It’s been over 14 years now, and I can still recall those dark days vividly…
In 2008, I saw the clouds forming in the commercial real estate sector that ultimately became the tsunami known as the Great Financial Crisis.
The economic chaos ripped through my family, forcing me to part ways with many of my beloved real estate assets… and dreams of becoming a rich real estate landlord.
It reminded me of the classic Ray Bradbury novel, Something Wicked This Way Comes. In the story, two childhood friends venture off to the carnival and get lured into the dark side.
That’s precisely how I felt. The carnival was raging all around, yet few people noticed the dark clouds on the horizon.
I can assure you: These were dark times. And as I rebuilt my net worth, I promised myself I would never have to put my family through the agony again.
However, I’m now seeing similar clouds forming within the commercial real estate sector… and they appear to be extremely “wicked.”
Here at Intelligent Income Daily, we use our decades of experience to help you prepare for even the worst market conditions. By showing you what to expect, you can prepare yourself today with the best income-producing opportunities on the market – and avoid the dangerous ones.
Today I’ll share with you how to prepare, navigate, and hopefully benefit from the chaos that is about to unfold.
The Banking Crisis
Let’s first recall what sparked the Great Recession…
A subprime meltdown elevated debt-service coverage ratios, which translated into high default risk. Simply put, people and institutions didn’t have the cash flow to cover debt obligations.
That recession essentially started in the housing sector where many homeowners were drastically underwater with their home mortgages.
The clouds I see today are not in residential, but commercial real estate. That’s a market of around $35 trillion globally. In the U.S., it consists of $4.5 trillion backed by income-producing properties and $470 billion of construction loans.
According to Cohen & Steers, banks hold less than 40% of income-producing loans and 45% of all commercial real estate loans.
We’ve been discussing bank failures at Wide Moat Research quite a bit as the top 25 largest banks (by assets) own 13% of all commercial real estate mortgages, which is only 4% of their total assets. That’s not much.
However, regional banks (like the one I do business with) hold 31.5% of all commercial real estate loans, so their exposure is much higher at 20% of their total assets.
These tighter lending conditions and slowing fundamentals will impact banks and borrowers.
Being a developer is part of my DNA. And when I was no longer able to obtain financing for my deals back in 2008, I pivoted to research. If I were a developer today, I would be extremely concerned as lenders have pulled back dramatically.
Granted, that’ll also drive down supply, so this could be healthy for the market overall. But in the short term, here’s what I see ahead for the economy…
Over the course of the next 12 months, we expect to see increased loan defaults. Especially as there’s $448 billion of commercial real estate debt that will mature in 2023 ($25.5 billion of commercial mortgage-backed securities) that will triple to $1.5 trillion through 2025.
And there’s one sector within commercial real estate that’s at highest risk in this scenario. Of the $25.5 billion of conduit (CMBS) loans that mature in 2023, around $6.3 billion is in the office sector.
According to Cohen & Steers, that makes office the most exposed property sector in the near term.
Not Every Commercial Property Is the Same
Some properties may not survive the coming credit crunch fueled by loans coming due… Especially the office buildings that require enormous spending when tenants vacate.
As loans mature, office landlords may be forced to hand over the keys to the lenders, since there aren’t any lenders to refinance the properties.
Another sector we think could see some pain is multifamily properties. That’s because borrowers must put in additional equity consistent with how much property values have fallen (especially investors who originated loans in 2020 and 2021 at peak valuations with short-term financing).
And here’s the big question on everyone’s minds: Could the trouble brewing in the commercial real estate sector be the tipping point that puts the economy into another financial crisis?
From where I’m sitting, the answer is quite possibly yes, especially in certain markets where I was just a few days ago – New York City and Chicago.
These gateway cities enjoy a glut of office space. And to maintain these properties, landlords must be adequately capitalized for paint, carpet, and in some instances, complete refurbishing.
But not all commercial properties and markets are the same.
That’s why we’re avoiding these markets completely. Instead, we’re focusing on geographies that have better supply/demand characteristics and landlords with well-structured balance sheets.
As the wave of defaults continues, higher-quality landlords – like my favorite investment, real estate investment trusts (REITs) – will be positioned to gobble up properties at pennies on the dollar.
Remember, I lived through the Great Recession. I learned the hard lessons. And in this cycle, instead of being the victim, I plan to be the victor (and I want you to be, too).
Cash is king, folks, and I always encourage you to maintain some dry power – especially now. Because over the next 12 months, there are going to be some amazing opportunities… I can assure you of that.
And we have an opportunity just like that in our portfolio at Intelligent Income Investor…
This REIT was our top pick in 2022 – rising 12.6%. And we expect the company to continue to outperform this year, driven by forecasted growth of 10% (in 2023).
Its dividend yield is 4.9%, and it’s well-covered by earnings (its payout ratio is around 75%). The company collected 100% of rents during the pandemic – primarily outside the office space – which means we expect to see more stability as the clouds keep rolling in.
That’s just one example of what we call “sleep well at night” investing. To learn more about this recommendation and our other picks at the Intelligent Income Investor, click here.
Happy SWAN investing,
Editor, Intelligent Income Daily