Welcome to the game of loans where when the Fed plays,
your property gets devalued.
So the participants in the game of loans in your upper left,
you'll find your office buildings and to the right of that your retail
and then office buildings and self-storage storage.
And in the lower left you'll find your industrial,
your medical office, your multifamily and of course, series or malls.
Each one of these commercial asset classes have very different debt and equity
structures, very different loan to values and very different interest rates.
And of course they're all in different markets and submarkets.
So like in any game in this game of loans, these asset classes are being affected
by lots of changes that are happening right now right before your eyes.
One example is that people's buying habits have changed as a result.
Sears is gone. Macy's is gone.
Kmart is gone.
And now recently, Bed, Bath and Beyond on the commercial office buildings.
Work from home is now a thing, and therefore,
the occupancies are way down and they're suffering currently.
Last mile distribution is on fire for industrial landlords
because everyone wants something the minute they order it right away.
And of course, regional malls are dying on the vine and have been for some time
and are now in the process of being redeveloped all over this country.
So why does all this matter?
Because when these properties were bought or constructed, they originally
had a tenant or multiple tenants in there that originally had a plan.
That's completely changed as of today.
The other thing that's changed is that the values and the cost to own
these properties has gone up, as have the interest rates
from the Federal Reserve's last and rate increases.
And as such, the value of many of these properties have gone down
because occupancies are actually down, expenses are up.
Interest rates are always up and cash flow is at an all time low.
As a lender, all financing is more challenging.
On all of these asset classes.
The cost of borrowing loans has definitely increased.
The lenders are lowering their loan to values from, let's say, 70 to 80%
to 50 to 60, which requires more equity to be put down at a purchase,
a refinance, or even at a sale because is back,
which means that you're going to see a lot of loans
that are going
to be personally guaranteed, which is going to put more people at risk,
increase capital requirements and increase reserves, basically means
less distributions to the people that actually own these properties
and more reserves at the bank level
as these banks continue to be concerned about potential default.
So what we're seeing is the outflow is down 75% from last year.
The Federal funds have raised the rates ten times
and they said in their last meeting, their recent meeting that
they're going to raise at least two more times at a quarter point each.
We have 1.5 trillion in commercial loans that mature by the end of 2024.
The office sector is in horrible shape.
Regional small banks have lots of exposure.
The general partners are starting to issue cash calls and cap rates are up
and values are down.
So some of you might be asking, well, what does it all mean?
Can So I broke it down in this chart here.
And as you can see in 2020, let's just assume it can be any of these buildings
and the total income in that building, say, $2 million,
let's say in the upper left corner here with this office building here,
all the tenants paid roughly about $2 million in rent in one year.
And to operate this building, we're talking of property taxes,
insurance and utilities and capital maintenance.
And all of those things are 1 million, which gives this property
about a 1 million net operating income or why?
So in 2020, interest rates were about 3%.
So the banks, if they use the 1.3%, that service coverage,
that means that they would loan about $700,000
annually against the $1 million net operating income.
And the partnership would then have about $300,000 a year
cash flow to be able to distribute cap rates or about 4%,
which would put the value of this property at about 25 million.
If you can divide 4% into the 1 million,
you get a value of 25 million.
So now let's fast forward just three years later.
The big difference, of course, is the debt
that went from 3% to 6%,
increasing the cost of debt to about 1.4 million.
So as you can see, there's no lender on the planet
that's going to offer a $1.4 million debt service when the A.I.
is still $1,000,000.
The irony is that this property hasn't really changed very much.
They're still getting $2 million in income and $1 million of expenses.
However, what's really changed is, of course, the cost of the debt.
So because debt so much higher, this is what's rocking
the world of all these commercial asset owners.
If they're up for refinance, that particular lender is going to say,
there's no way that I can lend you this property at the same loan
because rates are so much higher and therefore these asset owners
have to do a cash in just to keep the property.
If they're trying to sell the property, as somebody like me,
now, I'm going to the exact same lender and the lenders
telling me the exact same thing.
So what's happening is somebody like me or even the bank at a refi
is actually valuing the property at, say, 15 to 20 million.
And cap rates have then gone up to five or 6%.
So cap rates have gone up a minimum of 20%,
which is lowered the value of all these assets.
It's all because rates have gone from 3 to 6%.
So jumping back to the left side here, I think you can imagine that if this deal
was put together, let's say with 5 million of equity and 20 million of debt,
but rates went from 3 to 6% over here to the right
and the value is now worth 15 to 20 million,
this same building is actually not even worth the cost of the loan.
So therefore, this particular owner is faced with two things one, the cash
call the existing partnership and try to get enough money to keep the property.
Or two, they turn it back over to the bank
and all that equity that started over here in 2020 is gone.
Now, of course, what would change all this back would be
if interest rates went back down to 3%,
because the fundamentals of these buildings have not changed that much.
What has changed is, of course, the cost of the debt because of course
the cost of debt has gone up.
No buyer is going to pay
what a seller paid for the same asset because of course
they're basing their offers on cash flow and cash flow alone.
So to summarize, the real risks moving forward
on all these asset classes is that debt service coverage is up.
More reserves are being required from the bank.
The Fed, of course, has said that they're going to raise rates
at least two more times before the end of the year.
There's no rate cuts in sight, according to the Fed.
General Partners are going to continue to do cash calls.
And of course, cap rates could continue to go up
and values could continue to go down, which would actually put more
and more of these assets in jeopardy because the cost of these assets in 2021
are not worth, in many cases, the loan that they have on them right now.
So as they continue to mature,
you're going to see more and more of these defaults
and they're going to make their way into these small and regional banks,
which is potentially going to create another banking crisis.
So in this game of loans, it could end just like the Game of Thrones,
where at the end the dragon brought everything down.
But we don't know yet. Stay tuned.