Uncovering Opportunities in Commercial Real Estate: The Power of Location

Hello everyone. Welcome to another episode of Understanding Edge, brought to you by Diamond Hill. I'm Jessica Schmitt, Director of Investment Communications, and today, I'm joined by Douglas Gimple, our firm's senior portfolio specialist for fixed income.

In today’s episode, we’ll discuss the Fed’s recent meeting and the latest outlook on inflation and rates. We’ll also dive into the commercial mortgage-backed securities market and look at recent deals and how the market has evolved.

Whether you are a regular listener or tuning in for the first time, we hope this episode offers valuable insights. So, sit back, grab that cup of coffee or tea, and let's get started. Thank you for tuning in, and I hope you enjoy this conversation with Douglas Gimple.

Hey, Doug, great to have you back on the podcast.

Thanks, Jess, for having me on as always. It's a pleasure to be here.

Well, great. Let's kick things off as we normally do. The FOMC meeting was held June 11th and 12th, and hoping you could start by giving us some highlights from that meeting and any key implications for investors.

Well, Jess, the theme over the past several FOMC meetings has been consistency, and June's meeting marks the seventh consecutive meeting in which the Fed has held rates steady, surprising, really, no one. The biggest shift was in the summary of economic projections, which includes the dot plot. And the dot plot, if you'll recall, provides insight into the various members' expectations for the future path of rates, combining all of the members' projections into one chart that communicates expectations for future rate changes, and this was the biggest change coming out of this meeting.

The Fed has communicated an expectation for three 25 basis point rate cuts in 2024 since the beginning of the year and, more accurately, since the December of 2023 meeting. At this most recent meeting, the Fed lowered expectations from three 25 basis point cuts to one 25 basis point cut by year-end, and 2025 expectations were also adjusted. Previously, the projection called for five 25 basis point cuts, and the new dot plot indicated four 25 basis point cuts. A reinforcement of that higher for longer mantra that the Fed has been talking about.

Also, in the economic projections was an expectation that core inflation will move to 2.8% for year end, which is higher than the previous 2.6%, most likely fueled by some of the stronger first quarter inflation that we saw. In his press conference, Chair Powell reiterated that the direction of rates continues to be “meeting by meeting with data leading the way.” And despite the ongoing communication from the Fed, they've been very clear about everything. The market continues to defy them, now pricing in two 25 basis point cuts by year-end, looking at roughly November and December, if you're looking at Fed fund futures.

So, Jess, as we've discussed in prior podcasts, the Fed strives to remain nonpolitical, but this will be put to the test in the coming months. There are four FOMC meetings before the end of the year, and the general consensus is that July is off the table for any kind of change in policy.

We've got the Jackson Hole Economic Symposium in late August, which is not an official meeting, but that's been used in the past to communicate any changes and expectations interim meeting from the Fed.

So that leaves September 18th, November 7th and December 18th as the meetings in which the Fed can move. September 18th is 48 days before the November 5th election, and November 7th is, obviously, two days after the election, when we still may not know who won. So it's hard to imagine the Fed making a move at either one of those meetings unless there's clear economic data that is so compelling that it forces their hand. Otherwise, any move could, and isn't necessarily meaning that it is, but could be construed as trying to help either candidate with the election.

So that means we're looking at December for the first rate cut, and unless there's a very significant shift in the markets, 25 basis points seems most likely for that initial step in the new easing cycle. Because as we all know, they can go 50 basis points, but the expectation is that we're going to be kind of 25 basis points from here on forward, unless the information dictates otherwise.

As we've discussed many times in the past, we here at Diamond Hill, we're not here to predict the movement of interest rates or how the Fed will behave. We're here to analyze the data and prepare our portfolios for any number of scenarios that could evolve.

And Doug, you touched on this briefly, but we've talked about in the past how market expectations sometimes align or misalign with what the Fed communicates. So dive in a little bit more into where we stand on that issue today.

It's more of the same. The Fed has been very clear and consistent in their approach to communicating their expectations for the future path of rates. While some may not agree with how they've approached this rate cycle, I think we can all agree that they've been very transparent and direct in the communications.

Earlier in the year, the Fed was adamant that they were expecting to lower rates during 2024 to culminate in 75 basis points of easing throughout the year. The market completely disregarded that and started the year with expectations for more than six 25 basis point cuts totaling over 150 basis points in reduction, which would've brought the fed fund rate to 3.875%.

By the end of the first quarter, the markets had shifted in line with the Fed, projecting just under three 25 basis point cuts by year-end, but that shift in expectations came with some pain, and the Bloomberg US Aggregate Bond Index was down 78 basis points in the first quarter as the market readjusted their expectations.

In the days leading up to the June meeting, the market was looking at roughly, we'll call it 37 basis points in cuts by year-end, and after the June meeting when the Fed said they were only going to go once at 25 basis points, fed fund futures were pricing in 50 basis points of cuts. So, basically the Fed has been very consistent and transparent, clearly communicating shifts in outlook, but the market continues to bounce around that Fed target based upon their own expectations.

Heading into this call, futures were pricing in roughly 46 basis points in cuts for the remainder of 2024 targeting November and December. From a performance standpoint, the Bloomberg US Aggregate Bond Index has been back into positive territory really from the end of the first quarter to now and is getting close to flat since the beginning of the year. So, encouraging sign that maybe everyone is finally getting in line, and even if they're not, the difference between the two is compressed, so maybe some of that volatility starts to dampen down a little bit.

Okay. Well, it'll certainly be an interesting second half of the year, especially with the election and all that, so we'll see where things go. Let's pivot now, Doug to your monthly commentary, which for our listeners is available on our website at www.diamond-hill.com. This time, Doug, you take us on a really fascinating real estate journey. What inspired you to choose this topic for the month?

Well, everyone knows that one of the biggest headlines in fixed income over the past year or so has been the strain that's being felt in the commercial real estate market. I mean, we had rising rates in 2022 into 2023. That's passed as we've reached again this higher for longer kind of stasis, but commercial real estate continues to pop up, and while we all know that there are definitely areas of concern throughout the market, we can't lose sight of the fact that there are decent properties in good locations with a diversification of tenants that have performed well and are expected to continue to do so. We can't paint an entire sector with this broad brush of challenges.

The fact that more workers are opting to either work from home or have adopted some kind of hybrid model has been dissected and reported on relentlessly, as well as how that shift in the work dynamic has and will impact the commercial real estate market. Why maintain an office with 40,000 square feet when in reality you only need maybe half of that because of this shift that we've seen in the labor market?

But as gloomy as we're continually told that this is, it's not all bad. I thought it was important for investors to kind of take a step back and realize that there's been a bifurcation in the real estate market, and that despite some of the headlines, there were some good opportunities if you're willing to dig in and do your due diligence. And wanting to be fair, I covered a property that has felt quite a bit of pain and one that has done pretty well.

Okay, well, let's dive into those properties, Doug. The first one that you took a look at is 1740 Broadway in New York City. Can you share some of this building's history and why it's pertinent to today's discussion?

So, the first bit of trivia, which has nothing to do with the overall topic of commercial real estate, is the fact that this building was the inspiration for the Tommy James and the Shondells’ hit “Mony Mony”, which was later covered by Billy Idol, which I was much more familiar with, and it was even parodied by Weird Al Yankovic with his song Alimony. James had written the song, but he didn't have a title. He had written something that was very catchy, but he needed just that final piece. And so the way he tells it, looking to get some fresh air, he walked out onto the terrace of the building in which he was working in New York City and spied the Mutual of New York building with its initials, MONY, illuminated in red, and thus musical history was made. He used Mony Mony as kind of the chorus and the catch for the song and the rest is history.

But let's go back to the topic at hand. So, 1740 Broadway, despite its musical history, would be considered really a Class B property. It was completed in 1950 and highly concentrated with only really two tenants. L Brands, which occupied 77% of the space, announced plans to exit in 2021 while law firm Davis and Gilbert left the building in 2019. So 1740 Broadway is a 26-floor building consisting of roughly 600,000 square feet of office space serviced by 14 elevators. Building was purchased in 2014 for $605 million, part of which was financed with a $308 million mortgage, which was then packaged into a CMBS deal. In May of 2024, the building was sold for $186 million, and once you took out fees and advances were paid, the CMBS deal, the bond received $117 million, which caused complete losses across five of the six tranches with the A tranche, which is that front pay bond, recovering only some of its investment. That A tranche experienced 26% losses.

As you would imagine, the sales proceeds weren't enough to pay off the bond entirely. And as I mentioned, subordinate tranches from B through F were completely wiped out. So, anyone that held those bonds had received interest for a while and then would receive absolutely nothing else because the building was sold and there was not enough to pay off the bond.

As one would imagine, the impact of this deal was widely publicized and put forth as an example of the pain being felt in the commercial real estate market, which is accurate, but it's not necessarily the full picture. The losses on 1740 Broadway made headlines, and it serves as a cautionary tale about the office building market. But the story for 1740 Broadway isn't over, and we're seeing this more and more. I mean, we've seen it here in Columbus, Ohio with the Chase Tower. They're doing the same kind of thing.

The new owner of the 1740 Broadway property, having bought it at a significant discount, is going to put money into it and plans to convert the property from office space to residential, which is that trend that we continue to see because really what are you going to do with these office buildings if people aren't coming to work? One way to fix it or to adjust to the new environment is to create residential properties, condos, apartments, whatever it may be.

So, the transformation of these properties is going to benefit their neighborhoods. I mean, it has to. But the potential roadblocks such as cost overruns, delays, and all of the headaches that go along with transitioning from an office floor layout to individual units where people will be living, it just creates a lot of apprehension for investors. So you're not going to see as many investors jumping into something that's more of a transformation where there's a lot of uncertainty there.

Doug, that's really interesting about that property. The next property that you dive into is 980 Madison Avenue, which has a little bit different story to it. Can you tell us more about that one?

So, I'm a Midwestern guy. I spent some formative years in New Jersey, but I'm definitely, I'm not a New Yorker, but I've been there quite a few times. It's my understanding that 980 Madison Avenue is one of the hubs of the New York art community, and I'm definitely not an art guy, so I apologize in advance if I butcher the names of these galleries.

The building was built in 1948 and served as the headquarters of the Parke-Bernet Galleries until 1987, and that's one of the names that I probably butchered. At which point in 1987, the Gagosian Art Gallery took over a large portion of the property. And the Gagosian Art Gallery added a couple of high-end women's fashion stores over time to help add some diversification to the mix. The property was purchased in 2004 for roughly $126 million and was appraised most recently in May 2021 at $350 million.

Tied to the building is nearly $200 million in debt that's securitized by two different CMBS deals. The first deal is a single asset, single borrower deal that is roughly $172 million, using the building as collateral. And the other is a $25 million segment that is one of 61 loans in a conduit deal associated with a variety of different properties.

980 Madison Avenue recently sold for $560 million, which is a 60% premium over the most recent appraised value, meaning that all the bondholders will receive full payment of their loans despite recent headlines that are even attributed to this property. In September of 2022, the single asset, single borrower deal failed a debt service coverage ratio test, which means that the building wasn't earning enough revenue to assure the loan servicer that the payments would continue to be made. As a result, the deal was moved to the servicer's watch list, indicating concern about the future for the deal, but once the purchase was announced, the deal was removed from the watch list with the expectation that all tranches associated with the CMBS deal are going to be paid in full.

The new tenant, Bloomberg Philanthropies, will occupy 86% of the property, which could raise some concerns around tenant concentration, but given the backing of former mayor Michael Bloomberg, maybe those concerns should be minimized.

Well, these are two interesting properties, Doug. And I know they're both in New York, and of course, we've got a lot of other big cities and small cities around the country that are probably seeing, like you said, both positive and challenging times in commercial real estate. So beyond New York City, are there any emerging trends that investors should be aware of in these other cities?

Well, we all know that one of the mantras in the real estate world is location, location, location, and that's never been more accurate than today. We've covered two different outcomes for properties both located in New York City, and expectations are that we're probably going to see more issues like 1740 Broadway than 980 Madison Avenue. It's just a function of how the market has been shaped.

Buildings and their financing have been getting by through year-to-year extensions on debt deals and waiting for lower rates. If people aren't pricing these buildings via transaction, then there's no price discovery. Now that we're getting some price discovery, I would imagine we'll see more and more of this bifurcation in the market, rewarding deals that are well-structured with Class A properties and diversification in tenants. Renovations can definitely help. $120 million spent on 277 Park Avenue in New York City helped to lower office vacancy near Park and 6th Avenue to 11%, which compares favorably to Manhattan's overall vacancy level of 20%.

And it's not all bad in the office space. You tend to hear about the really bad news. That's what makes headlines. Jones Lang LaSalle stated that even though vacancy rates are around 22% in office buildings, roughly 60% of that vacant space was in 10% of all office buildings nationwide.

So, if you're willing to do the work, conduct solid due diligence and evaluation of the structures of a deal, investors can find securities that have felt the broader pain of the market but are well-positioned going forward. And it's going to be geographically and building type dependent. For every 1101 Vermont Avenue in Washington, which sold for $16 million off a 2018 valuation of $72 million, or distressed office building in Chicago that sold for $4 million off a 2012 price of $51 million. There's a Turtle Bay Resort in Oahu that just sold for $725 million. That property previously changed hands in 2018 when it was bought for $332 million, and the resort was shut down from March 2020 through June 2021, as the owner took advantage of the COVID-induced travel restrictions using the time to renovate and improve the property. The revamp paid off as a recent sale represents a significant gain from the prior appraisal.

But I mean, let's be honest, a lot of the value in the Turtle Bay property is based on the fact that it's located on the North shore of Oahu, which is pretty nice, though it obviously will benefit from the upgrades across the property.

So, it's going to come down to is it a luxury hotel in Miami or Hawaii or somewhere in California, or is it a hotel in Columbus, Ohio? And the office buildings, it's the same approach. Is it an office building that's got a good diversification of tenants, and so if one leaves, it can still manage through it, or is it something that's heavily concentrated like 1740 Broadway?

Doug, another fascinating discussion for sure, and I think it's a great reminder that you mentioned, which is despite sometimes the gloom and doom of the headlines, there are really interesting and attractive opportunities out there. So it was a great discussion. I appreciate you coming on the podcast again.

My pleasure. And I look forward to our conversation next quarter.

Sounds good. Well, thanks again, Doug. Thank you to our listeners, and we'll be in touch with you soon about more updates on the fixed income markets.