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As we pick up the pen for our last commentary of the year, we recognize that it is customary to share a "year in review" to discuss how themes have evolved over the course of 2024. In this spirit, we will share a brief summary of this year, but quite frankly, we are more excited about the prospects for the coming year than we have been in a very long time, potentially the last decade. So, at the risk of writing commentary that has the potential to not age well, we will venture a bit further into prognostication than we normally do.
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TLDR - Themes we are highlighting in this publication
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While 2024 was a year of volatility, by in large, 2024 was also a year of small wins - policy rate cuts, post-election market strength, the market pricing risk rather than avoiding it, and meaningful CMBS volume bringing CRE liquidity.
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Looking Ahead - Opportunities in 2025:
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As payoffs climb due to CMBS volume, bank liquidity is expected to increase, driving spread compression across the capital stack as more efficiently priced capital returns.
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Many employers are implementing return-to-office mandates in the new year, driving increased office utilization while layoffs of those unwilling to return-to-office could provide a reprieve to the Fed's inflation versus unemployment balancing act.
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As mentioned in previous commentaries, the volume of sidelined capital in money market accounts is larger than some countries' GDPs. The redeployment of this capital into longer duration investments should greatly benefit commercial real estate.
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REAR VIEW MIRROR - 2024 IN REVIEW
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The roller coaster was once again in full force this year, particularly in the rates market. However, comparing year-end 2023 to year-end 2024, the results are less dramatic. In the Treasury/SOFR world, we consistently overcorrected in both directions, only to end very close to where we began. If the market closed today, the 10-year Treasury would be within 25bps and SOFR within 75bps of where we began.
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Post-election, the pendulum has potentially swung a bit too far into inflationary territory in our opinion, but this is more consistent with our belief in the normal (not higher) for longer expectation. We felt it last year and we still feel it now... the anemic rates we've endured since the GFC are not the norm; that was an extended hangover from the worst downturn in one hundred years.
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The flip side to this is that today's rates (particularly SOFR) are also a hangover of their own, built on excessive liquidity injected during COVID. Our belief is that we finally have a chance to settle into a more conventional environment. As the labor market softens, inflation will slowly moderate, ultimately approaching the FOMC goal of 2.0% -2.5% PCE, allowing SOFR to be driven back below 3.0% and a normal term structure in Treasuries, leaving the 10-year in the high 3s or low 4s. The data helps frame this as well, because historically speaking the 10-year treasury has averaged 4.55% since inception (yes, 1790) and spends as much time above 4% as it does below that line. Recent history has been skewed by some massive events but all trends return to the mean at some point. Barring the next black swan that could drive the market in either direction (and would be impossible to underwrite), expecting an "average" that is driven by the not-so-invisible hand of the FOMC seems like the most rational approach.
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Source: Bloomberg, Global Financial Data
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What the market did more consistently in 2024 was price risk. While there are hills and valleys to everything, the constant trend for spreads of all sorts (IG corporate bonds, high yield, leveraged loans, levered structures like CLOs, and yes, CMBS) was an improving landscape for risk taking.
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Source: Bloomberg, Green Street, BofA Securities, Barclays Capital, Citigroup, Credit Suisse, Deutsche Bank, JPMorgan Securities, Morgan Stanley, and Wells Fargo Securities
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Corporate debt is the easiest to track, so we default there for the most transparent message. While actual yields remain in the upper quartile, the allocated risk premium is collapsing to a decade low, with record spreads in sight. We will touch on this in the second half, but we see a viable path for records to be broken here.
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Restarting the Flywheel - Debt Liquidity
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While headlines in CRE provided significant headwinds touting CMBS delinquencies, AAA losses, office attendance stuck in the 60%s, etc., throughout the year supportive underlying asset fundamentals and the growing demand from potential bond investors drove spreads tighter at all points on the curve, AAA through non-IG, even as volume picked up dramatically. Even the much maligned office component of one year ago has once again grown as a percentage of larger and larger deals. Yes, that means more and more office loans have a path to paying off at "reasonable" cost.
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CMBS is far from the only place that has benefited from spread compression this year. Lenders of all sorts have either chosen (belief in lower risk) or been forced (competitive landscape) to allow lending standards to loosen (ie tighter DYs) while also tightening loan spreads. Our typical life insurance loan once required a spread of north of T+200, while now we'd be hard-pressed to see them quote above mid-high 100s. Debt funds are benefitting from better back-leverage and also feeling the pressure to put out capital, allowing them to tighten 50-150 depending on profile.
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So where do we go from here? Perhaps it's time for us to turn our focus forward to 2025...
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LOOKING AHEAD - OPPORTUNITIES IN 2025
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Remember in late 2023 when the phrase "Stay alive to '25" was in vogue? Well, we "survived" quite well, and some investors even found significant "wins" in 2024. We are now at the precipice of 2025... so what's next? What can we hope to see during 2025?
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Here we stand at a confluence of events so compelling they have the ability to rewrite the script for years to come. In the same way that a decade of low rates created the expectation that they were the norm going forward, losing banks as a support for our marketplace for the past 2-3 years resulted in a sense that they may never bring their inexpensive capital base back to the commercial real estate market. This too will prove false. Much like our view that risk-free rates are normalizing, we think the biggest story of 2025 may very well be the re-emergence of bank lending.
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Admittedly this is a risky statement, and we are typically hesitant to go out on such a limb. However, given the amount of bullishness we are about to express in this upcoming section, we are likely to face some amount of "that didn’t age well," so why not lay it all out there?
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As 2024 progressed, systemically important banks spent most of the year trying to slowly reenter the CRE lending space in targeted ways with little luck and, we might argue, even less exuberance. That changed dramatically around the end of Q3 and excitement, or even FOMO, intensified post-election. A combination of: (1) increasing payoffs (even a few office loans), (2) less onerous capital treatment (it is quite possible that Basel Endgame fades away), (3) passage of time that allowed for meaningful loan loss reserves to be built, (4) the potential for a bottoming of office values, and (5) a politically unified Washington DC softening the regulatory environment has allowed banks to once again offer competitive financing options directly to borrowers as well as through warehouse lines, driving down spreads at debt funds. Life insurers have feasted for 2-3 years, but now competition is heating up just as capital deployment goals are once again growing. Borrowers will benefit from the return of this competition.
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While a bank's share price is not a direct indicator of how much CRE lending they will do, it is an indicator of expected activity and the regulatory environment they will face. There is no easier way to see the bank market's view for what is ahead than by watching the massive run-up in the KBW (Bank Index) over the past 14 months.
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Source: NASDAQ, Bloomberg
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Tangentially, this could also be the environment where bank mergers begin again. In that case, incentives to grow asset bases are even more stark and could lead to some aggressive growth strategies that would almost certainly include our space.
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While we do not mean to imply an immediate windfall of bank capital availability beginning January 2025, we do believe that at this time next year, the discussion will center around how the re-emergence and prevalence of bank capital has positively changed the CRE landscape into the next real estate cycle.
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CMBS Starting the Flywheel
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Truthfully, we have mentioned this in prior quarters, so this is not a new part of today's landscape. What is new, however, is the sheer volume. Both conduit and SASB CMBS executions are prevalent with CMBS volume up 63% year to date over 2023 to $136 billion (including Agency CMBS which is housing specific) with improved pricing, regardless of asset type. Most critically, office loans of many stripes are finding a variety of refinance options. 5-year, 10-year, fixed or floating, stabilized office loans can be sized and priced with realistic expectations, and the bond buyer market has shifted from shunning the risk to pricing the risk. Year to date, over $20 billion of this year's CMBS volume is attributed to office (or mixed-use with an office component) loans including both SASB and conduit executions. Spreads are tightening, demand is increasing, and deal size is growing. Much like any other cycle, when investor sentiment palpably shifts (and it has on the debt side), the virtuous cycle begins. In this case, loans get paid off that were recently feared to be lost causes, and limited construction leaves a considerably more constructive landscape at today's basis at the same time the restoration of the "Five Day, In Office" work week may finally be upon us.
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Back to the Office - All Five Days (5DRTO)
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This development has two positive, intertwined components for the years ahead. The most transparent one is a re-engagement of the urban core thanks to a uniform move back towards full workweeks for both public (federal) and private jobs. We won't spend any time discussing how great that will be for dynamic work environments or for contemplating long-term value for some of the most expensive real estate in our country. Instead, it is the second facet of 5DRTO that is worth a few extra words. We've seen some very large companies (banks, tech, etc.) all require a regular work week, with non-compliance as a fire-able offense. Now, the new Department of Governmental Efficiency (DOGE) is threatening to do the same. In both cases, it seems to us that the employers drawing a line in the sand may actually be hoping for non-compliance as a way to trim payroll. Layoffs can carry a tough stigma in the long term, but self-selected unemployment is unlikely to get painted with the same brush.
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The FOMC feedback loop may not have been as directly effective at cutting inflation this time around without the help of floating-rate home mortgages. However, corporate America has felt this pain, and a higher unemployment rate (no matter how we get there) may be just what the doctor ordered to help with that last mile of PCE. A moderating job market equals lower inflation, resulting in lower short-term rates. The virtuous cycle begins once again.
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While we will begin and end with debt, because that is what makes the world go around, we can't forget the capital formation that has occurred over the past two years. Lending (directly or through bond purchases) is simply the lower-risk end of the investment spectrum. As more capital is being put to work at that end of capital stack, there is more availability on the equity end of the spectrum. In the last five years alone, money market accounts have skyrocketed from $4 trillion in investable dollars to north of $6.5 trillion! While we do think that the 10-year Treasury may be appropriately priced around 4.0%, we believe that SOFR will normalize in the medium term to somewhere in the low-to-mid-3% range. As the FOMC continues to cut the policy rate, this money will once again find its way back to investments with duration. There will be a significant delay for this capital to come off the sidelines, so we are not anticipating all of it to flood the market at once. However, even a slow trickle of that scale will have meaningful impact.
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Source: Bloomberg, St. Louis Fed
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Add to this the global position the US holds thanks to long term stability and recent outperformance, and even a strong currency can't dissuade foreign investment coming over the border. Currency hedges may be expensive, but losing money in a recession is much worse.
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The Mosaic Theory - A Style of Financial Research in which the Analyst uses a Variety of Resources to Determine... Value
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We first heard this in a CFA module so many years ago. It specifically refers to a way to value a particular stock. We think of Mosaic Theory as the only way to analyze long-term investing, especially if the only options are to either invest or sit in cash. There are plenty of risks in the months and year to come, not the least of which is a unified Washington DC (historically, gridlock is the investor's friend), and black swans are considerably more common than we'd like to admit. However, when we pile all of the positives together, we can't help but think that the resulting mosaic favors the CRE investor.
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As we alluded to earlier in regards to historical interest rates, our opinion hasn't changed. Our economy is closer to "normal" than it has been in 17 years. Short-term rates (2-5 years) remain elevated, and a 4.0% 10-year Treasury is much closer to our expected long-term trend on a historical basis. This dynamic allows lenders, buyers, investors, etc., to deploy at the current entry point, even if risk spreads compress from here, which we think they will.
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Steady pressure makes diamonds, and pressure of the good sort is what the market is about to feel. Pressure from global investors looking for safety, pressure from cash in short-term investments looking for longer-term (and higher-return) homes, and pressure from the largest lenders in our world returning to the market. Events can always derail us, but rarely does the capital mosaic paint such a bullish picture.
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For the readers who don't remember 2006, fixed-rate AAA CMBS traded as tight as T+17.5bps versus today's T+75bps, and BBB's were 200-300bps tighter than today. We may not get back to those astounding levels, but corporate bonds appear to be threatening their records with spreads dipping below 50bps today versus the 5-year average of 65bps and November 2022 high of 111bps, so one can only assume CMBS AAA's have plenty of room to tighten in tandem.
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Source: BOA, Barclays, Citigroup, Credit Suisse, Deutsche Bank, JPMorgan, Morgan Stanley, Wells Fargo, Green Street
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HAPPY HOLIDAYS AND EARLY NEW YEAR
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We are publishing this commentary a little early this quarter to avoid getting lost in the holiday shuffle, so the major themes mentioned above will shift a little by the time the books close and we all begin singing "Auld Lang Syne" to ring in the new year.
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2025 is not without risks: Could tariffs decrease global demand for dollars? What are the impacts of military decisions? Could other flagging economies bring us down? Could the market begin to severely dislike a unified DC? Only time will tell. However, the known landscape appears to us as one where the magnitude of positive themes outweighs the negative by enough for us to suggest 2025 will be a great year.
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During this holiday season, we want to express our gratitude to you, our clients and partners. Our toast to you - may you deploy your capital early in 2025 and staff up to get the most out of a great vintage!
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