Is The Banking Crisis Likely To Continue On With Commercial Real Estate Loans?
Commercial real estate (VNQ) – especially certain subsectors – is on a shaky foundation right now. Meanwhile, the regional banking sector (KRE)(KBE) – which has significant exposure to commercial real estate – is in crisis mode. In this article we take a closer look to see if the banking crisis is likely to continue on with commercial real estate loans.
The Shaky State of Commercial Real Estate
The US commercial real estate sector – particularly the office subsector – is facing significant challenges due to the formation of a perfect storm of macro trends:
An oversupply of office space in major cities like New York, Los Angeles, and San Francisco that has only been further aggravated by the mass exodus in the wake of the COVID-19 lockdowns and the ensuing riots.
The rapid rise in interest rates over the past year has driven cap rates higher while also making refinancing maturing debt on commercial real estate properties more difficult.
The surging work-from-home trend is reducing corporate demand for office space.
Weakening economic conditions are prompting companies to reduce their head count (and by extension demand for office space) in order to cut costs.
This confluence of headwinds have pushed office valuations down by 15% on average as of March 2023. Moreover, stock prices of office REITs like Boston Properties (BXP), SL Green (SLG), and Vornado Realty (VNO) have declined even more over the past year, influenced in part by the effects of leverage as well of the tendency for public markets to be more volatile than private markets:
On top of that, the average occupancy of US offices remains below half of the levels seen in March 2020, and the worst may not be over yet. Some think that office property values could fall by over 30% this year as a surge in office mortgage defaults could lead to excess supply on the market.
The impact of these trends is likely to be devastating for office landlords, with a race to the bottom in rents and office REITs potentially unable to refinance their debt, leading to a spike in debt defaults at the corporate level in addition to the defaults at the asset level. While the very best real estate assets may still be in demand, the outlook for the sector as a whole is uncertain, with many challenges ahead.
Even legendary billionaire investor Charlie Munger of Berkshire Hathaway (BRK.A)(BRK.B) has warned of ‘trouble’ and ‘agony’ for the real estate sector, stating:
A lot of real estate isn’t so good any more. We have a lot of troubled office buildings, a lot of troubled shopping centers, a lot of troubled other properties. There’s a lot of agony out there.
This distress is already being felt by major office landlords, including leading asset managers like Brookfield (BN)(BAM) and Blackstone (BX)(BXMT), with both recently reporting defaults on mortgages attached to office properties in their real estate portfolios.
Will The Banking Crisis Impact Commercial Real Estate Loans?
While things do not look good for the equity stakes of office landlords in the near-term, what about their creditors? In particular, how will this impact the banking sector given that Goldman Sachs data indicates that ~55% of US office loans are on bank balance sheets, with regional and community banks – which are in crisis mode right now – accounting for 23% of the total?
The ultimate impact will likely be determined by the direction of interest rates. If they remain elevated for too much longer – which seems increasingly likely after the Federal Reserve’s latest meeting and press conference – things could get really nasty for the office property sector and banks, by extension. This is because many office properties are underwritten at mid-single digit cap rates and mortgage interest rates are at least that high, if not higher. As a result, given that property values are expected to fall in the near-term, it makes little sense for landlords to refinance maturing mortgage debt since they will likely be generating little to negative cash flow from the assets while also seeing their equity value in the property decline with falling values. This will especially prove to be the case if pricing power and occupancy continue to weaken from the work from home and recessionary trends currently facing the economy.
This will then result in a glut of bank-owned properties on the market, which most lenders will look to sell given that bankers are lenders not real estate operators.
With most property mortgages ranging between 50%-80%, many banks will likely see meaningful amounts of their principal wiped out, especially once all of the legal, transaction, and other fees are accounted for in the foreclosure process and ultimate fire sale of the property. There is even a risk of a run on smaller banks similar to what happened with Silicon Valley Bank (OTC:SIVBQ), which could lead to even more bank failures.
Approximately $270 billion in commercial real estate – including ~$80 billion in office property – loans mature this year, virtually all of which were underwritten at higher valuations and substantially lower interest rates. When combined with the challenges already facing the banking sector, there could be some steep losses in both the office and banking sectors this year.
In fact, commercial real estate was among the top concerns cited by some market participants as a “possible trigger for systemic risk” in a survey that accompanied the Fed’s stability report. This concern was listed alongside inflation, banking sector stress, and the debt limit.
Nobody knows for certain how badly the office sector will suffer this year, but the market’s pricing of office REIT common and preferred equities is certainly not pretty. Moreover, one merely has to look at the market’s treatment of the mortgage REIT sector (MORT) to see how it feels that commercial real estate lenders will do as well:
While there are pockets of opportunity on the peripheries of this crisis – for example, we think that life sciences REITs with stellar balance sheets like Alexandria (ARE) and some regional banks with minimal office lending exposure like New York Community Bancorp (NYCB) are opportunistically priced and face practically none of the headwinds discussed in this article – in general we are steering clear of the broader banking and office REIT sectors.
While the potential for deep value is certainly there, the risk of severe permanent principal destruction is too great for us to dumpster dive right now.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.