Is the sky really falling for Commercial Real Estate? How are the challenges in Commercial Real Estate affecting the Kirkland Income Fund?
It is hard to look at news feeds on the web or turn on the TV and not hear about how Commercial Real Estate is all going to collapse. Investors in the Kirkland Income Fund, both current and new, are also eager to talk about commercial property loans, CMBS debt cliffs, and the impending doom of commercial real estate.
According to MSCI data US commercial loans that are set to mature in 2023 and 2024 have a notional value of nearly $900 billion. These maturities are coupled with a lending environment that has much higher cost of capital, increased risk aversion from bank failures, and whispers of another round of bank regulations. As can be seen by the chart below a greater percentage of these maturities are going to be further burdening the National and Regional Banks. It does not look like conventional lenders are done taking punches.
US COMMERCIAL LOAN MATURITY
The banks know this and have been cutting lending since 2022 as we have discussed in prior newsletters. The chart below shows the lender pool shrinking since 2021 except in one category, hotels. With that sector having already been the punching bag of the pandemic period it is not surprising to see some lenders finding opportunities in properties that were not at massively compressed cap rates and lofty valuations.
US LENDER COUNT by CATEGORY
There is news of multiple multifamily properties failures, now hotel failures, and for months, if not at least a year, there has been news about failing office buildings. All of this is true. So, you may ask why are we bringing these topics to light? We want to clarify a few things regarding this news and the data supplied by MSCI and how it relates directly to the Kirkland Income Fund.
“The direct negative relationship of these challenges to the fund is very little, if not close to zero. ”
The direct negative relationship of these challenges to the fund is very little, if not close to zero. Commercial Mortgage-Backed Securities (CMBS) is a lending source for very large institutional lenders and borrowers. Since 2010 the average size of a CMBS loan has been from $223 million to $334 million. The properties that are failing are primarily office and almost every one of them are in a gateway city/major urban center (primary market). Even the multifamily projects on the edges of these gateway cities that are failing are very large and often consist of thousands of doors.
So yes, clearly large balance commercial real estate generally located in gateway city centers have challenges. However, Kirkland Capital Group lends in the micro-balance commercial real estate space that is in secondary and tertiary markets. The properties in this space have certainly experienced increased valuation prior to 2022 but not to the level seen in gateway cities. On average, the projects we underwrite have cap rates of over 10.0, compared to a range of 2.0 to 4.0 for properties in gateway cities. Our loans range in size of $200K to $1.2 million, certainly not the level of CMBS. We also currently have not lent to traditional office properties, regardless of geography.
The looming debt cliffs for the big players are not a direct concern of ours. We did recognize and put into place more conservative underwriting with regards to property values. Also, as many operators are under business and personal strain, we are putting heavier weight towards due diligence of the borrower’s financial condition.
We felt this was important to bring to light as many investors have questions about commercial real estate. They are certainly justified as we have showcased above, but even with the broad commercial real estate market in for some troubled times, we are not exposed directly to these headline risks.
The fund has had a strong and consistent performance this year despite uncertainty in the markets. A loan was side pocketed in February as the borrower missed a few payments, and this certainly caused a drag on performance for the months of March and April. The foreclosure process was started but legal action was not pursued as the borrower sold the property in May and we were able to capture all principal and some of the accrued and unpaid interest. We still have one loan in foreclosure. We are waiting for a valuation assessment on the property and hopefully with that information we can begin to find a path to settlement. This market is still turbulent, and we continue our conservative approach to control risk through solid underwriting and diversification of exposures in the portfolio.
If there are any questions and you want to talk further regarding the credit crunch or commercial real estate, please reach out.
