Market Recap: Year-to-Date
In April the S&P 500 recovered from the banking issues that caused much turmoil in the prior month. Under the surface of this bounce back, an interesting trend developed. Instead of low-quality firms leading the market higher, as was the case in January and early February, mega-cap technology companies have now firmly taken the lead. Just eight firms accounted for 100% of the S&P 500’s year-to-date gains through April 30th. Apple and Microsoft alone account for one third.
Mega-cap technology firms demand, and deserve, a premium relative to the overall market due to their seemingly endless ability to grow earnings regardless of the economic environment. It can be argued that these technology companies should be driving the market higher. They are simply better than the competition. Microsoft proved the point with their recent earnings, which surpassed expectations handily.
While we agree generally that Microsoft and Apple should be more richly valued than the rest of the market, today’s valuations are stretched. Microsoft has only been this expensive relative to the rest of the S&P 500 1% of the time over the past five years. Apple has only been this expensive relative to the S&P 500 1.5% of the time. The last time Microsoft and Apple had valuations this high was in January of 2022, near the peak stock price for both companies and for the broader market.
The story for the first four months of the year has been that a handful of firms that have scale and a near monopoly over their product markets are doing very well. Everyone else has gone nowhere or down, for various reasons. The performance of big tech firms has been enough to offset the aggregate impact of the remaining 492 companies in the S&P 500 doing nothing year-to-date. It is challenging to see how this scenario can continue. Historically, markets are weakest when leadership is narrow.
Recent data suggests a deceleration in economic growth in April, with little progress on inflation. At this point even the Federal Reserve staff are calling for a recession this year. As far as we know, the Fed has never explicitly forecasted a recession. One of the main reasons for the challenging forecast is the impact of higher interest rates on the banking sector. The specific implications of the availability of credit from the banking sector on commercial real estate is the primary topic of this month’s commentary.
TIAA Real Estate
The TIAA Real Estate account (TRE) has been a long-running staple of any PIM portfolio that has access to TIAA. Yet, nothing is permanent in finance. TRE is currently experiencing its worst performance in a decade, down 6.5% from its September 2022 peak.
Since the beginning of the year, we have reduced the allocation to TRE by 75% in all client accounts. This was done in two trades, one in early January and the second in March. Each trade sold 50% of the position, bringing the allocation to 25% of the initial size. The first trade was done due to commercial real estate valuations being too high in our view. The second reflects our view that stress in the regional banking sector will reduce the availability of, and increase the cost of, financing to the sector – this on top of rising cost of capital from the Fed’s inflation-fighting rate-raising campaign.
From our perspective, the risk/return profile of real estate is unattractive relative to cash and short-term bonds. During “normal” times, we would expect TIAA Real Estate to return ~4% a year. Currently, cash and cash equivalents yield ~5%. We prefer to avoid an asset class experiencing a difficult environment when safe and liquid alternatives are available.
The Lending Market
Although financial markets have stabilized since the regional bank defaults that took place in March and the takeover of First Republic by JP Morgan Chase in April, the value of bank stocks has recently fallen to new lows. The SPDR S&P Regional Banking ETF (ticker KRE), has fallen from $64.79 per share on February 7th, to $36.09 per share as of May 4th, a decrease of over 44%.
Banks face higher funding costs (they need to pay interest on savings accounts) and therefore need to limit the risk in their loan books. Smaller banks accounted for roughly 40% of all commercial real estate lending at the end of last year. If banks can’t or won’t lend to the sector, lack of capital will likely result in lower commercial real estate valuations.
We’ve said before that the cost of a loan only matters if you need a loan. Well, banks have roughly $360 billion worth of commercial real estate loans maturing over the next two years. The commercial real estate sector will need one trillion overall if you include other large real estate investors such as insurance companies, private lenders, and the commercial real estate bond market (known as CMBS). Loans maturing now, or soon, were made several years ago under generous terms at low interest rates. Those terms and rates are no longer available. The result will be lower valuations for commercial real estate overall, though specific properties with solid economics will still have access to capital.
For example, according to some measures, office buildings in downtown San Francisco are only 70% occupied. Office buildings in the Southeast are 80-90% occupied. As lenders implement more stringent and selective standards, relatively unsuccessful properties, particularly office buildings, may struggle to access needed credit.
One might wonder why the availability and cost of credit to the commercial real estate sector would be a concern for TIAA Real Estate, which owns much of its portfolio properties outright. The properties in the TRE portfolio are valued quarterly; there is a comparative aspect to this process. Appraisers will use the sale price of buildings that have sold in the same market, adjust the figures to represent the building in question more closely, and create an estimated market value. If the buildings all around a TIAA-owned property are selling for less and less, this will be reflected in the valuation of the TIAA property. You’ve probably seen a similar dynamic in the residential real estate market where you live. If the overall commercial real estate market is struggling to find financing, some owners will be forced to sell at a lower price than expected a year ago. This process can spiral, with lower appraisals creating even lower appraisals. Currently, buyers and sellers appear unwilling or unable to find common ground, so commercial real estate transactions have slowed considerably. A wave of maturing debt in the next couple of years will force the issue.
The Opportunity
While owning commercial real estate today is not particularly attractive, owning the debt on these buildings might be. If small banks won’t loan to commercial real estate, investors will step in, at the right price. In portfolios in custody at Charles Schwab & Co., we own the Axonic Strategic Income fund, which specializes in commercial mortgage-backed securities (CMBS).
Commercial real estate loans are backed by physical collateral, which reduces risk. Worst case, the lender (bond holder) can take ownership of the building. Commercial real estate loans generally require 30% equity (down payment), substantially higher than residential mortgages, which gives investors a healthy level of protection. Commercial mortgage-backed securities pay investors principal and interest at the same time, just like your residential mortgage. This means that the related debt becomes less risky every month payment is made. Not only is the remaining loan principal lower every month, but the building owner has more incentive (as equity builds) to continue to pay the debt.
CMBS, like the residential mortgage market, dramatically strengthened investor protections and credit quality after the financial crisis. This change is most apparent with structured finance. Structured finance is a term for a lending structure that prioritizes bond payments based on the credit rating of the specific bond from the same underlying collateral (commercial building or pool of buildings). This area is arguably the most complex part of the bond world, but the broad takeaway, for our purposes, is that the structured finance market has evolved to stress investor protection. This change in focus was mandated by federal regulators and ratings agencies in the wake of the financial crisis. For example, the amount of credit enhancement, or protection the bond has from loss of income in the underlying building(s) for a AAA rated bond has increased from ~10% to ~22% over the past decade. This means that the amount of income from a commercial building destined for the bondholders would need to fall by ~22% for the AAA bond to be impaired. Any impairment on the bonds would happen after the building owner stopped receiving any income.
The Axonic Portfolio
The Axonic Strategic Income Fund currently holds approximately 20% cash. As banks evaluate their loan portfolios, either voluntarily or as encouraged by regulators, the fund is well-positioned to take advantage of opportunities. In addition to cash, the fund has investments that fall into two general categories.
The most straight forward type of commercial real estate debt is agency-backed bonds for multi-family apartment buildings. These bonds are backed by the U.S. government. Yet, these securities yield roughly 0.50-0.80% more than comparable Treasuries. This type of security could be backed by one large multi-family property or a pool of apartment buildings. Other than the obvious difference in collateral, these securities function the same way as residential mortgage-backed securities and often get lumped together (Axonic owns both types). As interest rates marched higher in 2022, these bonds sold off like everything else in the bond world. Now that the Fed is at or near the end of their hiking campaign, Agency CMBS appears unusually attractive. This type of security is a healthy part of the Axonic portfolio.
The other category of the Axonic portfolio is securitized bonds that do not carry government backing. These range in yield from 6.5% to 12% depending on the credit quality and timeframe of the bond. As banks reduce exposure to commercial real estate lending, funds like Axonic can step in to provide the capital building owners need, but at an interest rate that is advantageous to the shareholders. Even before recent solvency issues in the banking sector, certain areas of the non-agency sector appeared attractive on a historical basis because of last year’s bond market sell-off. With limited bank lending expected in the sector, niche funds like Axonic will likely see more attractive opportunities. Of note, the management team at Axonic does not find office related CMBS to be attractive and does not hold any related bonds.
Summary
Agency, and non-agency commercial mortgage-backed securities have been around since 1985. This isn’t new. But this rather unusual set of conditions may provide more compelling opportunities than is typical. In times of stress in the commercial real estate market, building owners take the first loss, either through less income from rent or lower building values. This is what the TIAA Real Estate fund is currently facing. This stress, coupled with tighter lending conditions, creates opportunities in the bond market, specifically the commercial real estate lending space, in which non-bank lenders ascend to fill the void created by the banking sector. Many large asset managers have been raising billions of dollars to take advantage of these opportunities in hedge fund structures. The Axonic Strategic Income fund is a knowledgeable and competent player in this space, well positioned to hopefully capture attractive returns.
Closing Comments
The first four months of 2023 have been an erratic period for capital markets. It seems like the narrative changes every month. January was a risk-on junk rally. February was dominated by concerns about higher interest rates. March was a regional banking sector panic. April was a mega-cap tech rally. The market can’t decide if it wants to advance or decline.
Enter the Fed, which raised interest rates on May 3rd by another .25%. Chairman Powel delivered his remarks, as usual. And as usual of late, nobody knows quite what he meant. The overarching theme appears to be that future decisions about additional interest rate increases are data dependent. In other words, let’s see how things look next month….
There is a case to be made that the U.S. avoids a recession. There is a case to be made that the U.S. practically can’t avoid a recession. We recognize the merits of both positions. We are just to the recession side of center. As such, client portfolios remain conservatively positioned. The risk of our conservative approach is that the market goes on a tear, and we aren’t fully participating. But even if that happens, the cost is relatively minimal and short-term. More likely, markets trade sideways for the next several months, with occasional more pronounced volatility along the way. As with the past four consecutive quarters, the inflation and employment numbers will lead the market, in whatever direction.
Your Feedback Requested
Prior to the COVID-19 pandemic, PIM produced commentary on a quarterly basis. Early in the pandemic, we changed to monthly commentary for several reasons. The world was in such a state of uncertainty, we thought it wise to communicate our views more frequently, in writing. We decentralized our business operation, set up work-from-home environments, and transitioned to Zoom, telephone and email communications. Travel stopped. In person meetings stopped.
Today, Friday May 5th, the World Health Organization has declared an end to the COVID pandemic emergency. The timing of the WHO announcement is purely coincidental, but we are contemplating a change to the frequency of this publication from once per month, 12 times per year, to eight times per year. We would publish quarterly, as we have always done, as well as once intra-quarter, the timing of which we would decide based upon economic and market events.
Our consideration of this change reflects the reality that from one month to the next, there is often little change in the economic and/ or capital markets landscape, making it difficult to select topics that are both timely and of general interest to PIM clients.
This publication is a good example. While market leadership did change within the S&P 500, little else really did. There may be a recession. There may not be. Inflation is moderating slightly but still stubbornly persistent. The Fed raised interest rates again and indicated that future decisions are data dependent. Same theme for many months now.
The main body of this publication includes two related topics. The state of TIAA Real Estate may only be of interest to those who own this investment, and the commercial mortgage-backed securities market may be of interest to everyone, or no one.
Trust us. Brian and I are happy to get into the weeds on any topic within the worlds of economics, investments, and financial planning. But we wish for these commentaries to be interesting and meaningful. This might be better accomplished by publishing a bit less frequently.
If you have made it this far, then you are our audience. We would be grateful for your feedback about changing from 12 publications per year to eight. Does this seem reasonable? Would you rather we continue publishing monthly? All comments are welcome and appreciated. Simply reply to the email that delivered this document to share your thoughts.