The general economy has been quite resilient over the past year despite persistent inflation
pressures, rising interest rates, tight credit markets and a slumping China economy. Home
prices and labor markets have been pleasant surprises and have anchored the overall
economy. Home values – which usually represents a family’s single biggest asset – have
remained steady and have buoyed consumer confidence. Labor markets have also
unexpectedly outperformed all forecasts as seen by the addition of 2 million new jobs this year
alone. All eyes remain on the Federal Reserve later this month to see if interest rates are
pushed-up a notch.
The first and second quarters of 2022 witnessed slight declines in economic output, which led to
widespread anticipation of a prolonged and potentially deep recession. Prices were climbing
swiftly – along with interest rates – and many prognosticators warned of a sustained period of
stagflation accompanied by steep declines in asset values. Fast forward to today, and we see
the S&P 500 is up over 17% since the mid-year mark last year, unemployment is at record lows,
bond prices are stable, commodity prices are generally lower, and inflation is waning.
While the future is bright for the overall economy, banks have tightened credit at a time when
commercial real estate loans are coming due in big chunks. In the past few weeks, we have
learned that the biggest retail center in San Francisco defaulted on its $500 million loan, Jimmy
Buffet’s $310 million Margaritaville Resort in Times Square has declared bankruptcy, and
several large office towers in the southeast are on the brink of bankruptcy because of an
inability to refinance current loans. This is the beginning of an onslaught of CRE loans coming
due in the next three years and a potential catalyst that restricts credit further.
The RCG Stable Fund provides Collateralized Loan Obligations (CLOs) to businesses with
unencumbered assets which are used to secure a loan. The CLO market in the U.S. is $910
billion within the broader $12 trillion securitized loan market. Collateralized loans represent a
high yielding, scalable, floating-rate investment alternative with a history of stable credit
performance. The steady performance during the 2008 – 2011 financial crisis and COVID-19
cycles has supported growth in the CLO market, broadened its investor base and cultivated a
strong secondary market.
The Stable Fund has performed well since its inception in 2019 because of its credit and
structural research, analytical processes, and sophisticated structuring capabilities. The Fund’s
current yield has increased meaningfully as the Fed has increased rates and is now 10.75%.
Our focus on collateralizing variable rate loans with liquid corporate assets such as specialty
loan portfolios and inventory of finished goods has provided consistent loan portfolio
performance. We continue to see both strong loan demand and a favorable pricing environment.
due to tightening of available credit from traditional sources.
The collapse of Silicon Valley Bank in the Spring sparked debate about whether SVP was an isolated incident in an otherwise sound banking system or was this failure an indication of swiftly deteriorating balance sheets across the industry. Then Signature Bank was seized.
Then the First Republic was rescued. Suddenly, three of the four biggest bank failures in history happened seemingly overnight, and the safety and soundness of the entire system was under scrutiny.
The Federal Reserve bailed the system out (yet again) by acting as lender of last resort and opening the cash window to banks in trouble. Interestingly, these bank failures weren’t caused by the usual suspect – bad loans – but from bad asset management. Each bank failed because its investment portfolios held low yielding bonds with long maturities, and those bond values plunged as the Fed relentlessly pushed interest rates up. The building losses eroded regulatory capital levels and caused doubt that deposits were safe. While the system withstood the estimated $425 billion of withdrawals in the first quarter, liquidity has tightened as have lending protocols.
The Federal Reserve increased interest rates ten consecutive times since March 2022, hiking the prime rate to 8.25%, its highest level in 16 years. The impact from these rate hikes will certainly cause a drag on activity throughout the economy, but the commercial real estate industry is anticipating a particularly difficult period which may lead to an avalanche of loan defaults.
$1.5 trillion of CRE loans are coming due in the next three years according to data provider Trepp. CRE loans represent about 33% of all loans on the books of banks with assets between $1 billion and $10 billion according to Fitch, and higher interest rates will put many loans at risk of default.
While CRE mortgage delinquencies currently sit at a benign 0.76%, interest rates have more than doubled since January 2022 and refinancings will be tough to navigate for certain sectors of the market. To be clear, this is not a replay of the 2008 financial crisis as banks are much healthier today and CRE borrowers are generally much stronger financially than the sub-prime borrowers that lead real estate into the depths 15 years ago. Still, we expect foundational cracks to surface in bank CRE loan portfolios, especially with those over exposed to office and retail sectors.
A wildcard for CRE borrowers refinancing properties will likely be sharply lower reappraised values set by banks. Office and retail sectors are in tough shape and borrowers will likely face steep mark-downs in property values. Meanwhile, losses in bank portfolios have tightened both liquidity levels and loan criteria which, among other factors, will require a higher percentage of cash equity to be in place to secure a refinancing. So, the challenges are real, and we expect some borrowers and lenders to struggle as the CRE market recalibrates with imaginative repurposing plans to rehabilitate underperforming properties.
The U.S. stock markets rebounded from a dismal 2022 in the first quarter led by the Nasdaq soaring 16.8%. The S&P 500 and the Dow Jones significantly lagged the Nasdaq, but still posted gains of 7.0% and 0.4% respectively for the quarter.
The stock market’s first quarter performance was a bit unexpected given the Federal Reserve’s continued fight against inflation and increases in the federal funds interest rate. Despite these rate increases, the bond market rallied during the quarter to push government yields lower and help the Bloomberg U.S. Aggregate Bond Index post a 2.5% gain.
A bounce was to be expected after both the stock and bond markets had a tough 2022, with both falling double digits. Investors were looking forward to a pause in interest rate hikes by the Fed and a slowing in the rate of inflation. Banking troubles, big layoffs in big tech, and a pullback in consumer spending forecasts choppy economic waters in the quarters to come.
The S&P 500 is a weighted index, which means the biggest companies have an outsized impact on their performance. In fact, the ten biggest companies in the index represent 29.5% of its market capitalization and accounted for 90% of the gains during the first quarter. After the shellacking the index took in 2022, passive stock investors transitioned to equal weighted stock index ETFs in 2023. While this transition may have been ill-timed given the equal weighted index which fell 4.3% during the quarter, an equal weighted index is arguably a better benchmark for how the 500 largest publicly traded companies performed during a given time period. Looking back at 2022, when the weighted S&P 500 fell 18.11%, the equal weighted S&P 500 Index fell only 2.5%, representing a 20.61% difference in performance. Given these massive performance gaps, we believe using both performance benchmarks provide a better gauge for investors to measure the Fund’s performance.
Despite a doubling in the 30-year mortgage rate over the past year, residential real estate continues to show impressive resiliency due to tight supply and sustained demand. While hot markets like Phoenix, Las Vegas, Austin and Boise, Idaho posted declines in average home prices, most markets in the Northeast, South and Midwest showed solid gains. This price stability is driven by existing homeowners’ unwillingness to exchange low mortgages on current homes for today’s higher rates on new homes.