give us an overall picture of that as well? And let's dive into a few of those specifically.

Brian Bailey: Right. I think one of the concerns I've been watching, Whitney, for the last 18 months is operating expenses and their growth rates. Many operators have said, when was the last time that property taxes and insurance and utilities and labor were all up double digits? And really that's a a perspective across all property segments. And you think about that in context with what rents are doing. We know that there, up until the last year or so, there was growth, sizable growth in rents, in multifamily. Rents are certainly growing at healthy rates in retail. and industrial, not so much in office. But on that front, we know that expenses have been growing and growing at a very sizable clip. On that front, we know that there may be stagnation or erosion to operating income. And so on that front, I think that, and we know that it has implications for property value. So another kind of challenge that the industry has to face when it's trying to accurately gauge what property value is kind of how fast our expense is growing. We know many of the folks that I'm engaged with right now are talking about challenges associated with insurance. And whether you're on the coast and your rates are up 300% that is happening in coastal Florida and coastal Louisiana right now, I'm sure there are other areas, to areas that are inland where it's up 100% to even areas in the southeast that are not or the Midwest that are not impacted by natural disasters where rates are up 20 or 25%. So on that front, insurance is growing at a very rapid clip. Beginning to hear challenges of folks, this may be a challenge with the resurgence of the commercial real estate market, is that folks are having challenges getting insurance. If you cannot get insurance, that obviously creates challenges for a number of parties down the road, i.e. your lender, etc. On that front, that could begin to create greater headwinds as far as transaction volume returning to a more normalized rate, transaction volume rate. So I think there are some issues that are beginning to crop up, insurance being one of them. I think another one that we'll have to watch is what are the implications for property tax values as a number of our large cities derive a significant portion of the city's budget from property taxes, which we know values in commercial real estate are coming down. there'll be certainly an offset on the residential front, but will this also mean that there's some kind of reduction in the services that the municipality provides? Will that fall to the rank-and-file commercial real estate owner to kind of backstop and come in and fulfill some of those burdens already seen at taking place, which then in essence creates more challenges on the bottom line. So I think there are some challenges that I'm watching and certainly they've come back. They're accelerated in the last 18 months and I expect them to be with us for the foreseeable future.

Whitney Sewell: It's interesting thought about the, the property taxes and the values coming down there for the property taxes potentially coming down. Uh, but I, I would see the, the property taxes going up instead of in some way, right. Versus coming down and you mentioned maybe even the city's then providing, uh, less services, right. But because of the lack of income, uh, and there's definitely implications of that, right. No doubt about it. Uh, but, uh, one other, or yeah, let's talk about that just a moment. What do you see, Matt, looking, how, honestly, I haven't thought about that, about the, I don't know how, what that timeframe would be, where we would see the implication of that, where cities are actually providing less services because of the less income and how, say, multifamily communities or whatever, maybe commercial operators are going to, what are we going to do, right? in that? Well, let's talk hypothetically.

Brian Bailey: Let's say that it manifests itself in the fact that we are not able to hire as many police as we need. From that standpoint, their response times, it takes a greater amount of response time for them to show up at an event. And from that standpoint, then people begin to get perception challenges, sediment, negative sediment around pieces of property or areas or neighborhoods, that kind of thing. From that standpoint, that negative sediment can certainly impact property values. And I think that we'll see there, there are. significant downtown areas, New York, San Francisco, Washington, DC, downtown Atlanta, and the list goes on and on, where I think the value of those office buildings are coming down even as we speak. There was a deal in the suburbs of Atlanta this week that traded at 50% less than what they paid for it last year. of these. And so on that front, that has to impact not only the property tax revenue coming off of that property, but all the ones in the immediate neighborhood. And from that standpoint, I think that The city at some point has to figure out, Hey, we're either going to raise taxes. We're going to derive income from somewhere else or we're going to cut services. And I think in essence, if there are the response from property owners could very well be to create a special tax district. And then we have our own. security force. If we do it correctly, we have off-duty police officers that can, in essence, make sure that there are safe areas, safe properties. And from that standpoint, crime is under control. And that has a positive settlement and a positive impact on property value.

Whitney Sewell: Yeah, no, I appreciate the perspective there and just thinking through that a little bit. And even for operators right now, just think through the implications of that potentially in the future. As some of these projects, we may plan to hold another seven, eight years, right, or longer, and we'll see the implications of that during the life cycle of those properties, most likely.

Brian Bailey: We think about the impacts on affordable housing. From that standpoint, there are a lot of police calls to affordable housing. Right. those projects, those complexes become synonymous with slower response times, potentially the perception of more crime. In essence, your insurance could go up. You may not get insurance depending on the viability of the market. And so from that standpoint, I think there are a lot of spillover effects that we have to continue to be aware of. As we need a, a, an efficient marketplace, but we need to get back to an efficient marketplace in essence, to get property transactions back to some level of what you would call normal.

Whitney Sewell: Yeah. Going back even to the insurance piece, well, it was so important, right? If we have proper insurance, I mean, it's so crucial, but you talked about some places that going up 300%. Yeah, you can't even, so many were not planning on that, right? That was not in their forecast of their, or in their underwriting, right? When they were buying that project, I bet that they were expecting that. Any, what have you seen operators or buyers do to combat that, right? Or the risk of not being able to get insurance or any thoughts there?

Brian Bailey: Right. I think there's so many folks who are not expecting that kind of increase. Even we're constantly talking to the regulated lending universe about, Hey, you need to stress test. You need to run stress tests on rent. You need to run stress tests on expenses and cap rates and debt service. But in essence, your stress test, if you were at one on expenses is not going to. There's probably a very remote chance that you said, Hey, the outside is insurance is up 300% this year. I think that is one way that I know to kind of manage some of the risk. In essence, if you're aware that the risk can occur from that standpoint, you begin to kind of put your head around kind of the abstract view of risk. If rents can go up, they can also go down. Same thing with operating expenses. We've seen insurance rates during the early 2000s and even the early 2010s, where in essence rates were up very little, even in some cases declined. Now we're seeing them grow at an enhanced rate. And from that standpoint, I think doing stress tests to mitigate that risk, to understand it was probably the first step in one of several. But for me to kind of go further and comment on reducing specific tactics probably doesn't add a lot of value because what we know is commercial real estate is very individualized.

Whitney Sewell: Thank you for being with us again today. I hope that you have learned a lot from the show. Don't forget to like and subscribe. I hope you're telling your friends about the Real Estate Syndication Show and how they can also build wealth in real estate. You can also go to lifebridgecapital.com and start investing today.