What's Going On With Commercial Real Estate and Regional Banking?

In this podcast, Motley Fool host Dylan Lewis and senior analyst Bill Mann discuss:

• How rising rates and low occupancy rates continue to put pressure on interest-only commercial real estate borrowers.
• The follow-on effects that could hit regional banks.
• Why insiders at regional banks are buying up shares despite the pessimism. 

Motley Fool producer Ricky Mulvey talks with CNBC host Melissa Lee about the new documentary Making of the Meme King and why founding a company is much different than turning one around. 

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on June 07, 2023.

Dylan Lewis: How office space went from a story about how we work to a story about how we finance. Motley Fool Money starts now. I'm Dylan Lewis and I'm joined over the airwaves by Motley Fool Analyst, Bill Mann. Bill, great to have you.

Bill Mann: Hey, Dylan. How are you doing, man.

Dylan Lewis: Doing OK. Today we are taking a look at commercial real estate and how it may affect regional banking. Bill, the reason that we're talking about this today is we had a CNBC interview this morning where Treasury Secretary Janet Yellen said, she thinks there will be some issues with commercial real estate. This is something that we've been watching for some time. It's been one of those evolving stories as a lot of the world has changed with the pandemic.

Bill Mann: Seemed awfully breezy, didn't she?

Dylan Lewis: She did.

Bill Mann: I don't know about you, but I look around me and I see a lot of buildings, and so you know that there is a fair amount of value and investment built into them. I looked it up. I did some research before we spoke our speaking.

Dylan Lewis: I always appreciate that.

Bill Mann: Just a little. $20.7 trillion in commercial real estate estimated in the United States by values of 2022. Twenty trillion dollar slug of money that's out there that is currently under the double or triple stress of having number 1, the echo boom from COVID with people remaining out of office, relatively low in-office rates and in 2022, moving into 2023, the fastest rate of increases of the federal interest rate in history. It is creating a lot of stress for something that I do again want to stress, is a $20.7 trillion component of the U.S. economy.

Dylan Lewis: This is also one of the stories, Bill, where I think people can very tangibly see it playing out, right? I'm recording this from our office in Alexandria and I can say the office environment around us, the campuses around us are not nearly as populated as they once were. I think a lot of people listening to this show probably are seeing that in their own way too. This was so much a how we work and corporate culture story for 2020 and 2021. You mentioned the interest rate environment a little bit. In 2022 and 2023, this is becoming more of a financial story because these interest rates have climbed and are staying high. As someone who maybe doesn't follow commercial real estate as much, you learn very quickly the loan environment and the way that these deals are structured, very different than the traditional consumer mortgage.

Bill Mann: That's exactly right. This is why it matters to us. We think, OK, there are big investors out there and they've built these buildings. Or they're these building owners and maybe they have a problem. But you have to think of the commercial mortgage backed security market or you have to think about commercial mortgages as being similar to bonds. Banks go out and loan for the buildings to be built, buildings to be maintained, buildings to be bought. As of last year, nearly 90% of those loans were done on what's known as an interest only basis. Which means, unlike your mortgage at home where you're paying principal every single month and slowly paying things down so that your last payment will be of equal size at your first payment, in the case of commercial buildings, they have interest-only and then they're going to come up to a period of time in which they have to satisfy the entirety of the loan by paying it off, which is harder to do when you have the level of vacancy at buildings throughout the country as we've seen. Because as you know, vacancies, the flip side of that is the cash flows in for the buildings. We're looking at a massive potential reset in those valuations, which hurts the banks. We're also looking at a rising default curve, which hurts the banks. Those are the same banks that provide loans to us, that provide loans to small businesses. They don't really know what to do with themselves.

Dylan Lewis: I think we've all had to become banking experts in the last six months or do our best imitation.

Bill Mann: It is never good when we as individuals have to become banking experts, is it?

Dylan Lewis: No, it's not. It's a sign that something has come into the headlines that we're not used to seeing. I think to bring this around a little bit to some more of Secretary Yellen's comments from earlier today, we started out on the downer note, but she did reiterate that while there will be pain, she feels like the banking system has the capital and liquidity to handle the strain. Bill, I'm curious what your thoughts are and what you're looking at as you see the story play out.

Bill Mann: The system, sure. But that doesn't mean that all individual banks don't have an exposure that they would be able to handle. This one is what's important about that interest-only component. By the way, we've already seen it this year. You've seen huge borrowers and huge building portfolios like the ones held at Brookfield Asset Management that are kept inside fun. It keeps the borrower harmless from anything from contagion from these loans. But the banks are already taking title to these buildings. I don't know if you know this about banks, they're not set up to be in the landlording business. They're not set up to be in the building speculation business. What they are trying to do is lend, and then take that collateral if those loans go bad, and then recycle that collateral into more cash. Really, when she talks about the entire system having enough liquidity, the really important thing to note about the banking system is that it is a bunch of notes. As we saw with Silicon Valley Bank, that one single note going into distress can cause contagion across a much wider subset of the financial system.

Dylan Lewis: You mentioned that banks are generally not in the business of holding assets. They don't like to be maintaining things and having physical real estate that they have to be in charge of. I think one of the other curious elements of this story and this landscape in general, Bill, is a lot of the banks that play in commercial real estate are these regional banks that we've seen a little bit more pessimism around and people have been a little bit more scared of because of some of the banking failures we've seen. How do you look at that space right now?

Bill Mann: This is really important what you're bringing up. Because when you think of a regional or a local bank, they have a great deal of exposure to the area in which they are operating. One of the things that these smaller banks have done is that they will have their lending areas, their geographies be in some ways wider or in a different space for their deposit geographies. For example, you'll have a bank in Ohio that will open up a lending office in Nashville, Tennessee, because there's a whole lot more opportunity to land for development, things like that in Nashville, Tennessee than there is in a rural part of Ohio. When we are talking about the smaller banks, what you have to keep in mind is that those types of loans that are out there are huge components of some of these banks' balance sheets. The balance sheets because these are leveraged companies, you will take a deposit franchise of a billion dollars, say, and you will make loans on top of that of four billion dollars, for example, it's a small bank. But that's an OK example. That when there is any movement at all on the asset value, it can really impair the bank's capacity to land.

Dylan Lewis: Bill, based on our conversation so far, I think we'd be generally looking at pessimism in commercial real estate and also pessimism in some of the banks that service those loans and make those loans available. One thing that I think is interesting in doing our prep for the show is I saw a story that I'm trying to square with everything that we just talked about. It is that insider buying at regional banks hit a three-year high in the second quarter of 2023. I'm a little surprised to see that much activity, and interest, and ratio of buyers to sellers hitting a record high in Q2 when it seems like there's so much pessimism in the space.

Bill Mann: You know I had a great interview a couple of days ago with Chip Mahan from Live Oak Bank based in Wilmington, North Carolina. He talked a lot about the areas in which they make loans. Now, Live Oak Bank's stock has been hit as has every other small and medium-sized bank in the country. When you think about banks, on certain levels, it is a utility and then on top of that is a risk-taking enterprise. The price, so it does not surprise me at all to see good bankers looking at their own books of business and saying, OK, we may be in for a little bit of trouble but we're going to come out on the other side because we're well capitalized and we know the types of areas where we give loans. I would be a little careful to take too much signal from that because as you know anything that gets observed can, in fact, be gamed. There's always the risk of an insider going, hey, if I buy just a little bit of stock then maybe people will think that our stock is cheap and we're not in trouble, but I think that there is a whole lot to be said for the fact that these professionals do know their businesses better than anybody else. In particular when you see a CFO or you see a lending officer make a purchase on the open market of their own stock, that's something to pay attention to.

Dylan Lewis: We never want to blindly follow it, but it's always worth paying attention to.

Bill Mann: Absolutely because it's money. What is it that Roone Arledge said, is that the answer to all of the next and your questions is money. 

Dylan Lewis: It's dead-on. For folks that are eyeing some of these regional banks and perhaps seeing opportunity or being interested because they've seen this insider activity you mentioned looking at the geographic focuses and the diversity that some of these regional banks have. Is there anything in particular that people should be paying attention to in addition to that?

Bill Mann: Well, I think that to the extent that you want to become a banking analyst, there are capital ratios that you should pay attention to. I would also pay attention to and be very specific about how you go about reading banks the letter to shareholders and they will describe very carefully there and then also in their financials the types of industries and the types of areas where they are lending. I would be really careful buying a bank that has seen over the last five years a large growth in its CMBS portfolio; that's commercial mortgage-backed securities or direct real estate, commercial real estate. Be a little careful with those. But you can find banks that are making loans in areas where they have a lot of expertise and it isn't necessarily going to be as sensitive to the economy as a commercial real estate might be.

Dylan Lewis: Bill Mann, thanks so much for joining me today.

Bill Mann: Hey, thanks, Dylan. 

Dylan Lewis: It's tough to be an activist investor especially when you're invested alongside the government of the People's Republic of China, but that's not stopping Ryan Cohen from trying. Ricky Mulvey caught up with CNBC host Melissa Lee to talk about the new documentary, Making of the Meme King and why founding a company is much different than trying to turn one around.

Ricky Mulvey: Melissa, it takes a certain amount of confidence to ship 30 pounds bags of dog food to people as a business. Can you take us back to the founding of Chewy and maybe the original Ryan Cohen playbook of building and growing a business.

Melissa Lee: It takes a lot of confidence and it also takes a lot of confidence in light of the fact that our business had tried to do that before in that business with spectacularly bust during the dot com bubble, I'm talking about pets.com. But when Ryan Cohen founded Chewy it was I don't want to say inspired inspiration, design inspiration, but it was like that he had met the co-founder in high school through a chat room, and they decided to get together and open a business. The original business was actually a jewelry store, and then one day he was shopping for pet supplies for his dog -- a little poodle -- and discovered that he was much more passionate about this category, and that he felt that he could enact change in this part of the industry. The naysayers were plenty. It was difficult for him to find the start-up money, to find people willing to back him. As you mentioned the economics of shipping dog food in the mail were not great, and people had seen another business go bust or trying to do the same thing.

There was that reluctance, but he had that passion. He was a entrepreneur who wanted to defy logic, who thought out a game plan and really went with it and really went with his gut and with his heart. I think that is one of the hallmarks of Ryan Cohen's just playbook of investing, but understanding Chewy and how that company was founded, how that company grew into a business is really keyed up understanding who Ryan Cohen is. He thinks that he can go in there and take a look. He's an operational person. He built out these giant warehouses for Chewy. He decided that it was going to be growth at all costs that he went over the customer. If you had to refund a customer for a broken bag of dog food and do that repeatedly, that's what it took as long as you're generating cash to grow the business. That was what his mentality was that you could grow to greatness, and the thing about Chewy was that Chewy unlike GameStop, you can't download dog food. You can download video games, and so that was the threat that that GameStop's story encapsulated for Bed Bath & Beyond. You might say, maybe those businesses are similar, but Bed Bath & Beyond was already really far down the line in terms of its difficulties being much closer to bankruptcy than to its early growth stage, and so time is just not on Ryan Cohen's side for that one for him to even hope to really enact meaningful change, operational change there. I think those are the key differences between Chewy some of the other businesses he invested.

Ricky Mulvey: I'm still left wondering with Chewy why Amazon didn't just take it out in the early days. There has to be something that Ryan Cohen understood about the pet business that Amazon did not.

Melissa Lee: I think Ryan Cohen understood that if you win over the customer and you treat them really well, then they'll be yours for life. We interviewed many customer service representatives. It's part of this documentary to really understand what that secret sauce was. You hear repeatedly oh, it's OK. It was OK for you to stay on the phone with the customer. They lost their pet and cry with them. It was OK to give them back their money, they're unhappy. No matter how many times they had to do that that was all fine with Ryan Cohen. He even sent personal thank you notes to customers around the holiday as just to say thank you for being a customer of Chewy. He sent personalized portraits, hand-painted portraits of people's pets to them. If you've got a portrait of your Scottish terrier, you probably are a customer for life at Chewy at that point. That was the big difference between the nameless monolithic Amazon and this little start-up that wanted to focus on people who love their pets.

Ricky Mulvey: PetSmart then purchases Chewy for about $3.3 billion. It's the largest e-commerce acquisition of all time at that point. I don't know if this was covered in the documentary, but then he virtually puts all of his money into Apple and then inexplicably Wells Fargo stock. But then after that, when does the meme stock fascination with Cohen start there or is it when he gets involved with GameStop?

Melissa Lee: I don't think that he was fascinated with meme stocks. I don't know if that's the right order. I think it's more of a chicken and an egg thing. Because when he started investing in GameStop, that's when things really started taking off. There was already a community around it and they really see onto Ryan Cohen when they saw him get in. They knew that Ryan Cohen was this guy who made his own money. He started from nothing. He built up Chewy. He became a billionaire with that sale to PetSmart. Here he is, he's going to bring that Chewy magic to GameStop. People wanted to believe it. He also encapsulated what this group of people on Reddit, apes, whatever you want to call them, what they believe. What they believe is that they wanted to to defy convention. They wanted to stick it to the man in a hotel Wall Street that you are not going to dictate how things work. We have a voice here. I think he was the perfect figurehead at this exact time when the meme stock crazed and started taking off, it was the perfect just culmination of events in 2019.

Ricky Mulvey: Beyond the hype, what was the Chewy magic for transforming GameStop that he wanted to bring, and maybe why did that not work out as well as anticipated?

Melissa Lee: The Chewy magic. Chewy was an e-commerce-only business and so GameStop, one of his major criticisms. If you read the letter to the board, was that they completely missed the boat when it came to online sales. They miss the boat and during that time, they also miss the notion that people will soon be able to download video games. They had this existential threat in front of them. People thought that Ryan Cohen was employed because he was an e-commerce wizard entrepreneur, that you'll be able to use that same playbook and turn GameStop around, reduce its bricks-and-mortar exposure, and get operational efficiency going. Change this to an e-commerce-first company. But what people didn't understand and maybe what Ryan didn't understand was that the video game business is not the same as the dog food business or the chew toy business. You can't dis-intermediate dog food by downloading it, and that's the threat that GameStop was facing at that time. You still have to physically buy bones and collars and dog beds. There's no way to just download that software. I think that there was a case to be made for certain changes that could have been enacted using the Chewy playbook, but it was just a different ballgame in terms of the product that they were selling in the threat to that business.

Ricky Mulvey: Harder to send a portrait of someone playing a video game. It's also the direct-to-supplier connection where you can buy a PlayStation game directly from PlayStation, where you can't buy your dog food directly from the dog food maker. But to give Cowen credit, he has made GameStop profitable even if sales are declining and even if he's facing this monolithic competition, it is a company that is profitable on I think a cash-flow basis now.

Melissa Lee: Yeah, absolutely. People, his backers will point to that for sure. His critics would say, as you pointed out, sales are declining. How did you make the company profitable? You cut costs. That he'd close a lot of stores down. Is this the kind of "profitability" or "growth" that is sustainable? I think that's still yet to be seen.

Ricky Mulvey: One of the curious things that the documentary Explorers is what Redditors, what investors wanted Ryan Cohen to be, and maybe who he actually was and especially how that perception clashed with his actions in the case of Bed Bath & Beyond?

Melissa Lee: Yeah. At that point, he was called on Reddit, Papa Cohen, the messiah that destroyer shorts all of these monikers that portrayed him as god-like figurehead in the Reddit community. When he went into Bed Bath and Beyond, he was viewed the same way. That day that he unveiled at stake. I think the stock was up something like 70% on that one trading session. People were really looking to him as leading them also into Bed Bath & Beyond. They trusted him, they wanted to follow him. They were investing their life savings, in some cases their life savings to what he was buying. They went in as well. But there was a rude awakening in August of 22, when he decided that he was going to sell his entire stake. This is the interesting part of the story, the interesting turn in terms of Ryan Cohen being perceived as this flawless, god-like figure to perhaps somebody who might have an ulterior motive. Maybe not, but there are questions here around what his motives were when he went into Bed Bath & Beyond, put three directors on the board. Then there's a technicality here. He had to make a new filing, basically refile because the number of shares that the company had outstanding changed. His stake, looked like it went up. He refiled that in part of that filing. He also refiled his call positions in Bed Bath & Beyond way out of the money calls.

Basically, a bet saying that he believes the stock is going to be X times higher in a far date out, I think it was like January or something like that and was August. People saw that and they assumed this is all new news. The stock just went nuts. But what we found out a couple of days later is that he sold every single share right after that. The question is, the timing of it. Is this just a coincidence? Did you do this on purpose to goose the staff before he sold it? They're all sorts of questions. I don't think many people, according to people we interviewed, but it's questionable. They don't think that any heated anything illegal. But at this point, it's not about the legality of it to this community and to the average investor who had believed and Ryan Cohen. It's like, who are you? What are you doing? Are you taking an advantage of us? Was this just a rough ball and you left us holding the bag? We try and go into that issue as well.

Ricky Mulvey: It's always interesting to see what he says versus watching the hands if you will. He bought a stake in Alibaba and is imploring them to buy back shares. Meanwhile, the share count under GameStop, I think rose about 15% under his tenure. There always seem to be unrelated stories, if you will, that have connections with Ryan Cohen.

Melissa Lee: Yeah, I think that's really interesting point that you bring up. With Alibaba, this goes to who are you Ryan Cohen as an activist investor? There's a question of who are you as this Reddit meme king, but also, who are you? Ryan Cohen as an activist investor with GameStop, the jury may still be out, with Bed Bath and Beyond. He determined that he couldn't make the change. He's sold out. Then he got into an Alibaba, had a minuscule state compared to the size of the actual company. By the way, it's a Chinese company that's effectively influenced by the Chinese government. Who are you, the American activist investor to come in and tell Alibaba what to do with the shares. There's a question about whether or not he's an effective activist investor as well. I think after being the real American success story with the wild success of Chewy now, they're all these questions emerging about Ryan Cohen, Second Act.

Ricky Mulvey: The documentary is Making of the Meme King. It's available on YouTube and cnbc.com/documentaries. I really enjoyed it, but listen. Thank you for your time and joining us on Motley Fool Money.

Melissa Lee: Thank you so much, Ricky.

Dylan Lewis: As always, people on the program may own stocks mentioned in the Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Dylan Lewis. Thanks for listening. We'll be back tomorrow.