The Fall of Silicon Valley Bank (SVB)
This hit the news and the markets like a wrecking ball. Hundreds of millions of uninsured deposits were at risk but not to worry, the taxpayer came to the rescue.
The bank was heavily invested in tech and venture capitalist-backed startups. Looking back, you can see that it was not well diversified at all and in late 2022 and early 2023, the tech sector started taking a hit with a lack of funding and mass layoffs. This is a symptom of the 2020 government stimulus. There was plenty of money in this sector leading up to the bank collapse but when the money ran dry, the companies started to suffer. As the news of the struggling bank spread, depositors wasted no time withdrawing their deposits. The problem, of course, is that banks do not keep enough liquidity to handle a bank run such as this, so they were forced to liquidate assets to meet the demand. The assets that could be liquidated were treasuries, which we are told are the safest investments you can buy, but when you have a rapid rise in interest rates, the value of those assets tumbles. These treasuries had locked in low interest rates making them far less valuable. As the losses sank in, the bank could not meet its obligations and within 48 hours it collapsed.
SVB was the largest bank to fall since 2008. Shortly after, four additional banks went down including First Republic which is the second-largest bank failure in US history. In all, five banks worth a combined $549 billion expired giving 2023 the record for the worst year in US banking history.
Rapid Rise In Rates
It is no secret that interest rates increased in 2023. The overnight rate controlled by the Fed increased by one percent to 5.5%. This actually felt like relief from the massive rate hike campaign of 2022. It was extremely clear that the Fed was going to do whatever it took to get inflation under control. They believe that inflation hurts citizens more than high rates, so it was a top priority to get inflation down. Although not directly related, these rate hikes do eventually impact mortgage rates. The average 30-year fixed rate started the year at 6.48% according to Fannie Mae, peaked at 7.79%, and has been falling since. As I write this it is at 6.95%. The story here is less about the increase in mortgage rates and more about the length of time the rates have been at these levels. The thought is that mortgage rates this high will slow borrowing and spending and increase saving. That combined with declining home values should drive inflation down. The problem though is the resilient housing market.
Steady Home Values
Housing has been uncharacteristically stable. Through 2022 and 2023 we saw the Fed raise rates faster as a percentage of where they started than at any time in history! Mortgage rates more than doubled yet people continued to buy homes, and in many markets, home values actually increased. This was possible even with rates shooting up because we had a lack of supply. In fact, seasonally adjusted, we have only seen supply this low one time since it has been tracked. And the interesting thing about that statistic is we have more people now than we have had so you would think that housing inventory would increase. Demand for homes can fall off a cliff, which some would say it has, without impacting home values if there are no homes to buy.
The Fall Of Commercial Real Estate
I was speaking to a friend who is fighting his way through a development deal. Although he is building a product that has not been impacted as harshly as some asset classes, I asked him if he was concerned with a looming commercial real estate crash. He said, “Kevin, it is already here!” I feel there is more to come but I guess he is right. I should have realized after reading articles suggesting that Blackstone turned over the keys to a 621,000-foot office building in Manhattan, or that Starwood Capital defaulted on the $212 million office loan in Atlanta. There have been plenty more just like this across the county. I also read several stories about large apartment complexes going under in the same way. The office and apartment sectors have taken a beating this year.
Cap rates are used to determine the value an investor will pay for a property. The higher the cap rate, the lower the value. Both apartment and office cap rates have increased significantly on a national scale. Office cap rates have increased further but both fall between 1% and 1.5% from the low to put this in perspective. If a property has an annual net income of $500,000 it would be worth $12.5 million at a 4% cap. If that cap rate increased to 5.5% the value would drop to under $9.1 million. That is a 27% decrease in value! Obviously, the increasing cap rates are in general terms and in no way reflect any specific area or quality of assets. Office in San Francisco has been hit harder than most other markets for example.
Looking Forward: Real Estate In 2024
Housing was clearly the bright spot in 2023. So, with the information we have now what should we expect in 2024? I believe the crystal ball I ordered should be arriving soon, in which case I will update my thoughts but for now here are some ideas on what 2024 could bring.
The Federal Reserve indicated in its dot plot that it projects the overnight rate to be .75% less than it is today by the end of 2024. That is a clear indication that they are planning some rate cuts but in no way did they say this is locked in. In fact, the message was that they are not convinced they have done enough, and rate hikes are still on the table. And Fed dot plots are often wrong. With this said, the market has already built in three rate cuts which is why we saw the stock market have a run after this was announced. Some rate cuts would feel great after the pressure we have all been under, but .75% is hardly enough to jump-start an economy and that is even if it does happen. I would expect more of the same honestly. Mortgage rates will likely stay between 6.5% and 7% for most of the year, credit card debt and defaults will continue to rise, and we may see the impact of the tightening settle in with job losses and a continued decline in inflation.
Ever since the fall of SVB, banks have been super tight to lend. The reason for that first and foremost is that they are expecting more commercial loan defaults. When a bank of that size fails, it gets the attention of the industry. Not to mention that massive defaults have already occurred in this space. All of this is true, but the biggest concern is DSCR. DSCR is a debt service coverage ratio and is one of, or maybe the most, important ratio commercial lenders look at. This is the amount of income a property produces divided by the annual debt payment. Basically, does the property produce enough income to afford the loan? Banks typically want to see a ratio of 1.2 or higher. A 1.2 DSCR ratio means the property produces 120% of what is needed to pay the debt. Banks are heavily regulated and audited and regulators want to be sure that loans in their portfolio meet this requirement. The concern I have is that the massive amount of commercial loans coming due, over $2.1 trillion over the next two years, have low interest rates. When the loan becomes due, the borrower is forced to refinance but now the property is worth far less because of the increasing cap rates and the income no longer produces a 1.2 DSCR with the increase in interest rates. I would not be surprised if we see further softening in the commercial sector this year.
Continued Strength In Housing
Like 2023, I would expect housing to be the darling of 2024. It comes down to supply and demand. We could double supply and still be low and I believe there is pent-up demand just waiting to pounce. Many first-time home buyers, as much as 85%, who qualify and would like to buy, say now is not a good time. The concern of course is high interest rates. As rates come down, more and more first-time homebuyers should enter the market. Investors like you are me are also waiting for cheaper homes and/or lower rates. One thing that could even this out to some extent is the aging population. Half of all boomers are retired at this point and may slowly start moving into assisted living or smaller shared types of housing. In those cases, they could be adding to the inventory without buying a new home. Although this is valid, I do not believe this will add enough available homes to drive values one way or the other. Overall, I would not expect to see much in the way of value increases or decreases this year.
Although I expect much of the same, I am hopeful that 2024 will be easier than 2023. Looking back, it was a tough year in real estate overall with some exceptional challenges in commercial investing and financing. Transactions are way down which has decimated real estate sales and lending positions. Despite the challenges, or maybe because of them, I am happy to report that Pine Financial had a record year and is entering 2024 with a strong portfolio and an amazing team!