US banks are growing increasingly concerned about the drop in commercial property valuations and the possible risk to lenders’ balance sheets, some senior executives worry. Office valuations, in particular, have been hit by rising interest rates and the shift towards remote working since the Covid-19 pandemic, according to a recent report by the Financial Times. Despite these concerns, a number of industry experts are quick to reassure investors that the risks are broadly distributed among banks and other institutions and that there is no significant systemic risk in the industry as a whole.
The impact on the industry over the last three years has not been even. While many office property types have been deeply affected by the changing landscape of how work is performed and where, Class A properties have held up relatively well, while Class B and C properties have been declining steadily, the report stated. Yet, the largest issue lies with the confidence in the sector, which, if it falls, may pose a risk of contagion and deeper economic unsettling, according to some estimates.
“The question we all have is whether contagion will spread from the office sector,” said Bryan McDonnell, PGIM’s head of real estate debt operations in the Financial Times report. His team manages over $122 billion and is an active investor across several commercial real estate industry segments. “If you get to a confidence issue, then, all of a sudden, people might put all commercial real estate in the same bucket.”
First-quarter bank earnings have shown real signs of rising stresses. Wells Fargo, for example, reported that its non-performing commercial real estate loans had risen almost 50 percent since December of 2022 to $1.5 billion, while Morgan Stanley cited the commercial real estate sector as one of the main reasons for its sharp rise in provisioning compared to last year.
This is not an issue with only large financial institutions; smaller lenders may be exposed even more. Commercial real estate loans account for around 40 percent of smaller banks’ total lending, Financial Times stated, while the books of larger lenders hold around 13 percent of their loans in the sector.
Even large institutional investors, like pension funds, are finding that challenging circumstances may define the foreseeable future. California State Teachers’ Retirement System’s (CalSTRS) chief investment officer, Christopher Ailman, estimated commercial real estate values have fallen around 20 percent. His fund is bracing for significant value reductions on the fund’s $52 billion real estate portfolio, as The Registry reported last week. Blackstone, the world’s largest property investor with $332 billion of real estate assets under management, in its first quarter of 2023 analyst call, announced a decline in earnings from its real estate business for the first quarter of 2023 on the scale of a 58 percent drop compared to the same period in 2022. The decrease in income from asset sales and disposals was a result of a market slowdown, with net realizations down by 98 percent, from $567 million down to around $10 million. As a result, the company’s assets under management and management fee income from the sector slid to $535 million in the first three months of the year, down from $1.3 billion twelve months ago.
Investors are increasingly jittery, with nearly fifty percent of those surveyed by Bank of America identifying commercial real estate as the most likely source of a systemic credit event. The sector is also causing concerns beyond the US, with a top official at the IMF describing the commercial real estate industry as “a point of focus.”
During an interview last week, Jonathan Gray, president of Blackstone, expressed positivity regarding the commercial real estate sector. Gray highlighted that large portions of the commercial real estate industry are still performing well, including logistics, hotels, rental housing, and data centers. Gray’s expertise in Blackstone’s commercial real estate arm emphasized how broadly real estate investments are held and distributed amongst big banks, small banks, insurance companies, government agencies, securitization companies, and REITs, to name a few. He concluded that he doesn’t believe that commercial real estate poses the systemic issues people claim it may.