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Is The US Commercial Real Estate Market Brewing A New Storm?


By Yuan Yujing

While the international banking crisis appears to be temporarily eased, the United States’ commercial real estate market is showing signs of trouble. Recently, Brookfield Asset Management, one of the world’s largest investment managers, defaulted on a USD 161.4million commercial mortgage-backed securities (CMBS) loan to a dozen office buildings mostly around Washington, DC. Earlier this year, Brookfield has defaulted on the debt of USD 784 million in debt tied to two buildings in Los Angeles, the Gas Company Tower and the 777 Tower.

Similarly, on 1 December 2022, Blackstone, the global asset management giant, suddenly announced restrictions on redemptions from its flagship real estate investment trust (BREIT), sparking concerns in the market about the real estate industry. In early March this year, Blackstone was also reported to have defaulted on a EUR 531million (USD 562 million) Finnish CMBS.

With rounds of shocks, confidence in the U.S. real estate market, especially the commercial property, is becoming fragile. The Federal Reserve’s constant rate hikes have led to a surge in market interest rates. The recent bank failures have distressed the market, which was already hit hard by the Covid-19 pandemic. In addition, consumers become increasingly pessimistic about the global economic outlook. The future of commercial real estate looks even bleaker.

Some analysts said that based on relevant indicators, the U.S. commercial real estate market is indeed showing signs of weakening. For example, since the outbreak of COVID-19, the vacancy rate of U.S. commercial property has continued to rise, from11.5% in the first quarter of 2020 to 15.4% in the third quarter of 2022. This is especially true for office buildings, whose demand has significantly decreased due to the trend of remote work and recent cost-cutting measures by tech companies. In the fourth quarter of 2022, the commercial real estate loan default rate rose again, up 3 basis points to 0.68% quarter-on-quarter. Although the aggregate is still at a historical low, the marginal change is a cause for concern. As of the third quarter of 2022, the leverage ratio of the U.S. non-financial corporate sector reached 78.8%, much higher than the 75.3% in the fourth quarter of 2019. the leverage ratio is high enough to restrict capital expenditure plans among firms, and commercial real estate demand may continue to be under pressure.

Meanwhile, there are signs of much stress coming to the surface in first-quarter bank earnings. Last week, Wells Fargo reported that non-performing commercial property loans had jumped nearly 50% to USD 1.5 billion since December last year. Morgan Stanley cited deteriorating commercial real estate and economic prospects as the amount of provisions largely increased more than those the last year. In response, Boris Schlossberg, BK Asset Management managing director of FX strategy stated that the real estate industry is affected most by interest rate shocks, and liquidity pressures are expected to lead small and medium-sized banks to reduce lending, with most of the loans provided to commercial developers and managers. Xander Snyder Senior commercial real estate economist for First American Financial believes that its big exposure to commercial real estate is affecting the stability of the banking industry and will have a greater impact on the economy. He pointed out that statistics show credit supply for all commercial real estate has been getting scarce this year. The recent difficulties in the banking industry could exacerbate this trend.

In the U.S., it is reported that commercial real estate loans account for about 40% of total loans from small banks, and about 13% of loans from the largest lenders. It makes the risks of the commercial real estate market prone to spread to various institutions. On April 21, Bank OZK, headquartered in Arkansas, reported that it had to increase loan provisions by10% in the first quarter due to its high-risk exposure to commercial real estate. Its current loan provision stands at USD 36 million, ten times higher than that a year ago. Christopher Ailman, Chief Investment Officer of the California State Teachers’ Retirement System (CalSTRS), revealed recently that he estimates the value of the U.S. office buildings has dropped by 20% around. He is therefore preparing to write down the value of its $52 billion real estate portfolio in the latest pain in the property sector. Further, a report by Goldman Sachs indicated that the CMBS delinquency rate for office buildings has begun to rise recently and is expected to go up significantly in the future, as the rising delinquency rate is closely related to the current interest rate cycle.

Finally, this industry has also caused similar concerns outside the U.S. A senior official from the International Monetary Fund (IMF) described commercial real estate as a priority this month. The IMF’s latest financial stability report warns that the toxic combination of declining real estate values, tighter financial conditions, and insufficient market liquidity could make it difficult for borrowers to refinance increasing amounts of maturing loans, leading to a sharp rise in default rates.

Economists at ANBOUND analyzed that the latest stress on commercial real estate in the U.S. is unlikely to evolve into a wave of systemic crisis. Firstly, to a large extent, it is a normal response to the Fed’s tightening policies, rather than arising from fragility or critical points in real estate market itself. Secondly, compared to the residential property, the prices of commercial property in the U.S. have not risen excessively in consequence of the COVID-19 pandemic. Thirdly, from the perspective of transmission path, the commercial property loan in banking is not at a level too high. At the same time, the financial regulations introduced by the American government following the 2008 financial crisis have curb down the disorderly growth of commercial real estate derivatives such as CMBS. So far, the market scale of the American CMBS is far smaller than that of RMBS. Finally, the Fed’s policies and the market’s self-correction mechanism have taken effect. In terms of policy tools, the liquidity injected into the market by the Fed through tools such as the discount window is easing the pressure on small and medium-sized banks. Hence, it lessened the possibility that the commercial real estate market conditions would continue deteriorating in a low liquidity environment. After the crash of Silicon Valley Bank, the market’s expectation on the Fed’s rate hike has cooled down. The fall in risk-free rates has boosted the prices of assets such as CMBS, to some extent also decreasing the pressure of floating losses on the banks and institutional assets.

Final analysis conclusion:

Facing multiple challenges, fundamentally, the U.S. commercial real estate market is subject to many unfavorable factors. However, considering the country’s banking sector that is sound, it is premature to foretell new systemic crisis hidden behind the U.S. commercial real estate market.

Yuan Yujing is a researcher at ANBOUND

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