NIC Chats Market Conditions Podcast with Jim Costello

Beth Mace (00:03):

Hello, and welcome to the NIC Chats Market Conditions podcast series.

Beth Mace (00:08):

My name is Beth Mace, and I currently serve as a Senior Advisor at NIC, focusing on the economy and capital market trends and implications. Thank you so much for joining us today. The focus of this series of the NIC Chats podcast is talking to experts and industry leaders impacted by today's property and capital market condition and trends as it pertains to the senior housing's transaction market, property, pricing, deal flow, and market sentiment. As you listen today, I hope that you'll find some insights and ideas that are relevant to you and your business, be it as an operator, developer, banker, private equity provider, public entity, or other capital provider. Today's podcast will be a free flowing conversation with my guest, Jim Costello. Jim is the chief economist for the MSCI Real Assets team. Jim and I have known each other for many years, tracing back to his days as an economist and senior strategist at CBRE when I was a director of research at AEW Capital Management, both located in Boston. So, hello Jim, and thank you for joining me today in our inaugural NIC Chat's podcast series focused on Capital Markets.

Jim Costello (01:17):

Thanks for having me and it shows the Boston Network continues to spread.

Beth Mace (01:23):

Yes, indeed. So, Jim, tell us a little bit about your role in the position for MSCI and from my perspective, you have a really unique window into the capital markets and transactions markets, and what makes this the case?

Jim Costello (01:37):

Sure. MSCI is a global index provider helping capital sources worldwide understand performance across a wide range of asset classes, public assets and private assets increasingly, they acquired a company IPD in 2012 that helped them get into the real estate market. It's now real assets because we have some indexes on the performance of infrastructure as well. But then in 2021, they bought the company I was with Real Capital Analytics, people might be more familiar with Real Capital Analytics because we had performance measures on sales, pricing of assets, and we're trying to bring all that together to help people understand the risks and investment opportunities that are out there and just all the information around the performance of these different asset classes. It's been fun being here because all the other asset classes, there's wicked smart people as folks up in Boston might say. And it's just been interesting to talk with people in other asset classes about how they're thinking about the world and the tools they use. And despite everything we try and do to make real estate more transparent and make, you know, the real estate information better, the other asset classes just have when everything is priced daily and by the minute, it's mind boggling, the type of things they can do.

Beth Mace (03:08):

Absolutely. And then if you go into the sort of the smaller asset type of senior housing that's even more, less transparent in the sense of the data that's out there, getting more and more transparent through efforts of our sister company NIC MAP Vision, and through all the work that we've done in the past with RCA and MSCI in terms of trying to get information out there. So we're gonna focus on senior housing, but initially, I want to give a broader perspective to our audience on, it's really what's going on in the capital markets. So, you know, as we've talked about a lot has happened in the capital markets since the Federal Reserve really began raising interest rates in March of 2022. Today the Fed Funds rate is in a range of five and a quarter to five and a half up virtually from zero, 17 months ago.

Beth Mace (03:51):

As the Fed has hiked interest rates 11 times, an unprecedented 11 times, and the Fed really acted quickly to try to raise interest rates to slow overall economic growth to try to take the steam out of inflation. And there's a lot of debate about what caused inflation. We won't get into that, but certainly we've seen a lot of progress and inflation now is, you know, about, what, 3%, 3.2%, I think in that range of CPI and the most recent data down from 9% about a year ago. So we've made great headway on that. But as a result of that severe increase in interest rates, there's been a lot of disruption in the capital markets. So can you focus and comment a little bit on what you think is going on in the broader economy fed policy, recent actions, and then how that's translated into capital market turmoil?

Jim Costello (04:36):

Sure. But instead of talking about the Fed relative to last year, I'm gonna take it back a little bit further. When I've been out and about giving talks and helping people understand my view of the world. I've been, I'm not a prop comic, but I've been using a prop a bit recently. I've been going into talks, I don't have one today. I've been going in with a rubber band. And really, that's what we're dealing with. If you go back to 2020 and, you know, the initial shock of the lockdowns, think of it like you got the rubber band, you're stretching it out, you pull it back and let go, and it just reverberates back and forth. That's what's been happening with every economic data series, every price measure, every investment market you've had this zigging and zagging back and forth as conditions react to the initial shock and some follow-up shock that was caused by it. And so, for instance, in the commercial property deal market we are tomorrow morning, Wednesday the 23rd, I'm not sure when this is gonna come out, but on Wednesday the 23rd, we're publishing our July figures for deal volume, and it looks like commercial property will be down 70% from a year earlier.

Beth Mace (05:57):

Well, 78 or 70?

Jim Costello (06:00):

And you were, I mean, you said it yourself just now. Wow, that's a, that's a big percent change, but it's a big percent change on a base that was elevated the year before. So it's kind of, you know, in this weird transition period of the zigging and zagging and are you in the, in the right place? And I think that's the thing that people are getting caught up on. They'll hear something like the 70% decline and thinking, oh, it's the end of the world. It's another financial crisis, but it's this up and down in response to that initial shock. And at some point it should settle out to something that's more normal.

Beth Mace (06:42):

How would that compare with like 2019? So pre-covid the volume transaction volumes of, you know, year to date or even all of, you know.

Jim Costello (06:50):

Oh, yeah. And that's, that's the kind of analysis that I've been doing. I've been talking to folks - don't focus on whether, you know, you're on the zig or you're on the zag. You gotta focus on sort of pre pandemic trends. And there too, it is down, you know, we are down on average, you know, that five years before, you know that those happy days from 2015 to 2019 when deal volume was at a healthy level, but not excessively high that generally speaking, were lower than those than those periods. Not as low as the current market relatives to last year though. But it varies by property sector. Some sectors are doing worse than others, and it's all about uncertainty. The office sector, particularly the [C...] office sector, that's doing the worst, that's the furthest down from that period.

Jim Costello (07:46):

You also had a little bit of an excess in that 2015 to 2019 period for the offices with Chinese money coming in and trying to buy at more of a capital preservation kind of motivation as opposed to an IRR driven motivation. So you had a little bit of excess pricing at the time. But even stripping that out the office sector is lower than it had been in that previous period. Other sectors are still a little bit good. The industrial sector, it is at a higher level than where it was in the 2015 to 2019 period. Apartments pretty close to that. So that is a transition. But generally speaking, things that are driven by the demographic driven strategies, and investment classes that have a demographic driven argument, and the strategies around demography, you know, investors have been focusing a little bit more on those simply because they're more predictable in this environment.

Beth Mace (08:48):

Does that include senior housing?

Jim Costello (08:50):

It includes senior housing. It's, I mean, it's down like every other sector.

Beth Mace (08:55):

We're talking transaction volumes.

Jim Costello (08:57):

Transaction volume and pricing. You increase the Fed funds rate and see the 10 year treasury going above 4%. It doesn't matter if you have some good income trends, you're gonna have a bad day just on the capital side, you know, that you can't get away from that. But that's, that's not necessarily the end of the world to have, you know, a little bit of loss on value, so long as you have some income still moving ahead. And that's what some of these sectors have. That's the challenge that people have with things like office, things like retail, things with some old hotels. They're just not sure. It's the uncertainty around what's the CapEx gonna look like moving forward versus the tenant demand versus my ability to finance. It gets complicated. And in the face of complication and uncertainty, buyers are gonna step back. Nobody wants to take that risk. And it really, the reputational risk of being that person that, you know, everyone talks about at a conference in five years and says, Hey, remember Frank and who did that last deal at the top of the market? Where's Frank now? Nobody wants to be Frank.

Beth Mace (10:11):

So there's still pretty big spread bid ask spreads. Right. Which raise uncertainty. And also, lack of transparency between what a buyer is willing to pay and what a seller is willing to sell at.

Jim Costello (10:23):

Exactly. But less so of a bid ask spread for say, the industrial sector.

Beth Mace (10:30):

Okay. So when will this settle out? What's gonna happen to cause this to finally turn? So there's lots of talks about maybe one, I mean, the fed's meeting this week in Jackson Hole, we expect a speech from Jerome Powell on Friday. Any speculation about whether there's gonna be one more increase? Lately the conversation shifted from, you know, the number of increases to how long will it stay high? How long will interest rates stay high? Will they go back to the levels that they once were, you know, is zero interest rate policy? Is that likely to occur again? And what has to trigger that shift in the markets? Is it just interest rate or what else?

Jim Costello (11:09):

Yeah, honestly, I'm not focused on what is or is not gonna be said at that conference to drive that come to Jesus moment for pricing, really, it's gonna be, it will be the distress situation.

Jim Costello (11:26):

You have current owners who are not realizing losses that they have probably seen on paper and nobody's forcing them to. And that's when you are going to see that, you know, really translate through to people being willing to give up the ghost when they're forced to. When they literally have that reckoning moment with their lender who says, you know, your loan's coming due, if we do an appraisal on this, it's 20% below where we gotta figure something out here. And I think that that has been delayed...the low interest rate environment allowed some people to kind of, you know, extend their loans out to low rates and kind of keep things going. But we have about $1.5 trillion maturing between 2023 and 2025 of commercial property loans that we're tracking. And that's as all that comes due you're gonna have some very uncomfortable conversations between borrowers and lenders. And I think that is gonna drive that activity.

Beth Mace (12:37):

Haven't the regulators been a little mindful of that? And I think they've given some new guidance to some of the lending institutions in terms of when they have to really be tough on some of the borrowers.

Jim Costello (12:47):

They have. And you know, the regulators, that'll be an important thing for the banks that are doing lending. But the banks aren't all of the commercial lending world. And in fact, they're not even the riskiest loans, the riskiest loans were the loans that were done by the debt funds. They were the folks that were doing the highest LTV loans, fewest covenants, shortest terms and that stuff. There's no regulator telling them what they can and can't do at that level. It's all about capital preservation and trying to get the most out of that investment that they made on the debt side. And so at that point it's like working with an old line hard money lender. I'm not sure that...

Beth Mace (13:34):

They're gonna be so forgiving.

Jim Costello (13:36):

Yeah. I mean, they have their own investors to look out for.

Beth Mace (13:40):

Okay. So with regard to senior housing, a lot of the debt financing for senior housing comes to the regional banks, and it comes from the GSEs, Fannie and Freddie, less so CMBS. So it's not the same sources of debt financing as some others. So do you have any insights or observations about what you've seen in senior housing?

Jim Costello (13:59):

Yeah. You know, if you think about it, because the GSEs are involved, for apartment, for senior housing, there's a little bit of a cushion that doesn't exist for other property types. When we look at the distress that is out there so far, either announced problems at properties, you know, rolling up to the portfolios that the GSEs, manage or just things of potential distress things, noting like delinquencies, short-term delinquencies, stuff like that. It's still a small portion of the market, outstanding potential distress. We reckon the senior housing sector is something like 3% of the total market current outstanding distress, we think is about one point half percent of the market. So it's not a big portion of the market so far.

Beth Mace (15:03):

Right. But about how much would that be? So, if you look at seeing housing relative to, you know, the broader commercial real estate industry in general, you'd say it's a, you know, 1%, 3%, something like that. But what's the dollar value of that? Do you have an idea? So I'm trying to just give it for our listeners a context because the listeners are gonna be all senior housing focused, or generally, or is that that a big number or a little number?

Jim Costello (15:26):

Well, the transaction market, let's start that way. For 2023, so far we're tracking sales of around $5.6 billion for the senior housing and care sectors. Versus a total market for 2023 across all property types of around $205 million. So senior housing is around

Beth Mace (15:48):

Billion, right. Billion.

Jim Costello (15:49):

Billion, right. Sorry. So senior housing is around 3% of the total investment market. So the fact that the outstanding distress is about 1.5%, says that, you know, it, it hasn't been impacted as much yet.

Beth Mace (16:05):

Probably focus more on the office. Right. That's where the dominant...

Jim Costello (16:09):

Oh yeah. The office sector is the dominant market rather dominant sector for outstanding distress just the, you know, issues around tenant demand and ongoing CapEx requests that is driving a lot of uncertainty and challenges in the office sector, and it's leading people to really pull back on what they want to do in offices.

Beth Mace (16:36):

Okay. So let's go back to your comment. You said that, you know, that sort of demographic strategies, so that would be what other sectors inclusive of senior housing, but what other sectors would benefit from sort of the demographic trends that are going on

Jim Costello (16:51):

Student housing? Yeah, apartments in general gets a boost from that. The medical office, type stuff. Anything that's lab life science gets kind of a twofer there both with a need for ongoing medical spending as people age plus new investments and new life science companies. So there's activity there and self storage gets part of that as well. People needing to store stuff as, you know, they have life circumstances change. So all those kind of demographic driven strategies, there's been more investor interest in those because it's, you know, there's a certain level of certainty. But speaking as an economist, you know, back in the day when you're at, we'd provide, you know, all these forecasts and stuff, but we knew there was a big cone of uncertainty around some of the economic drivers. But the demographic drivers, that is a little bit more predictable. 'cause population growth is you count the number of young men, number of young women, nature takes a course, and you get population growth. And that that is, you know, it leads to a property type that, you know, property types are driven by that, those demographic features just to have a more steady performance metric.

Beth Mace (18:09):

Okay. So let's talk about green shoots. So when will we start to see some green shoots in the transaction markets? I think you said first we have to see the distress. Yeah. To have that actually play out and to sort of provide some level of, I guess, transparency really, because everyone's talking about the distress. So what would it be another green shoot that we should be on the lookout for?

Jim Costello (18:34):

So, I think that is the first one. You know, do we see that start to pull away? I think the other important thing is just what's happening with the availability of debt. We had a record 2022 in many periods for a deal activity, but then also mortgage originations. And so we've seen a decline and mortgage originations over the last year, and that mirrors the declines in deal volume. And so the worry is that, well, it will it continue down because if it gets harder and harder to find a loan, it'll be harder and harder for deal volume to recover.But you know, what I'm looking at for, from some preliminary second quarter figures, kind of shows that has retreated a bit, but not at an accelerating pace as it had been earlier. Also, I'm not quite sure if, maybe,

Beth Mace (19:39):

Maybe leveling off a little bit...

Jim Costello (19:42):

Maybe leveling off maybe, I'm not sure yet. It's still a little preliminary that data, but that's the kind of thing I'm looking at. And you know, the, I've been looking at data that we have, kinda looking at loans from the loan level up. And I've been looking at the mortgage originations index that our friends that right here, Mortgage Bankers Association has some of their freebie sunglasses. They, Jamie Woodville there produces...

Beth Mace (20:05):

I know Jamie. Yep.

Jim Costello (20:06):

You should have him next. He does a mortgage originations index. And so I've been looking at that to see, you know, will we get an acceleration of the decline in debt of availability? Beause if you, if you take the debt stool away and 60% of the capital stack might be debt, and this was the problem that we had in the s and l crisis and in the financial crisis you had in both cases nearly a monoculture of debt in the financial crisis to run up the financial crisis. I had life insurance clients reaching out to me for help trying to make the case that there still is a need for life insurance lending. The CMBS market can't provide everything. And then the market fell apart and then there was just no debt for a bit because the CMBS market exploded.

Beth Mace (20:57):

What about debt funds? You see a lot of equity groups creating debt funds.

Jim Costello (21:02):

Well, there are debt funds out there, but my point though is that, you know, when you have downturns where you take the debt portion of the capital stack away, it hits harder than if it's just, you know, just repricing because of property income. The S&L crisis, that was the second, that was another example of that. You know, all we had nearly a monoculture of debt coming from banks and then banks wouldn't lend at any price because there was just so much uncertainty there. And that's what allowed the CMS market to get going originally because of that illiquidity in the other parts of the market. And so if we don't have debt disappear this time through, if it's more expensive, but just it's still available at some price, then that's the green shoots that I'd be looking forward to see that it's not continuing to accelerate down that we can find some kind of stable level on prices and deal volume.

Beth Mace (21:55):

So let's talk about this. What do we call the debt? The debt walk in terms of banks, regional banks no longer really providing as much debt as they once were because they haven't increased their interest rates on their deposits. So we see a lot of loans coming out of a lot of deposit base shrinking for the regional banks and going into investment instruments where a consumer like you or I can get a higher rate of return. And so there's a debt, a debt walk is what I was talking. There's, people are walking away from that. We used to call it a bank run or this, I guess we better call it like a bank walk probably than that. And so there's a lot of concern, in the senior housing industry. Because a lot of the debt is in fact coming from the regional banks. That's a really important source of capital. So what's your view on that, on that bank walk concept?

Jim Costello (22:50):

Well, here's the thing. At least you've got the GSEs there. So if your only source of debt was regional banks, this could be a bit of a problem because, you know, if you have one leg of the stool and you kick that out, you know everything's gonna get wobbly. But, you know, you've got at least two there with, you know, some of the credit coming from the GSEs. So there's an alternative. Now, this was one of the lessons of the Asian financial crisis as well. Those economies at the time, the debt that the Asian markets had was only bank financing. There was pretty much no other source of financing. And so they developed more advanced credit markets in the aftermath is a form of stability. So the senior housing sector, you've got a little bit more stability in the sense that you've got leases, you know, that other source. But I think also the notion of the, the regional banks, there's deposits, there's been stories about deposits walking and it creates issues where, you know, do they have the wherewithal to continue lending? Do they have to reserve more capital now because of additional risks? And so will that lead to a credit crunch on that side? Those are the things we're looking for. So far the in aggregate, I'm not seeing our preliminary Q2 figures suggesting that that availability fell even further.

Jim Costello (24:22):

I haven't looked at the specifics of the regional banks yet. There is one thing I am a bit concerned about. You know, there's been a lot of noise around the regional banks that I think is just wrong particularly there's been people saying that regional banks were behind 70% of all commercial real estate lending, and now it's just bogus. That was drawn from a misunderstanding of some fed numbers. It was a very good survey the Fed does of what banks are doing, and they will show in the banks 70% of commercial real estate lending came from those regional banks. But banks aren't everything because there's life insurance companies, there's the GSEs, there's debt funds, there's the CMBS market. And so it's an analysis that some in the industry did that just got some traction.

Jim Costello (25:13):

But they didn't understand that there were more sources of debt out there. But I think the regional banks, the other thing that's important here is that there's also sort of a bias against the regional banks. I think at times by the business press, you know, that people really glommed onto that story because, you know, they were trying to paint a story as if these regional banks are coming in and now they're doing 70% of the loans. They're trying to paint a picture as if it was, you know, Cletus the Slack-Jawed Yokel coming in and making loans on office buildings in Manhattan or something that these people aren't sophisticated and they're doing loans and more sophisticated investors are pulling back. And also that sort of bias against these areas, that was just wrong because it's not like they were suddenly doing more deals in other areas.

Jim Costello (26:05):

It's just that the investment market was moving more to the markets where the regional banks were more active. There were simply fewer deals. And the expensive coastal markets where the big money center banks and the CMBS market was so dominant. And as those deals pulled back, because people were afraid to take on the risk of buying a billion dollar office building in San Francisco as everything was so uncertain, it didn't fall back as much in middle America. And you don't have to, there's much capital that you're putting a risk if you're buying a senior housing facility in suburban Kansas City, for instance the prices in general are gonna be lower. So the deal sizes are smaller. And so that that migration to the secondary and tertiary markets that was happening on the investment side. And so it was only natural that the small banks were lending more on those areas. 'cause that's their bread and butter. They have those local relationships and know everybody. And that's the other reason why the senior housing sector is probably so driven by the regional and local banks. It's because it, it's still very much a local business. It's not, there's been attempts that people have had to consolidate the sector. We've sent a number of entity level deals in recent in over the last decade. But it's still somewhat disaggregated and

Beth Mace (27:32):

Regional banks are really important. So let's just shift a little bit, just briefly 'cause we're gonna have to wrap up in a minute, but let's talk about private equity. So there's a lot of, you know, private equity on the sidelines, right. Waiting to come in for distress or opportunistic funds. What is your sense of the volume of money that's there or what that private equity will play in terms of helping us sort of come out of this cycle that we're in capital markets?

Jim Costello (27:58):

Yeah, it's gonna be tricky, you know, because I think it's, people been talking a lot about dry powder and all the dry powder that's out there. And if you extend that analogy, the problem with dry powder is if a breeze pull picks up dry powder can blow away. I'm old enough to remember people were talking about dry powder in the start to the global financial crisis that, oh, look at all this money that's been raised. It's gonna protect the downside 'cause you know, we're gonna have capital flows in. It's gonna keep prices from falling. And once everybody saw that the writing was on the wall for price declines a lot of that money pulled back.

Beth Mace (28:39):

Well, most of these PE funds are fiduciary, so they have to be mindful of their client, right?

Jim Costello (28:43):

Right. You know, it just makes sense. But if they pull back, there's also an opportunity there because they pull back and say, okay, well we still want to get in the sector, but we now wanna go into distress and we wanna buy up everything on the cheap. And so that's what happened last time. And so I think people will try to do that this time too. But, you can't use the playbook from the last downturn. You can't just use the the GFC playbook. And in part because so much of the distress that's out there is different than before. The distress that was around in the aftermath of the financial crisis, it was financial driven distress. It was a property that was bought at too high of the leverage ratio, debt coverage coverage was just abysmal. And once everything reset, there was no way they were going to be able to make that loan live and be mature into some new kind of loan.

Jim Costello (29:40):

So they had to give up the properties. This time there are some examples like that. The multifamily syndicators in the southeast, there's some horror stories there of people buying at the peak of the market, raising money from private investors who didn't really know what they were getting into and loans coming due and just got awful rate and terms. So there's some of that, but by and large, the distress is more of a fundamental issue. It's not an office building that just is otherwise cash flowing. But with debt that was structured and properly and someone flying into the city, putting some new debt on and hopping back to New York that day, it's a building where the fundamental economic need has changed and nobody has come to the realization yet to what needs to happen to it.

Beth Mace (30:32):

That's for office. How about for other CRE sectors? How would say different than the GFC?

Jim Costello (30:38):

And for other CRE sectors? For retail this crisis is in some sense no different than what we've been dealing with. Retail's had for all property types, more distress over the last 15 years and others because it's always been sort of a constant low level form of distress, tied to obsolescence. It's not the internet coming in and displacing retail, it's just obsolete buildings that slowly have been given up to go. We overbuild retail tremendously in the seventies to the nineties, and then you throw some technological change in there of the, of the internet. It's not that it makes retail obsolete, it just obsolesces some buildings faster. And so we've had sort of a steady low line pace of distress in retail.

Beth Mace (31:32):

Any feeling, this might be more micro than, you know, but in terms of senior housing, how would this cycle vary from the GFC?

Jim Costello (31:40):

I haven't looked at this cycle versus last. The only thing that struck me was that it was just still a comparatively small portion of the market.

Jim Costello (31:53):

A demographic issue.

Beth Mace (31:55):

You're right. And one difference really was that this was a health crisis that started with the pandemic, right? And then see now was one of the sectors to get there. The market fundamentals for senior housing actually are improving pretty sharply. You've had almost, you know, two years of improvement in occupancy rates. Demand has never been stronger. Inventory growth has been slowed down. So the market fundamentals are looking good and it's the capital markets, it's a debt situation that's really been clobbering.

Jim Costello (32:20):

It's the same story as after the 9/11, you know, the hotel market for a year was down, demand was down, but then the stigma issue that had clouded hotel, performance went away and it had a steady rebound when people kind of went back to their real lives. And it just seems like, you know, the senior housing sector went through something similar.

Beth Mace (32:43):

Yeah, that's good. So in wrapping up, can you give us like a one minute soundbite on where you think we're heading, what's gonna cause it to shift and how long it's gonna be that we're in this turmoil of capital markets?

Jim Costello (32:56):

We are still responding to 2020. The pandemic is over, but the pandemic isn't done with us yet. We're still seeing the after effects of the medicine to deal with the problems that were there at the time in terms of a little bit of excess spending, a little bit of excess liquidity. And now we're getting some of the pullback in the other direction. I think the next three months, you know, we are still dealing with the after effects of what was a high level of deal volume in 2022, by the end of 2023, into December and then into January, February, 2024. I think that's when we're gonna get a really good reading on just where the commercial property market is, because we won't have as much of that distortion of that excess period of liquidity that we had in 2022. And that'll give us a really good read of where things are. So once it's, cold and snowy up this way, then I think we'll have a good read.

Beth Mace (34:05):

Well, I'll be hunkering down at that point. Yeah. So that's great. So Jim, I wanna say thank you very much. This has been really helpful. I think our audience is really gonna enjoy your comments and thank you for kicking off our first of many podcasts we're gonna be having on this topic.

Jim Costello (34:18):

Thank you. Always great to talk with you.

Beth Mace (34:20):

Thanks very much.