Editor’s Note: In a recent Oxford Income Letter mailbag, Chief Income Strategist Marc Lichtenfeld wrote to a reader, “The commercial real estate business is a tough one right now.”
And today, I’ve invited Shah Gilani from Manward Press to share his take. Check it out below!
– Rachel Gearhart, Publisher
Interest rates, interest rates, interest rates…
2024 will be all about interest rates.
The U.S. mortgage market just had its strongest week in months. According to the Mortgage Bankers Association, in the week ending December 1, total home loan applications increased by 2.8% compared with the previous week.
That’s good news, I guess… if you think mortgage rates being at 7.17% is something to cheer about.
At least they’re moving in the right direction.
But that good news applies only to residential real estate.
There’s still a huge problem lurking inside the commercial real estate (CRE) market…
Record office vacancies.
That’s bad enough on its own… but add to it the significant number of commercial mortgages due for refinancing in the coming years… and the fact that new lending rates for CRE are expected to be considerably higher than existing mortgage rates…
And you get a recipe for disaster for banks that hold real estate loans for office buildings in big cities such as New York, Los Angeles and San Francisco.
Here’s what I mean…
Situation: Dire
Office vacancies in New York City recently hit a record 22.7%, up from a decadeslong average of 11%.
In San Francisco, things are even worse. Office vacancies recently reached 33.9%, a new high for the city.
In fact, the vacancy rate in San Francisco has hit new highs every quarter for nearly two years.
Many of the problems facing office building owners and investors started with the pandemic. While it’s possible that over time we could see more workers return to the office, we are very unlikely to see a wholesale shift.
That means vacancy rates will remain high… at a time when commercial mortgages are due to be refinanced at higher rates.
The problems are so dire in some areas of the CRE market that landlords have simply stopped paying mortgages or have declined to refinance. In some cases, the banks that issued loans to these landlords have started to repossess the buildings.
And that’s no good.
Some of the biggest names in CRE, like Brookfield and Blackstone, have defaulted on mortgages and handed back the keys to their office towers.
This is a shrewd business move if you’re a landlord… but a disaster if you’re the bank that financed the loan.
I see the biggest risks for banks that have a lot of exposure to CRE, specifically office space, in the nation’s largest cities.
They’ll be in trouble… and soon.
Of course… that spells huge opportunity for investors who see the writing on the wall.
I’m playing this trend by identifying banks that have large exposure to CRE as a percentage of their total loan volume. I’m targeting them by using put options with expiration dates that go out to the second half of 2024.
I prefer using put options rather than shorting the stocks. Purchasing a put option gives you a capped downside (the amount you paid for the options) and unlimited upside.
Over the next 18 to 24 months, the action is going to be fast and furious… thanks to the $1.5 trillion in loans coming due by the end of 2025.