The State Of The Real Estate And Mortgage Note Space: Market Update For Q1 2023

April 26, 2023




CWS 245 | Market Update   We’re done with the first quarter of 2023. Over the last few months, we have seen some significant changes in the space that can inform us of how to move forward. In an ever-changing industry, we need to be aware of the movements happening in the real estate and mortgage note space (no matter how big or small). To keep you up to date, host Chris Seveney flies solo in this episode to give you a market update. From the state of the residential and commercial markets to the dwindling monetary supply in the United States, Chris has you covered and more! Join this episode as you uncover information that will help you navigate the markets.

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The State Of The Real Estate And Mortgage Note Space: Market Update For Q1 2023

We’re going to do a special episode where I’m going to talk about the state of the real estate and mortgage note space. We have finished the first quarter of 2023. We have seen some significant and very interesting changes starting to evolve. I want to mention these to investors so they can be out on the forefront of what we potentially may be seeing coming down the pipeline.

Mortgage Note Update

The first is the mortgage note space in general. Many of you know in 2021 to 2022 during COVID in the residential markets, there were limited assets available for sale. Those were priced at a premium. We have seen a significant uptick in the number of loans that have hit the market on the residential side. We will talk about commercial but we’re going to talk about residential where we had approximately $300 million of assets across our desk in the first quarter of 2023. Along with that, the pricing standpoint of those assets is also starting to come down. Sellers are starting to realize the pricing that they could get in 2022 because housing continued to go up. This deferred interest. This interest that was accruing was matching that rising price. We’re seeing the tables turn. What do I mean by that when we say the tables turn? When you have a nonperforming loan, typically you have taxes that you have to keep paying on the property. The property is accruing interest but you also have potential other expenses along with your legal. As long as the properties are maintaining or stabilizing in value or going up, it wasn’t a big deal because you realized you could get those funds back but now, the pendulum is starting to swing. What I mean by that is home prices are starting to go down a little bit. As the equity ratio of these assets which had equity or little equity starts to change, all of a sudden, you’re putting money out that door that you may not recover. Let me give you an example. Let’s say you have a $100,000 loan and that the property is worth $150,000 and the payoff is $140,000.
CWS 245 | Market Update

Market Update: Home prices are starting to go down.

  You’re going through and paying the taxes, which could be $4,000 a year. You have insurance on the property. You might have $7,000 a year of holding costs. You’re at $140,000. The next thing you know, you’re up to $147,000 under costs. That $150,000 asset could be worth now $145,000 or $140,000. Previously, that asset could be worth $160,000. It would start to go up. Now, it’s going down. Holding assets is going to be a negative for these investors who are holding these assets that they’re not doing anything with. Along with that, sellers are starting to realize now that buyers realize this and understand where the economy is headed. They are holding back and pricing things accordingly. There are still some sellers out there who are somewhat pie-in-the-sky. A perfect example was we looked at a pool of assets where we were at a high bid. This is over a $1.5 million purchase price. The seller wanted 50% more than the highest bid. It was not within reality to get to that number. We are expecting that we will see those assets probably in the next several months turned back around. At that point in time, it might be a lower price. That’s one of the things that I wanted to mention in that first quarter. For people who are investing in distressed debt, I would tell you to be patient. The assets are starting to come along. We have seen a lot more performing loans in the past several months. We’re starting to see now that uptick in the nonperforming debt as well. For people investing in distressed debt, be patient. Click To Tweet

Dwindling Monetary Supply

The other thing that was interesting that we have also seen as we look at the economy as a whole, and before we get into commercial real estate, is the money supply here in the United States and the banking industry in general. Everybody knows what happened to Silicon Valley Bank and Signature Bank when they had a liquidity crisis and had to run on the bank. They had to sell off some of their debt which caused them to go into the hole but here’s an interesting thing that happened. For the first time ever, at least back until 1959 when it was recorded, the monetary supply in the United States has gone down significantly. As everybody knows, I’m looking at a chart here. Our monetary supply went from $15 trillion up to $21 trillion. We printed about $6 trillion in debt. That now has gone down by about $500 billion. I’m not an economist but if you have more of something, it typically leads to inflation. When you have less of something, it leads to deflation, which will potentially lower costs. What is important to go along with that interesting component is bank contraction. There’s another chart out there that the banks have contracted by $100 billion. We have not seen a significant contraction like that since 2008. The other was in 2002 during the tech meltdown back then. If you looked at this chart throughout history, it’s a straight line across, and then it has a few blips that go up and down. Those are typical during the highest times of volatility.

Commercial Real Estate

The reason I talk about this is banks are giving out less money, and we have less money coming into the economy. That means there’s going to be less credit out there for people to buy homes for commercial, which we’re going to talk about next. Another interesting segment that happened is starting to make the news of a multifamily foreclosure in Houston. A syndicator had four assets that they had loans over $220 million on that went to a foreclosure sale. Everything that I’m going to state is my opinion. It’s not a fact. I’m not going to name the names of the entity I went through and read the loan docs and the foreclosure notices. First, I’m looking at the syndicator. This is important for people who invest in syndications. The About Us page of the company talked about the CEO’s experience in technology. The asset manager was an IT contractor. The investor relations individual had a little bit of real estate experience. The analysts that they had on their website, if you looked them up on LinkedIn, are overseas virtual assistants. This company bought over 2,000 units. For me, having been in real estate for 30 years and having built, managed, and overseen buildings with 500 or 800 or picking a large surplus of units, those are not for somebody that lacks experience. Based on what happened, that’s probably one of the main reasons. Another component of this was the type of debt they had. You’re going to hear a lot in the news coming up about bridge financing. What is that? Bridge debt is short-term financing typically at a variable interest rate. That comes in sometimes a second position. It could be in a first but a lot of times, it’s a second where the sponsor doesn’t have the down payment. They will contribute a portion of it. It’s a high debt to get refinanced out in 3 to 4 years. Unfortunately, what happened as everybody knows is in 2019 to 2021, you could get bridge debt financing for three years at rates of 4%. Those same rates now are at 8%. Based on the size of those loans, now the debt service is going negative. You’re seeing a lack of dividends being issued and a lack of cash calls. In 2008, the crisis was mainly because of giving a lot of loans that people didn’t qualify for. The other aspect of it was those 80/20 loans and some of these other loans, which were very low down payments. We’re seeing that happen now in commercial. We’re also seeing it in residential on the FHA side, which requires a 3.5% down payment. Those loans now have a 10% delinquency rate. The reason why it’s important to talk about commercial real estate is a lot of people who focus on single-family don’t understand the importance of the commercial market. For a lot of banks, especially small and mid-sized banks, a lot of their lending is on this commercial debt. They can turn around the residential debt and sell that to a government-sponsored entity like Fannie Mae or Freddie Mac. This commercial debt is debt that they hold. This low-interest debt that they may be holding with recent maturities or these delinquencies is going to put a significant impact on people with liquidity. You’re going to see lines of credit getting called and credit card reductions. There’s talk now about car lots not being able to pull lines of credit for the types of cars on their lots. As more money comes out of the system, the harder it is going to be to get financing. I will state again. We have our funds in the mortgage note space. We don’t take on debt. We think we’re in a prime opportunity with the cash we have to come in and buy this underlying debt but I want to reiterate to people some of the things we’re seeing. I will share with you two examples that I thought were very interesting. One is we had an office building note sent to us that the office building is worth about $5 million. It’s a $3 million note. It’s performing but it matures in eighteen months. The bank is willing to let it go at a discount because of several factors. One is 40% of the tenants’ lease expires within the next six months. The owner does not have commitments. We’re hearing the largest tenant in the building already said they’re not going to renew. When you think about that, the revenues are going to drop. The loan was written at a very low-interest rate as well. The bank is getting funds at a low-interest rate that’s going to be maturing. There’s equity in the property but if they do lose 25% of the tenants, all of a sudden, that property now will probably flip upside down. I give the bank credit in this instance. They’re being proactive to try and get this debt off their books. On the same token, investors who are looking at this debt understand the situation and are already pricing in that price damage accordingly and assuming what is going to happen. The other interesting thing that we have seen is a small office complex. It’s a two-story building on a main road with approximately 15 to 20 tenants. This place is 95% leased. It’s worth approximately $1 million to $2.5 million. It’s a great location with great mixed-tenant use. There’s not one tenant that takes up a huge amount of space. The owner has a $600,000 loan or 30% LTV on a $2 million valuation. The loan is maturing. The bank will not refinance them. The bank is not willing to refinance the office. I’ve heard about this on two other phone calls I’ve had with people that I’ve worked with in the past who own office buildings. They are struggling to find or get refinanced on these opportunities. People ask, “Why is that the case?” Let’s go back to COVID and work from home. A lot of companies now are downsizing their office space in that work-from-home environment and allowing people to work from home or certain staff to work from home or reducing office space because they’re going to do shared offices. People who come in 3 days or 2 days a week may share the same space, almost like a WeWork-style office within that office for people to share because that will reduce costs significantly. Between the commercial side of things, bringing this full circle, we’ve got several major impacts going on. We’ve got a lack of people going back into the office. The office space is shrinking. We have seen in Silicon Valley what’s happened. I forget the names of the companies. They’re giving $50 million to $100 million buyouts to the owners of these buildings to get out of these leases.

Multifamily Real Estate

Between that and the interest rate increase on these short-term loans, it’s looking like it’s going to cause significant financial harm in the space. We’re just talking about office retail. If we talk about multifamily, this is another interesting segment. An article came out. It was Bloomberg. Multifamily sales are down 74% in the first quarter of 2023. Let that sink in for a second. People will say, “Why has it gone down 74%?” There are several factors. One is this foreclosure that we talked about earlier. That was bought at a 4% cap rate. The cap rate is almost like the interest rate that you’re ready to return on that asset until you try and liquidate it or what you will sell it off of based on NOI. It’s a measuring stick. It’s not something to always abide by but it’s a measuring stick to get an estimated value. Let’s say interest rates are at 7%. Previously, you could borrow money at 3%, which is below a 4% cap. Let’s say that the differentiator has tipped about a 1 to 1.5-point spread. If interest rates are at 7%, you can’t borrow money to buy a 4% cap building because you would end up probably being at a 1% return where “risk-free” money from the government is around 4.5%. It’s causing people not able to finance these deals, or not making sense to them to buy these multifamily deals until those cap rates start to go up. Cap rates in the first quarter of 2023 went up 0.3%. Thirty basis points are significant and potentially the largest that they have on record. The theme that you keep hearing in this discussion is the swings that we’re seeing are historically the largest we have ever seen. People think that we’re in a safe cushiony spot. I can’t predict what is going to happen. Government intervention can impact a lot of things but we are seeing some major swings. We saw that during COVID when things went up significantly because there was an insurgence of money into the economy. That’s getting sucked out, and because of the interest rates, banks and other assets are starting to get devalued based on the borrowing cost.
CWS 245 | Market Update

Market Update: The swings that we’re seeing are historically the largest we’ve ever seen.


Residential Real Estate

We’re seeing a lot of concern coming into that space. What does all of this mean? Where is all of this going? I’ve touched upon a lot of things within this episode of my opinions on what I’m seeing on the real estate side of things. Residential real estate is down to an MSA and not as big as a macro but from a macro level, banks have less money. We have less inventory. Credit is tightening. Personally, I’m not seeing a significant increase in home prices anytime soon. We are going to see softening in prices because of several factors. One, real estate lags the market by easily twelve months. If you go back to 2008 in that downturn, real estate’s lowest prices were in 2010 and 2011. Based on the interest rates we’re seeing now, I’m not expecting them to go down significantly in the rate of inflation and job loss. We’re going to see a significant increase in distressed debt coming on the market. We’re at all-time lows. I don’t think we will get to the percentage or the rate we were at in 2008 but historically, the norm is around 4%. Now, because of COVID and everything else, we’re at 1.7%. If that doubles even though it’s still going to be at an average, it’s going to shock the system on the residential side. Other components that impact that are rent rates. Rental rates are starting to soften as we mentioned in this multifamily aspect. We can check multifamily is starting to soften on the rent rates that will go back and impact the single-family. The other component that’s going to impact the residential side is the short-term rentals. We had a significant uptick in certain markets on short-term rentals.

Pay Attention

People who got in early should be okay. People who got in later and were banking on returns from 2020 to 2022 potentially could see some trouble there because if they start going cash-negative, there are not going to be many options for them to refinance. That’s the residential side. On the commercial side, which I do believe has a significant impact on the overall markets and the banks, pay attention to what is going on. We have seen several bank failures. There was a report. BlackRock has $90 billion in loans to sell from Signature and a few of these banks that ended up going under. To give some clarity, in the 2008 crisis, BlackRock was responsible for selling approximately $130 billion of assets. We’re at the start. There’s already $90 billion that they’re going to have to start. Many people think we’re starting to peel back the first layer of the onion. I hope people don’t think this was a gloom-and-doom episode. It’s more meant for people. If you’re investing in traditional real estate, do a little extra due diligence. Look at some of the alternatives. We are in the note space. We do believe this is going to be an opportune time for us as note investors because if you ask people out there, every major news or institution is predicting distressed debt to increase. If you're investing in traditional real estate, do a little extra due diligence. Look at some of the alternatives. Click To Tweet Looking at alternative investments that do not take on debt structure and use the equity from the investors is going to pose a much lower risk compared to some of these other opportunities like the multifamily deals. Years ago, you may have been able to get 15% yields on those returns but now, we’re looking at, for example, this foreclosure. These investors lost everything or 100% of their money. To rub or add salt on the wound, a lot of people like to invest in multifamily because you get all this depreciation, including bonus depreciation. In this situation, from what I read, and I am not an accountant or a CPA but I thought this was very interesting, they took that bonus depreciation in year one but because they went under, they have to give that bonus depreciation back. What does that mean? On your K-1, you took extra depreciation, which gave you a better tax analysis. You probably got your money back. You have to give that back. Not only if you invested $100,000 in this investment that $100,000 is gone. You’re going to have to go back and give money back to the IRS as well. People don’t talk about these things pretty often or don’t talk about these risks. A lot of times, people only talk about the upside that people can see or go through but we’re starting to see issues and cracks within the markets. I want to come on and share that with people because I thought it was an important thing to discuss with investors some of the things that we’re seeing in real estate, whether it’s commercial or residential, and in that note space as well. I hope you enjoyed this episode. Hopefully, you enjoyed it. As always, please leave us a review. Thank you all.  

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