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Commercial landlords can’t pay mortgages … rising defaults … but have regional banks been de-risked? … Bill Gross’s recent banking business … how the sector looks through Stage Analysis
The dumpster fire that is the commercial real estate sector continues to burn.
According to Moody’s Analytics, during the first nine months of 2023, only one in three expiring secured office mortgages were paid off.
Here’s yesterday’s Wall Street Journal with more:
That’s the smallest share for the first nine months of any year since at least 2008 and well below the nadir reached in 2009, when 47% of these loans were repaid.
That share is also well below the rate before the pandemic, when more than eight out of every 10 maturing secured office mortgages were repaid within a few years.
Regular Digest readers know that we’ve been running a “commercial real estate watch” segment all year, monitoring this critically important sector of the American economy.
Legendary investor Warren Buffett once quipped, “You only find out who’s swimming naked when the tide goes out.” Well, with Federal Reserve Chairman Jerome Powell saying there is zero discussion of rate cuts on the table, and with $1.4 trillion in commercial real estate debt coming due by the end of next year, the tide is going out.. .
And no sector has more “nude swimmers” than commercial real estate.
***What the numbers tell us about the commercial real estate meltdown
The WSJ article explains that many office owners can’t repay their old loans because they can’t get new mortgages.
To make sure we’re all on the same page, the office sector relies on debt. Landlords are buying astronomically priced buildings with huge mortgages. When the mortgages mature, the landlords can’t pay off the building in full, so they just take out a new mortgage.
The post-Covid trend of remote work has resulted in a wave of office vacancies, which has lowered rental rates (reducing income for the owners).
Meanwhile, the Fed’s rate hikes have increased financing (and refinancing) costs, while also lowering building values (due to higher discount rates).
Given these changes, the math simply no longer works for many new commercial mortgages. Back to the WSJ for the result:
That combination is fueling an increase in defaults. The share of office CMBS loans that are delinquent has tripled over the past year to 5.75%, according to Trepp.
To give you more perspective on how bad it is, let’s compare 2023 to 2019.
Before the pandemic, when offices were full and interest rates were low, landlords could simply roll over their maturing debt into new, low-rate loans. In the first nine months of 2019, 88% of commercial landlords paid off their loans at maturity (by rolling into new loans).
Last year, we began to see the first wave of refinance contagion during this new era of higher vacancies, higher rates and lower building values. This translated to only 71% of landlords being able to pay their loans.
And this year? The figure dropped to 31.2%.
*** While we previously looked at the potential contagion effect in various office REITs, let’s shift our focus to a silver lining… and perhaps a business.
So, we have landlords unable to pay their old mortgages because they can’t find new mortgages.
Well, who is on the other side of the negotiating table in that equation?
Regional banks.
As we have indicated in previous Digests, the commercial real estate sector is closely linked with the regional banking sector. Regional banks are responsible for most commercial real estate. Bank of America puts the number at about 68%.
Now, you might be raising an eyebrow. If commercial real estate is in trouble, it would seem obvious that regional banks would be in trouble as well. In fact, back in the spring, we highlighted this JPMorgan analysis:
We expect about 21% of commercial mortgage securities outstanding office loans to eventually default, with a loss severity assumption of 41% and prior cumulative losses of 8.6%…
Applying the 8.6% loss rate to office exposure, it would imply about $38 billion in losses for the banking sector…
So, what’s different now?
Well, although Powell & Co. still making no noise about cutting rates, Wall Street currently believes we’ll see our first cut in May (and our own Louis Navellier is calling for it to come in either January or February).
To be clear, the onset of tax cuts will not mark the end of stress in the commercial real estate sector. But remember, Wall Street always looks ahead about 12 months. So, it will try to price-in how the economy and banking sector will look after another year of relaxed conditions.
This means that bank stocks are likely to move higher well before we see the real improvements in bank bottom lines.
***On that note, earlier this month, the “Bond King” Bill Gross, the co-founder of PIMCO made a bullish call on regional banks.
From CNBC:
Longtime investor Bill Gross said Thursday that regional banks are poised to rebound with the tailwind of falling interest rates.
“Regional banks … benefit from lower interest rates,” Gross said on CNBC’s “Last Call” …
Gross also noted that regional bank stocks are now very cheap, and many of them offer big dividends.
“Many of them are at 50% of book value, which is historically low. They give, in many cases, 7% plus with a 40% payout ratio, which provides a decent amount of protection,” he said.
Here are four regional bank names Gross likes along with their dividend yields. You will see that the returns are slightly lower than the 7% that Dirty referrals have been offering for the past few weeks. Still, pretty nice:
- Truist – 6.51%
- Citizens Financial – 6.15%
- KeyCorp – 6.69%
- First Horizon – 4.90%
***If we step back and assess the regional banking sector from a business perspective, it appears that a bullish business is setting up.
Let’s borrow a tool from one of our business experts, Luke Lango.
Regular Digest readers know Luke roots his AI Trader business service in a market approach called “stage analysis”.
In short, every stock at any point in time is either going up, down or sideways.
To that end, each stock is always in one of four unique stages: 1) going sideways at the bottom, 2) going up, 3) going sideways at the top, or 4) going down.
Stage analysis is the science behind figuring out which of these four stages a stock is in at any given moment.
The key to earning big returns consistently is to find stocks on the verge of entering Stage 2 – or stocks that are already breaking out.
Below is a chart of the SPDR S&P Regional Bank ETF, KRE with a crude phase analysis overlay.
You will see its previous Stage-2 bullish breakout back in 2020/2021 (in green) … which became a Stage-3 peak pattern (yellow) … which collapsed into a Stage-4 decline (red) … and are now sawtooth, appearing to be in Stage-1 consolidation (orange).
Source: StockCharts.com
To be clear, Gross has already pulled the trigger on his trades. He bought the stocks we highlighted above.
If you want to follow Gross into this trade, just be careful when you approach the approximate $49 level. As you can see in the chart above, this is the top of the Stage-1 consolidation range. KRE could hit its head at this resistance level, resulting in a sharp pullback.
If you are a more conservative investor and/or you want to follow the traditional rules of Stage Analysis, you would wait until KRE breaks above this $49 level on heavy volume. This would suggest that the sector is actually starting a new Stage-2 bullish growth.
Obviously, that will mean you miss out on some early gains. But that’s the trade-off for a greater sense of confidence that we’re looking at a true bullish breakout rather than a bearish fake.
We’ll keep you updated as that happens. But I will say that those juicy dividend yields look great today, especially in light of historically low book values.
We will keep you updated.
good evening,
Jeff Remsburg
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