Commercial Real Estate From a Hedge Fund Manager's Perspective

Recently, Mark Neely decided to depart from EFJ Capital, where he was a partner, Senior Managing Director, and Portfolio Manager. He helped them grow their assets under management from $400 Million to over $5 Billion.

Mark’s been working in Real Estate for the last 19 years. He started his career with DR Horton, moved on to Fannie Mae and joined EFJ ~12 years ago. He’s got a BA and an MBA from the University of Maryland. They are both in Finance. 

I had the chance to chat with him recently about his outlook on the commercial real estate space. I’ve been watching and picking the brains of anyone I can find about the trouble with commercial real estate, specifically office space.

Causes of Turmoil

Mark noted, on our call, that before the pandemic, a 30-person meeting would need to be in-person and would have to be planned far in advance. Now, it seems you could get 100 people on a video call with 2 hours’ notice. 

Throughout our conversation Mark’s optimism was apparent. I wasn’t expecting such a chipper personality from a commercial real estate hedge fund manager, but he mentioned that these periods in history, where things seem dire are often very valuable moments for the discerning investor.

I told him that I agreed and that I would like to hear more about his perspective. He mentioned that he had written a white paper on the subject, and I asked if I could read it. We share a common background in finance and real estate finance bonds. I thought that might allow me to understand his paper and its proposition.

The Forthcoming Recapitalization of an Industry (Commercial Real Estate)

To summarize: Outstanding Commercial Real Estate Debt, which totals $5.5 Trillion, according to Mark. $3.5 Trillion is in Multifamily Real Estate. The Holders of that debt are:

• Banks – 48%
• Government Sponsored Enterprises – 17%
• REITs, Debt Funds, and other entities – 16%
• Life Insurers – 12%
• Commercial Mortgage-backed Securities – 9%

The terms of these loans are concerning, as Mark estimates that around 40% of them are floating rate, annual loan maturities that exceed $400 Billion and most have balloon maturities, which refers to much larger payments toward the end of the loan. Cash strapped banks facing the prospect of balloon maturities on assets that are experiencing depreciation, present a significant loan default risk.

Retail, Commercial Office Space and Multifamily

To paraphrase Mark: Technological and logistical innovations have greatly benefited online retail and from-home workers. Amazon delivers your products with a speed that would have been unthinkable until the data centers and logistics centers were built up.

That value has been transferred to these other commercial real estate assets. Malls have had much of their draw diluted by the ease of online shopping and the office buildings are experiencing the same effect from these other commercial real estate assets.

Multifamily housing isn’t affected by the same forces. You can’t deliver housing more efficiently or conveniently by adding logistics or data hubs to the surrounding area. Maybe you can, I suppose prefab housing is exactly that, but Mark notes that “Multi family has not been immune to the storm blowing across commercial real estate.”

They’ve had a great run recently, with rents outpacing inflation and expenses remaining subdued. The nationwide housing shortage has been a “favorable macroeconomic factor.” As rents slow their marginal increase and inflation creeps into labor and goods costs, multifamily is feeling it in their income statements.

The net operating income has started to flatten and even decline in some cases, as the capitalization rate or cap rate (used in the world of commercial real estate to indicate the rate of return that is expected to be generated on a real estate investment property. Investopedia 2023) have started to move higher with the risk-free rate. This causes lower valuation.

Maturity Wall

A substantial amount of those loan maturities occur in 2022 – 2025, shown below. They come with optional one, two- or three-year extension provisions. Extensions allow the owners to wait for better times to refinance. Mark says that the fed funds rate is expected to be 3.5%, Which is still too high to refinance these loans.

His paper mentions that the other challenge facing owners is mandatory rate caps. When a property owner enters into a floating rate CRE loan many lenders will require them to enter into a “rate cap”, which limits the amount a borrower would have to pay in a rising rate environment (That’s today!). These rate caps expire usually before all loan extensions are exhausted creating yet another factor weighing on owners’ income statements.

So What?

Retail, commercial office space and multifamily real estate are losing value and that means

• Banks – 48%
• Government Sponsored Enterprises – 17%
• REITs, Debt Funds, and other entities – 16%
• Life Insurers – 12%
• Commercial Mortgage-backed Securities – 9%

are undercapitalized. Mark notes that the industry needs capital. Buy low and sell high is the general thought when it comes to investment. REITs are trading well below book value. (This is not investment advice, just an observation.)

It will take a savvy understanding of the underlying assets to identify where the opportunities for investment are. Understanding that office leases are “in the 3-10 year range, so it takes a good bit of time for true occupancy to roll over.”

Mark speculates that one might “purchase a single B rated tranche of hospitality CMBS at a spread of roughly 550 basis points above 3-year treasuries. This equates to roughly 9.5% yield to maturity and you would need the asset values to decrease by 40% before any loses are taken.” Meaning there are ways to approach the situation and invest safely to make a sizeable return.

He thinks there are opportunities in the stressed/ distressed loans, distressed loan sales from banks and other institutions, most recently Silicon Valley Bank and Signature Bank. He sees opportunities in the 20%+ return range for savvy investors.

My Takeaway

I don’t think you can put the toothpaste back in the tube. I think the logistics and data hubs are here to stay. He’s right that the industry needs greater capitalization, but if the fed funds rate went right back to pracademic levels, it wouldn’t resuscitate the office towers. It would, however, open opportunities for construction lending to convert the towers to more mixed-use properties.

Mark is an astute professional with a great background and an analytical mind that would make a great addition to any team that is looking for someone to work in a collaborative capacity and communicate complex ideas understandably.

If you need access to top-tier talent on your strategic team, get in touch with us using the form below. We’ll reach out to you right away and set up a time to talk about how we can make it happen quick and easy.