Bisnow Reports | First Draft Live: Director of Real Estate Economics for MSCI, Jim Costello — Did CRE Call The Recovery Too Early?

The 10-year Treasury rising past 4.5% has taken the wind out of real estate’s recovery sails. Momentum gained in Q1 is already reversing as the war in Iran pushes on inflation. MSCI Chief Economist of Real Estate Research Jim Costello said the volatile bond market is “a new wrench thrown into the works.” And while he believes the CRE recovery is still underway, it’s tenuous.
“[Investors] need to do more scenario planning these days, because that’s how you can deal with the growing uncertainty in the market,” he said.

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Mark Bonner: 00:07

Okay. Welcome to First Draft Live. It's Thursday, May 21. I'm Mark Bonner, Bisnow's editor in chief coming to you live from New York. So for most of this year, commercial real estate has been trying to tell itself a fairly optimistic tale.

Mark Bonner: 00:21

The worst of the rate shocks seem to be over. Capital was coming back. Transaction activity had started improving again. And after several years of paralysis, the market finally appeared to be finding a floor. But now the bond market is moving again, and suddenly, there are new questions about how durable that recovery actually is.

Mark Bonner: 00:41

Over the last month, The US ten year treasury has surged roughly 40 basis points, climbing back towards 4.7%. Thirty year yields have pushed above 5%, levels not seen since before the great financial crisis. And then suddenly this week, one of the biggest questions in commercial real estate was back on the table. What happens if long term interest rates stay structurally higher? Because the industry doesn't refinance off optimism.

Mark Bonner: 01:08

It refinances off math. And that math gets a lot harder when the benchmark for global real estate debt starts pushing back toward levels the industry once called the danger zone. At the same time, hundreds of billions of dollars in commercial real estate loans are still moving toward maturity. Office distress continues working through the system, and investors are trying to determine whether this recovery is actually durable or simply a market adapting to permanently more expensive capital. And increasingly, the story this year may not even be the Federal Reserve.

Mark Bonner: 01:41

Not anymore. The Fed has cut rates this year, but long term treasury yields have continued climbing anyway, which raises a bigger question for commercial real estate. What if the bond market, not the Fed, is now setting financial conditions for the entire industry? To help us think through all that, I'm joined by friend of the pod, Jim Costello, chief economist of real estate research at MSCI. Jim, welcome back to First Draft Live.

Jim Costello: 02:08

Always great to talk to you.

Mark Bonner: 02:11

Jim, let's start with the big picture. Commercial real estate entered this year expecting stability, but now the bond market is moving aggressively again. How significant in your mind is this latest treasury spike for commercial real estate? Is it mostly psychological?

Jim Costello: 02:26

It's it's unclear. That's the the real challenge here. But one one point you brought up, this volatility. Like, we were getting into a positive trend for the first quarter and recovering deal volume. Even the office sector, investors were jumping back in.

Jim Costello: 02:44

And so things were looking like we had gone through the challenges, things had repriced, and then investors could start moving forward from there. So this is a new wrench thrown into the works. And it's, it's an interesting trend because what it's showing me is that you had to underwrite to a lot more volatility these days. Gone are the days when you could just assume, oh, it'll be a nice stable structural environment and you can hold an asset for seven years and you don't have to worry. The money will just show up in your mailbox on a regular basis.

Jim Costello: 03:18

There's a lot more uncertainty in the world and so managers and investors have to do much more work trying to figure out just the chaos in parts of the economy and, you know, how do certain things change and then transfer over to the investment market. And and so it's a it's a more complicated environment for folks to work in.

Mark Bonner: 03:44

You know, I don't think anybody had the bond market on their bingo card to start off the year. All that uncertainty, there's a lot underneath that umbrella. But there's been this phrase that's been floating around the industry for years now that somewhere around four and a half percent on the ten year is the, quote, unquote, danger zone for commercial real estate. The idea being that beyond that level, refi ing huge amounts of low rate vintage debt simply stops working mathematically. Do you buy that framing?

Jim Costello: 04:13

A little bit. A little bit. There's a there's a couple things that drive it. The level itself, there's nothing magical about the level. In fact, over the long run, a 4.5% for the ten year treasury, over the long run, that's low.

Jim Costello: 04:27

I mean, from like, that I was looking at some figures the other day. Alan Greenspan, when he was chairman of the Fed, his whole tenure, the tenure was like 6% on average. And that's the period when we had some surges and collapses and deal and deal activity. And so investors are able to get deals done in that kind of environment. The challenge is what was the basis at which the investors went into those deals.

Jim Costello: 04:55

And when the tenure was at six, a lot of them went into deals at much higher levels earlier. It's the problem is the deals that were done at the ultra low interest rates around the pandemic era. If you have a deal that was, written, your your loan was written when the ten year treasury was at 60 basis points and mortgage rates, they don't move in a one to one ratio, but they rhyme. So when that fell, mortgage rates fell. And if you say you have an apartment building, you bought, you timed the market just worst, just the worst market timing possible and bought at the peak of the market and you're trying to refinance that today, for something like the apartment market, prices have done okay and so there's still some value in the asset but you're going to have to probably do a cash in refi to get that to refinance today.

Jim Costello: 05:48

So that is an additional capital call. But other types of investments and other vintages of investments, they might be okay in the sense of they've had, they didn't time the market wrong. Like if you got in before the big spike in prices, you've got some growth along the way that may make it an easier situation. The other challenge, so maybe you don't have a lot of distress coming just from that, except for certain vintages where it's a problem. But the other thing I think that that was a problem when when rates go up is the speed at which they go up.

Jim Costello: 06:28

Like just to get to the 4.5% level, if it's boiling a frog, you turn up the water slowly, they're not going to jump out. Just boiling water and a frog is put in there, they're going to jump out. And that that that issue, I think, is is the key one. We had interest rates go up very quickly, when, the the QE stopped and everything from the all the stimulus spending and all the government intervention following the pandemic. When you went from a 60 basis points up to just under five for a little bit, that was a long, that mirrored a period when we had a falling deal activity for about twenty months in The US.

Jim Costello: 07:16

And the issue there was the speed. It was going up so quickly that acquisition people could not underwrite investments because you're working on a deal, you're trying to figure out, you know, all the cash flows, trying to figure out the cost of debt, you think you have everything lined up, and then suddenly you talk to the lenders like, oh, by the way, you know, I I quoted you something a week ago when you started on this project, but now it's even higher. And it's at it's at adjustment and the speed of adjustment. And it had a very real financial consequences as well. Because if you hear, well, rates are going up, a better lock or a loan rate.

Jim Costello: 07:57

Well, in that kind of environment, rate locks become more expensive. And so that was a big topic of discussion when deal volume was falling. So if you just get up to 4.5 or five or something, it's a nice, slow, steady thing and people can make adjustments slowly over time. That's not going to hit deal volume. But if you have a very sharp increase, if you get additional months of 40 basis point changes, that's the kind of thing where it's gonna make it difficult to underwrite and you'll have some pencils down moments.

Jim Costello: 08:31

But in part, it's just how does a market react to slow moving news versus fast moving news. And fast moving news, it's hard to get deals done.

Mark Bonner: 08:41

Right. And, you know, you brought up the Alan Greenspan era. That was a different time, a different economy, a different domestic political situation, a a very different geopolitical situation. It was more certain. It was more stable.

Mark Bonner: 08:52

Right? One thing that's fascinating right now is that the data itself almost feels contradictory. Transaction volume has improved. Lending activity has improved. Leasing activity has improved in several sectors.

Mark Bonner: 09:06

Public brokerages are posting huge earnings rebounds. But at the same time, distress continues surfacing across the market, especially in office as you well know. So when you step back and start looking at the numbers broadly, do you still believe even after this news in the bond market that commercial real estate is actually recovering right now?

Jim Costello: 09:28

Well, I do believe it's recovering. I mean, now recovering up until this point. We'll see what happens next. The the increase we've seen so far in the ten year treasury, if, you know, in in the last week or so, if it sort of stays at this level moving forward, no problem. You know, there's gonna be a few, assets where people have trouble and you're gonna have a lot of folks who are gonna have difficulty for particular vintages getting loans refinanced without an additional cash injection.

Jim Costello: 10:00

But if you just kind of stay at this level, the market can kind of interpret it in the sense of how they were acting in the, in the first quarter. The moving forward issue is, is a, is a concern. You know, how much more will, interest rates and mortgage rates go up in response to a sense of growing inflation? And I mean, truthfully, if I could forecast interest rates effectively, I I I'd be living in The Bahamas, on a nice boat right now. And, you know, I I might, you know, you're fun to talk to, so I'd probably talk to you still.

Jim Costello: 10:32

But, I I wouldn't be I wouldn't be working here if I could do that. But you know, so I think that's the other thing with all this uncertainty, what investors really need to be thinking about, they need to do more scenario planning these days. Because that's how you can deal with the growing uncertainty in the market because there's there are things happening where the the rules of the system are changing. You know, it's it's it's not a statement of politics and saying it's right or wrong. It's just it's happening.

Jim Costello: 11:05

Trade patterns that weren't in place before. Those are changing. You know, how the the cost of funding the government get born. Those are changing. So that will have an impact on what property types will do well, which ones won't, and all the policies that are coming through.

Jim Costello: 11:23

It's not clear how many of them are permanent, how many are temporary, how many stick. So as an investor, need to take a look at all of it now I think and run a bunch of different scenarios to figure out how do the investments I'm considering or have in place, how do perform under some of these best case and worst case scenarios I can paint to really give yourself a comfort level of, you know, where I'm at and where I wanna go in this, world of growing uncertainty.

Mark Bonner: 11:53

You know, Jim, you said something recently that really stood out to me. You said sellers are finally capitulating, and that feels important right now because for years, this market was defined by extend and pretend. Owners waiting for rates to fall, banks waiting for values to recover, everyone hoping time would solve the problem. Has the market finally accepted that the old world isn't coming back?

Jim Costello: 12:18

Well, I do think the market has accepted that the old world of the office market is not coming back, that what we have today is about what it's gonna be moving forward. It's it's, man, I was thinking about that. We're we're going into the Memorial Day weekend, but I was thinking about that last year at Labor Day. I remember starting in 2021, I started hearing stories from people in the office market. Oh, just wait till after Labor Day.

Jim Costello: 12:45

After Labor Day, everybody's going to be back. The office market will be back. As I start tracking the subway ridership levels in New York and yeah, sure enough, the 2021, you had a 50% increase in the number of riders after Labor Day, relative to the previous year. But the previous year, of course, was 2020, so it wasn't hardly anything. And then it went up more and it went up more.

Jim Costello: 13:05

And now we're around 80% of the ridership levels of where we were before the pandemic on comparable days. So and it's been stable there for a bit and it's just New York. New York is not the whole US of course but it's good data and so you go where the data is and some cities you didn't have the the work from home phenomenon take on as strongly as it did in the expensive cities of the Northeast. Some of my clients in in Florida, didn't even believe the COVID existed, but the you know so they were like at the get go you know still back in the office in 2020. And so that that that that difference in in the demand side I think people have finally come around to the fact that where we are is where we're going to be and then you grow from here and fill up what you can from there and at least lease these spaces at whatever the new low rent is.

Jim Costello: 14:02

And so that's gone through that adjustment. The other property types though, it's and we can see the capitulation in the distressed sales figures for the office market. Most property types, there's some distress activity, but there's not a lot of distress sales yet. But it's the office market where you're seeing most of that distress activity. Now the other property types of capitulation, you know, the retail is growing again, but it's kind of a different thing.

Jim Costello: 14:30

It wasn't the people were capitulating and finally recognizing losses and values. In fact, retail values are climbing now. And part of the issue there is that there's still a lot of in store shopping. I will amend that. There was some sort of capitulation.

Jim Costello: 14:47

The folks who had the dead old malls have been capitulating by way of a bulldozer and that's been helping the existing properties to do well. We've got a case shaped market there. Right. With some winner properties and some loser properties and that's what the office market is really becoming at this point. And you know, there's some demolition of the, of the dead malls and dead, neighborhood community centers that's been helping, improve the bottom line of the, the ones of the winners and the exist, the existing winners.

Jim Costello: 15:14

So it's sales are going there, but not as much because the sellers capitulating in in that classic sense of just selling at whatever price. I I mean it's a capitulation of like, you know, when you call in the bulldozers to tear it down, you capitulated at that point and said, nobody wants this stuff. Let's turn this land into something more valuable.

Mark Bonner: 15:33

So, you know, publicly, I you know, what what we hear from commercial real estate power players is basically something I call eternal sunshine of the commercial real estate mind. Right? And and I understand that completely. Optimism, people who are optimists tend to get things done. They solve big problems.

Mark Bonner: 15:49

I agree with that. I I I aspire to be a person like that. But it just seems publicly that the industry is reticent to genuflect at the altar of reality. And that's fine from a public perspective because they have customers, clients, they have brands that they have to protect. Behind closed doors though, and especially in the last couple of days, Jim, are you hearing a different tenor of conversation just because of all the uncertainty that's on building that you've mentioned?

Mark Bonner: 16:14

But then this ten year thing, that seems like a really big deal. That that seems like a a pretty significant mile marker on the recovery narrative. One that might make it make it have to at least pause if not do with the u-turn.

Jim Costello: 16:27

Yeah. The optimism issue is, is kind of interesting. I remember working with this one client in the middle of the, of the financial crisis. Their asset values were falling. The, their investors were causing trouble, or not, they weren't causing trouble.

Jim Costello: 16:42

They were just raising redemption, issues and as the whole thing was becoming difficult, I'm sitting down with the CEO and the first question he had was, Jim, what's what do you think the next big sector our fund should invest in? To me at the time, that seemed kinda bizarre. Like, wait a minute. You're not trying to solve the current problem? You're not, you know, you're not consumed with all the, all the problems of, you know, the falling values and the investors who are, raising questions.

Jim Costello: 17:15

No, it was about, well, what's the next opportunity? You know, where do we go from here? And I think that you were right. These people just get stuff done. And it's sort of a mindset more than anything that it's not about making money when the market's good.

Jim Costello: 17:32

It's always about trying to take what's in front of you and make the most of it. And sometimes it comes off as optimism, but I really think it's just it's about just trying to just make your way through things because there's always going to be something that goes wrong. I mean, like right now the industrial sector is the most popular sector with, well not, not the most liquid, apartments are still the most liquid, but in the institutional world it's now like 40% of 42% of our ACOE index. That's all the, the high quality institutional properties that the pension funds own. And that's a that's a big allocation.

Jim Costello: 18:09

So they all want it. But even the industrial sector, there's defaults that happen. You know, prop something always goes wrong at a property, just something randomly. You know, one one client told me as a had a story of a client of a tenant who ran one of these cash to gold kind of places that was dumping all the waste stuff out the back door into a ditch. It was air polluted the property.

Jim Costello: 18:31

It's like, you know, that's that's not the market cycle. That's you got a crazy tenant. So something happens all the time. But you know, the the the the the there's always going to be some sort of negativity, some kind of challenge out there. Behind closed doors, yeah.

Jim Costello: 18:49

They'll ask questions about how do you mitigate risks of some of these macro factors? What are the ways to deal with the risks? But not in the sense of should I do a deal or not? They're still going to do a deal. It's a matter of how do I think about accounting for these different risks and pricing them properly.

Jim Costello: 19:10

That's why I was talking about the whole scenario analysis. And so it's, you know, this notion that, you know, oh, we're in a downturn. Oh, it's slow. I can't I can't get anything done. You can still get stuff done.

Jim Costello: 19:21

Just how you react to it is is what matters. And, and that, that's I think where the optimism comes from. It's not, it's not, sometimes it gets blown into, oh, they're just talking their book and sure, you know, we all, where you sit does determine where you stand but I think it's a little bit more than that. I think it's also a mindset of just, you know, it's a hustle mindset. You know, no matter what the market's up or down, try and figure out how to make money in it.

Mark Bonner: 19:44

Right. And that and that and that that mindset defines commercial real estate, and and I respect it. But the sentiment versus reality gap is starting to close a little bit. You know, one thing that stood out in the latest MSCI data is this sentiment, and the actual reality of closed transactions. Brokers still seem very busy.

Mark Bonner: 20:06

Pipeline still appear very active. That's not a fantasy. But April transaction volumes slowed sharply as rate rates moved higher again. So which signal matters more right now, Jim? What are people saying that they're working on?

Mark Bonner: 20:21

Are the is it deals actually getting across the line, or is it wait and see a little bit more at this moment?

Jim Costello: 20:29

Yeah. You know, the April figures, I have an interesting research project underway on that. I I guarantee that the April figures will revise up. Like when the GDP figures come out every quarter, you'll have a preliminary release and then a final release and it changes a lot in between there. When we talk about deal volume on a monthly basis, the monthly data revises quite a lot.

Jim Costello: 20:58

The first month of every quarter tends to revise more than any other month of a quarter. So, I'm not sure that we can make up all the ground to suddenly have growth in deal deal volume again. But the first month of every quarter does tend to just the way the data comes in from smaller markets that are more opaque, that that takes some time for that to to get updated. So I wouldn't I wouldn't make too much about that. Now the the pipelines, you know, they're you're just you're just dependent on on this.

Jim Costello: 21:31

Right? That's just, that's just, it's the chatter and just the market talk. And, and because again, it's an opaque market. You have to talk to people to get information, to understand what's going on at times. But if you're looking for outside signals, that might suggest that there's there's problems, I'd be looking at the cost of rate locks.

Jim Costello: 21:53

You know, that that's that's going to be a clear early leading indicator that if that's going up drastically, that would that would show some sensitivity on the on the credit side, which then later would lead to challenges on on deal volumes. That's one thing I'd look at. I'd also talk with mortgage brokers and just talk about just general liquidity in terms of the number of folks that they are dealing with right now who are actively lending. If they start to give any kind of, well there's fewer people, I mean they're going be optimistic because again, hustle culture, but there's also sort of how you read the relative degree of hustle there. That's that's you know that was when I was at CBRE we're trying to do some surveys of all the different brokers in the company to try and build some sentiment tools.

Jim Costello: 22:46

But one thing we were looking at was trying to figure out the relative optimism over time of certain people. Because if one person says, oh, it's great. You know that they mean it's great. And if someone else says, oh, it's great. You know that given how they've talked about things over time that that that means it's okay.

Jim Costello: 23:09

It's okay, but it's not, it could be better. So that's the other thing where you need just to go talk to people, build relationships and get a sense of how they deal with stuff to, to know how to interpret what they're saying. That's, that's, just the relative degree of optimism changes from person to person.

Mark Bonner: 23:30

So I like the old boy scout motto, hope for the best, prepare for the worst. Right? So let's talk about the worst case scenario just for a second. Okay? Okay.

Mark Bonner: 23:38

Let's say the ten year moves above 5%. Maybe inflation stays sticky. Maybe deficits keep pressuring the bond market. Maybe geopolitical instability worsens, right, where we don't solve the situation in The Middle East. If that happens, Jim, what happened what breaks first in commercial real estate?

Mark Bonner: 23:56

Are we looking at transaction activity, regional banks, construction, private credit? Where does the stress actually surface initially?

Jim Costello: 24:06

Yeah. The first thing the first signs you'll see will be through the credit channels. They move faster. And the bond markets move a lot faster than the commercial real estate markets. So larger, more liquid market.

Jim Costello: 24:17

So there's more signals from there. I'd be watching to see say how do the corporate bond markets change. So like I go talk to my research colleague Jared on our fixed income side. He looks at the credit markets a lot and just, you know, just get a sense of, hey, you know, how, how, how are prices evolving there? Because, again, even though, even though it's all in the data stuff, I, I like just, I've been trained in this, I've grown up in this commercial real estate world.

Mark Bonner: 24:50

We all need to call Jared.

Jim Costello: 24:52

Okay. I just I talk to people and just, know, get a sense that way. So I'd look at that, but look at look at the bond markets, look at how you know that is being priced. I'd get a sense from the mortgage brokers, what's happening with the cost for a rate lock. Because that's, you know, if that starts going up, that's an important thing because that shows that, you know, there's concerns on the lender side about where this is going.

Jim Costello: 25:22

And, you know, so that's another signal I'll be looking to. And if that starts to tighten a bit, then you're going to have a situation where the buyers suddenly, know, the market was starting to clear at one price level and they're not comfortable at that point if suddenly their cost of debt is going up. They may not make an adjustment to their underwriting assumptions about income growth in the future yet. That might come later, but they're gonna pull back at first on if it it that might come later if it's just a reaction to inflation. But they're going to, you know, start to underwrite, a little bit more conservatively to protect themselves from some of the extra cost of capital.

Jim Costello: 26:06

But I think it creates another downstream, it creates another issue. If you have higher inflation, that's, that's a tax on consumer activity and taxes, you know, it's a necessary thing. We, you know, we have to pay for all the services. Yeah, you know, it's, it's, I, I'm not trying to bash taxes. I, but, you know, it does distort, the economy.

Jim Costello: 26:31

We need to pay it just to keep, you know, the subways running, keep, our our military funded and whatnot. But, you know, the anytime you increase taxes, you know, then you're taking money away from something else in the economy. So how much of that slows other parts of the economy? How much does that slow job creation and spending in other parts of the economy? I mean, if your your budget suddenly you're you're you're paying double to fill your car to get to the office every day or get to the store or wherever, you're taking that money out of something else.

Jim Costello: 27:05

And so there's that will later have an impact on the health of growth in property income. Because remember, real estate. Real estate is just the box where the economy lives. And if, you know, there's less spending and consumers are pulling back one area, then there's going to be less tenant demand for certain real estate tied to what they were doing. So like retail would suffer from some of that because suddenly I can't spend as much on maybe the, the luxury goods and, some of the consumer discretionary things.

Jim Costello: 27:42

So some of that element of retail, might pull back. Well, it would pull back a bunch because that's where consumers would pull back the most. I mean, unless they could borrow a bit, but you know, there's, you know, not as much, that's harder to do when rates are going up. So then later, you know, after you get sort of a credit shock, then you have a little bit of an income shock. And then between all that period, you probably see some lower deal volume because it's just harder to underwrite on, an acquisition at that point.

Jim Costello: 28:16

And if sellers don't need to move, current owners don't need to sell, they're just going to sit pretty and just wait it out. The challenge in all that is the loan maturities that are coming. Because as loan maturities come forward Right. And if it's hitting, you know, the next two years are kind of the peak of the wave of maturities we have to refinance. If you have that worst case scenario coming through at a time of a need for a lot of refinancing activity, that that could lead to some additional distress situations.

Jim Costello: 28:54

So far though

Mark Bonner: 28:55

That loan wall.

Jim Costello: 28:56

Yeah. Right. And and so far the loan

Mark Bonner: 28:59

I mean, that's been the thing that's been kicked down the road for quite a while. Right? Yeah. And, you know

Jim Costello: 29:03

It has. I I think people make too much of it at the same time. They they made too much of it. We first did, an analysis of loan wall right after things are starting to recover from the from the financial crisis. Like the, the, the data, we started collecting loan data around 2012 or so and we, we, gosh, what was it?

Jim Costello: 29:26

I think it was 2015 we did, the first time we did sort of the, kind of a wall maturities kind of analysis. And that was Sean Cain on our staff who helped me with that. I'm remembering that now. But that was that was quite a, you know, a lot of worries at the time because people are thinking, oh, none of this is gonna be refinanced. But at the time, it didn't become a big problem because they pushed rates down so low.

Jim Costello: 29:55

All the QE had the benefit, making it easier to refinance all that. Now, would be the opposite. This worst case scenario you're talking about would exacerbate the problems of the, maturities coming forward. But I think it's it's going to be mostly a problem though for certain property types in certain markets. Clearly the office sector because like CBD office prices peak to trough it was like a 52% decline.

Jim Costello: 30:22

And you take away half the asset value of the underlying collateral you're going to have a bad day. And that, that you know is why we have in our distressed asset sales. That's why it's at the highest across all of them. The other property sector, so you've had some good price growth. Industrial has, has gone through some transformative, moves, for pricing.

Jim Costello: 30:46

An asset that has to refinance next year and if it was like on a ten year loan, you know, an industrial building financed in 2017, Yeah. The, the value has grown so much along the way. Even if you get a little bit of a drop now, it won't be a problem. Other assets, it's really a vintage issue. Like I was doing some analysis looking at the apartment market and the apartment market is a really interesting one because of the way a lot of undisciplined capital got into it during the, the worst parts of the slowdown following the, the COVID crisis When the ten year treasury was at 60 basis points, people needed yield anywhere they could find it.

Jim Costello: 31:28

And some of these syndicators really got ahead of their skis, you know, buying apartment buildings at three caps and such. I mean, it was such a frenzy time. I mean, when I go on my social media, all my apps will pull at the time we're pulling up. They know that I like real estate. You know, they, you know, they know everything about you.

Jim Costello: 31:44

And so I get all these ads fed to me on invest in our fund, returns better than gold, you know, double digit IRRs. I'm thinking to myself, do they have a compliance department? Like because when I helped managers write PPMs, you had to go through so many legal hoops and you couldn't say stuff like that. So at the time, I was thinking myself, oh my, how's this going to end? So if you look at some of those deals and you bring them forward to today where you have a higher mortgage rate, forget about the worst case scenario you're talking about.

Jim Costello: 32:13

Just today's levels. You have a higher mortgage rate if you want to refinance. Yet to refinance at a lower LTV prices relative to the peak, are, are they're growing recently, but they're down from the peak for apartments. Right. You get that combination.

Jim Costello: 32:30

There's some some properties that you'll need to put additional money into if you want to refinance and you have to do a cash in refi. And that's, that'll be a tough sell for some folks. Now extended pretend, so long as a lender is willing to, you know, keep getting that current yield and just pretend like that loan is fine, that's great. It can help, you know, the current owners stay solvent for a bit. The lender themselves for a while might be interested in doing that just to maintain the cash flow themselves.

Jim Costello: 33:08

But bank charge off rates have been falling. I mean, there's a bunch of different lenders, I think the banks, there's some transparency there that is helpful. Yeah. They had been reserving a lot of extra capital to be ready for writing off bad loans and having a higher rate of charge offs. But the charge offs never got as high in this cycle as they did after the financial crisis.

Jim Costello: 33:34

It's like they were preparing for a bigger storm. And the hurricane kind of moved a little bit. It didn't quite take the path of the last one. And so, you know, they ended up with more capital in place than they actually needed. So they, they, they can do some lending, but, conversely, maybe they can, can be tighter now and clean up stuff and not extend, anymore because they don't need to.

Jim Costello: 34:05

Like if I'm a lender, I don't want to, foreclose. I didn't get into the business of lending because I want to own property. You know, I just want the safe, stable yield. So the foreclosure, you are crystallizing some losses there. And so I, if I can, if I can extend and pretend and it kind of prevents that loss for a bit and it keeps me with some current cash flow, that's fine.

Jim Costello: 34:30

But now that it didn't hit as hard as everybody thought, maybe they, they you know, face less incentive to continuing to extend and pretend.

Mark Bonner: 34:41

I mean, the industry is living through what I believe is our uncommon times. Right? In the last five years, you know, the industry has spent has spent its time lurching from one shock to another, the pandemic, inflation, rate hikes, bank failures, geopolitical instability, and now the flavor of the moment, the bond market volatility. I know we talked about optimism earlier, Jim, and I understand that dynamic quite well, the wholesale culture of commercial real estate. But do you get a sense that there's some growing fatigue that's now starting to set in here?

Mark Bonner: 35:15

I mean, is a lot all at once.

Jim Costello: 35:17

It is a lot all at once. And you're absolutely right that what we're going through is different. There's, it's funny. I like talking and my favorite presentations are the ones where I use no slides. Every now and again there's a slide that, I like.

Jim Costello: 35:32

There's one I like that it shows. I took, the RCA CPPI and the old, NREI, National Real Estate Index, that was like Dan O'Connor, Dick Wallach back, you know, from coal and then I worked with them a tiny little bit, at CBRE. Jim Sempuri, he was there too. That index, some of it is available on the Fed's website. And so I mirrored a match, the, the NREI data with the RCA data.

Jim Costello: 36:03

And you see a nice stable trend from 1985 up until 2019 where every downturn had kind of a similar pattern of, I mean the magnitudes were different in everyone in terms of how high it went and how low it went. But at a nice stable kind of cycle, always a very predictable kind of sine wave pattern. And it really should because a lot of that was driven by construction risks. And we had a number of construction driven cycles. But the upswing in prices and a downswing in prices this time was due to a set of unique financial shocks.

Jim Costello: 36:43

And it's given us a different price reaction and different market behavior than all those previous cycles back to the 1980s. And so that kind of difference in place is something that it's hard for folks to make sense of. And you know, all the old analogies they may have used about, well, where I'm, where are we in the property clock today? The position today tells you where you are tomorrow. No, not, not now.

Jim Costello: 37:12

It doesn't work as well because you have a different dynamic. It's, it's not the construction side so much that was driving the swings in the market. It's evolution of what's happening on the credit side and then, you know, different, applications of stimulus to the market and pulling away stimulus in the market that's driving a much wilder swing in prices recently than we've seen back to the 1980s.

Mark Bonner: 37:42

All right, final thoughts, Jim. A year from now, what's gonna matter more for commercial real estate, whether the Fed cuts rates again, or whether the bond market volatility calms down?

Jim Costello: 37:55

Final thoughts. I thought we're just getting started. I know. Well, look, I don't wanna dismiss what the Fed does. I mean, it's it's it's the Fed, you know, it's it's it's important.

Jim Costello: 38:07

They they provide some guidance, but they can only jawbone, the long end of the yield curve. That's more important. And the, the, the bond market, you know, that's, that's what, you know, Fed cuts rates. Maybe it helps, maybe it doesn't. What do the ultimate investors and all the credit instruments that, you know, people price debt against?

Jim Costello: 38:29

That's what matters. And, you know, if if there's some uncertainty and some challenges there in the market that would feed over to our asset class. But I am optimistic too. And so the other thing on all of this is that in the face of all this instability and uncertainty in the market, the benefit of investing in real estate, at least you have a hard asset. Yeah, you can point to it and say, own this, I've got this building, I have a certain cash flow in place.

Jim Costello: 39:02

You might get in trouble in terms of how you finance it and everything, but there there is that element of when it's a risk off kind of world. There's certain types of real estate with more of the stable income characteristics and low leverage that, you know, can help part of portfolio weather that storm. And so that's, you know, the one silver lining in some of the challenges we might face.

Mark Bonner: 39:26

Jim, thanks so much once again for coming on the show. We really appreciate your time.

Jim Costello: 39:31

Yeah. Fun times.

Mark Bonner: 39:33

Alright. We'll be back soon with another episode of First Draft Live, and you can also find today's episode in all of our past conversations, including with Jim on your favorite podcast app. This is First Draft Live.