Empty office buildings’ bark looks greater than their bite.
Is commercial real estate the next shoe to drop? That is the big question as high office vacancies linger and some property owners have written down the value of some very high-profile buildings. Analysts warn that, with owners needing to refinance a seemingly large chunk of commercial property loans this year—amid far higher long-term interest rates—defaults are about to hit property values and lenders alike, creating new problems for regional banks in particular. We do think it is fair to presume there may be some turbulence. However, scale the issue, and it becomes pretty clear this likely isn’t large or surprising enough to wallop stocks anew.
The narrative underpinning these concerns is simple and logical enough. The pandemic accelerated a shift to remote work, reducing demand for office space. Layoffs and a general drive for more corporate efficiency have added to that. As a result, property owners aren’t collecting the rent they anticipated, leaving them with less cash flow to service debt. That is especially problematic for loans that need to be refinanced, as the new higher rates will increase the owners’ costs. Those who can’t pony up would have to sell in a pinch or default, hurting bank balance sheets. And with regional lenders having disproportionate exposure to commercial property, they stand to get hurt the most—while they are already under the microscope following Silicon Valley Bank and Signature Bank’s failures last month.
So goes the fear. But let us put some numbers on it. Commercial real estate does indeed make up a relatively larger share of regional banks’ balance sheets. But as Exhibit 1 shows, the biggest driver of recent loan growth isn’t offices but rather multifamily properties. Yes, you read that right. Multifamily dwellings fall into the commercial real estate category. It isn’t all office parks, data centers and warehouses.
Exhibit 1: The Surprising Drivers of Commercial Real Estate Loan Growth
Source: Federal Reserve, as of 3/30/2023.
As for offices, some banks probably are overexposed. About 15% of publicly traded US banks exceed commercial real estate exposure guidelines, but the affected banks amount to just 2% of publicly traded bank assets.[i] Regional banks’ exposure to office loans maturing this year is less than $50 billion.[ii] Less than $100 billion matures in the next two years. And considering how long this fear has lurked in headlines—and where regional bank stocks are trading right now—we think stock prices probably already reflect any speedbumps to a great extent already.
Crucially, the potential for broader contagion seems very, very low. In 2008, distressed residential real estate loans rippled through the financial system because accounting rules at the time forced them to. Banks endured only about $200 billion of actual loan losses during the financial crisis.[iii] But whenever a financial institution sold mortgage-backed securities at firesale prices, banks had to write every comparable asset on their balance sheet down to that sale price, even if they never intended to sell. That transformed mild loan losses into nearly $2 trillion in exaggerated and unnecessary writedowns.[iv] Regulators eventually figured out the error, thanks to the Congressional testimony of former FDIC head William Isaac (who literally wrote the book on this period, the brilliant Senseless Panic), and they have adjusted accounting rules so that this vicious cycle shouldn’t repeat if and when office buildings sell at bargain prices. Banks may take losses on a case by case basis, but the broader system won’t have to take unnecessary paper losses when that happens.
For a problem to wallop markets, it would generally have to be a sudden shock and have the power to delete a couple trillion dollars from the global economy. Commercial real estate issues don’t seem close on either front. They are too widely known and, in our view, too small. That doesn’t preclude short-term volatility as scary headlines hit sentiment, but as markets look further out and weigh reality over the next 3 – 30 months, we don’t think office problems should tip the scales.
Hat tip: Fisher Investments Research Analyst Ori Powers
[i] Source: FactSet and US Federal Reserve Bank of St. Louis, as of 3/30/2023.
[ii] Source: CBRE, as of 1/31/2023.
[iii] Senseless Panic, William Isaac, Wiley, 2012.
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