The potential future crash in commercial real estate

Marc Holliday, the CEO of SL Green & Co., sounded content just two months ago. The leader of the largest commercial landlord company in New York told Wall Street analysts that business was picking up at the company’s facilities and that more than 1 million square feet of space had either recently been leased or was under contract. The firm’s debt was decreasing, the construction of its 1 Madison Avenue tower in Manhattan was complete, and local authorities had just finished extending commuter rail service from Long Island to Green’s signature building close to Grand Central Station.

In the midst of a pandemic that rattled developers and increased the number of people working from home, Holliday said on the quarterly earnings call, “We are full guns blazing.” This raised the question of how much additional office space businesses actually require. “We can hopefully keep moving forward toward what we believe will be a turning point for us in 2023.”

After Silicon Valley Bank’s failure, Wall Street went into a frenzy.

Bank shares have remained low and shares of developers and the banks that lend to them have fallen dramatically. Analysts expressed fear that developers could default on a sizable portion of the $3.1 trillion in outstanding commercial real estate loans in the United States, according to Goldman Sachs. According to data from the Mortgage Bankers’ Association, about a quarter of mortgages on office buildings will need to be refinanced in 2023 at interest rates greater than the current 3 percent paper that makes up the portfolios of banks. With office vacancy rates at historic highs and existing contracts expiring this year, several analysts questioned how landlords might locate new tenants.

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There are reasons to believe the real estate sector and the banks that depend on it may face some bumps in the road in the future. Goldman claims that the stakes are enormous, particularly in the event of a recession, and that a credit crunch might cost the economy as much as 0.5 percentage points of growth. However, credit in commercial real estate has performed well up until this point, so it’s not certain that the likelihood of U.S. credit problems extending outside of real estate is high.

According to Kevin Fagan, director of commercial real estate analysis at Moody’s Analytics, “There are a lot of headaches about the catastrophe in commercial real estate.” It’s more of a standard downcycle, although there probably will be problems.

According to the brokerage behemoth Cushman & Wakefield, the vacancy rate for office buildings reached a record high of 18.2% by the end of 2022, surpassing 20% in important locations like Manhattan, Silicon Valley, and even Atlanta.

The main problem, though, is this year’s refinancing cliff, according to Scott Rechler, CEO of RXR, a privately held Manhattan development company. Even when vacancy rates increase or stay high, loans that are due will need to be funded at higher interest rates, which will result in larger payments. Buildings with higher vacancies are worth less, thus banks are less inclined to work with them without stricter conditions. According to him, this is particularly true for older, so-called Class B buildings, which are losing out to newer structures as tenants extend their leases. Additionally, banks find it challenging to determine how much extra cash collateral to require given the lack of recent transactions.

Nobody is aware of what a reasonable price is, according to Rechler. “Sellers and buyers hold different perspectives.”

The Fed’s comments on commercial real estate
The collapse of Silicon Valley Bank and Signature Bank was an anomaly, and neither failure had anything to do with real estate, according to Federal Reserve officials, including Chair Jerome Powell. Silicon Valley Bank had a meager 1% of assets in commercial real estate. The sector’s exposure to other banks is effectively under control.

At a press conference on March 22, Powell stated, “We’re well aware of the concentrations people have in commercial real estate.” “I genuinely don’t believe it compares to this. The banking system is solid, durable, strong, and well-capitalized.

The commercial real estate market is a bigger problem than a few banks that handled risk in bond portfolios improperly, and the deterioration in Class B office space conditions will have significant negative economic effects, including on the tax bases of municipalities across the nation where vacant offices continue to be a major source of concern.

However, there are grounds for optimism that the credit problems in commercial real estate will be managed, according to Fagan.

The first is that, despite being a sizable portion of commercial real estate, the office sector is only one among many, and the others are in particularly good condition.

According to Cushman and Wakefield, warehouse and industrial space nationwide has low vacancy rates. Despite the shift of consumers to Internet shopping, the national retail vacancy rate is only 5.7%. Additionally, hotels are earning record amounts of money per available room as a result of the post-Covid increase in occupancy and rates, according to research firm STR. Apartment buildings are included in the commercial real estate loans provided by banks; according to data from the Federal Reserve, their rental vacancy rates are 5.8%.

According to Ken Leon, a CFRA Research REIT analyst, “Market conditions are good right now, but what develops over the next two to three years could be pretty challenging for some properties.”

However, according to Fagan, the majority of the debt that will be due in the next two years may probably be refinanced.

One of the reasons Rechler has been bringing the problems to light is because of this. With the loans dispersed across their own maturity ladder, they shouldn’t creep up on the market or economy and should be manageable.

According to Fagan, almost three-fourths of commercial real estate debt generates sufficient income to pass modern bank refinancing standards without significant adjustments. Banks typically grant credit based on the assumption that a property’s operational revenue will equal at least 8% of the loan each year, however, other experts assert that some newer loans are subject to a 10% test.

Banks have essentially experienced no losses on commercial real estate yet, and businesses are showing little need to stop making bank loan payments or rent payments to owners of office buildings. The concentration of job losses among major tech corporations, at least in Manhattan, implies that tenants have a little issue paying their rent even while businesses lay off employees, according to S.L. Green.

Books of bank commercial mortgages
Consider PNC Financial in Pittsburgh or Fifth Third in Cincinnati, two of the largest regional banks.

PNC’s $321.9 billion in loans and the $36 billion in commercial mortgages it has on its books represent a little portion of its $557 billion in total assets. Office buildings only serve as collateral for loans totaling around $9 billion. Of the $207.5 billion in assets at Fifth Third, which also includes $119.3 billion in loans, commercial real estate accounts for $10.3 billion.

And the loans are being repaid according to the terms. Only 0.6% of PNC’s loans are past due, while commercial loans have fewer delinquencies. According to bank records with the federal government, the percentage of past-due loans decreased by over a third in 2022. Only $10 million of Fifth Third’s commercial real estate loans were past due as of year’s end.

Or consider Wells Fargo, the biggest commercial real estate lender in the country, where credit scores are quite good. According to the bank’s annual report, Wells Fargo’s chargeoffs for commercial loans last year made up.01 of 1 percent of the bank’s portfolio. Consumer loan write-offs were 39 times more common. The amount of debt classed as “criticized,” or with a higher-than-average chance of default even though borrowers haven’t skipped payments, fell by $1.8 billion to $11.3 billion in 2022, reflecting an improvement in the bank’s internal assessment of each commercial mortgage loan’s quality.

Delinquencies are still fewer than they were prior to the epidemic, according to CFRA Research banking expert Alexander Yokum. Every credit metric is still better than it was before the outbreak.

Wall Street has concerns.
Wall Street’s retort is that the positive loan performance news can’t endure, especially if there is a generalized recession.

According to research published on March 24 by JPMorgan Chase financial analyst Kabir Caprihan, 21% of office loans will default, costing lenders an average of 41% of the principal. According to Caprihan, this might result in writedowns of 8.6%, costing banks $38 billion in losses on office mortgages. But neither the reason for the dramatic value drops nor the fact that so many projects will fail is guaranteed.

According to RXR’s Rechler, refinancings are already displaying market downturn in ways that banks’ public reports have yet to indicate. According to him, the true impact is less evident in late loans than it is in the falling value of bonds supported by commercial mortgages.

RXR, which has good financial standing, has advanced $1 billion to other developers whose banks are requiring them to post additional collateral as part of refinancing applications. This is one indication of the tightening market. Rechler disputed rating agencies’ generally upbeat assessment of commercial mortgage-backed securities, claiming that markets for new CMBS offerings had been stagnant in recent weeks and that ratings agencies were slow to pick up on warning signals of concerns with the housing market before to the financial crisis of 2008.

Since the market for commercial mortgage-backed bonds is quite tiny, the economy is not significantly influenced by its short-term concerns. The issuance of new bonds has decreased significantly, but this trend had already started last year when the fourth-quarter deal volume fell by 88 percent, avoiding a recession.

As authorities take a closer look, the statistics “don’t reflect where it’s going to come out,” Rechler claimed. “You’ll need to rebalance loans on even good properties,” the speaker said.

Wells Fargo has tightened requirements, stating that it will only make “limited” adjustments to its credit standards for new loans and that payments on refinanced loans must account for a smaller portion of the building’s estimated rent.

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However, it’s unclear how the reasonably diverse loan portfolios of banks and insurance firms can become seriously troubled without a significant downturn in the economy.

Real estate would primarily affect the economy if a prolonged decrease in the value of commercial mortgages caused deposits to leave banks, forcing them to restrict lending to everyone, not just developers. In dire circumstances, that might put the banks themselves in danger. However, if developers continue making on-time loan payments and managing refinancing risk, MBS owners and banks will only receive payment as loans come to an end.

Markets are divided on whether this will materialize in any way. The S&P United State REIT Index, which fell by about 11% in the two weeks following Silicon Valley Bank’s failure, has mostly recovered its losses; it has fallen by 2% over the last month and is still just marginally in the black for the year. Nevertheless, despite the fact that deposit loss has reduced to a trickle, the KBW Regional Banking Index has fallen 14% in the past month.

A number of variables will combine to provide the answer. After this year, there are far fewer loans available for refinancing, new construction is already slowing as it typically does during real estate downturns, and loan-to-value ratios in the sector are lower than they were in 2006 or 2007, just before the previous recession.

In March, there were 236,000 new jobs created, which is about what was anticipated.

We anticipate suffering during the upcoming year, Fagan added. We “see our pivot toward a [recovery] for office” in 2025.

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