Real Estate Newsletter 3.4.24
Weekly News Roundup
- Commercial Real Estate Debt Risk Overblown
- Debt Risk Focused in Some Downtown Office Markets
- Debt Issues Concentrated in Few Regional Banks
Commercial Real Estate Debt Risk Overblown
The share of troubled Commercial Real Estate (CRE) loans will increase in 2024 as banks face roughly another $441 billion in CRE loan maturities, and many banks continue to tighten their underwriting belts in the face of uncertainty. However, to understand the full risk picture, it’s important to note that there are many mitigating factors that blunt potential losses for regional banks generally.
Going forward in 2024, many banks that face heighted CRE-related credit risks will adeptly manage those risks, like in prior cycles. Banks that will have serious hurdles in 2024 will be those that have knock-on risks, such as low capitalization ratios or management issues. The majority of regional banks have a limited exposure to non-residential CRE assets.
There are a number of mitigating factors overall that limit the downside risk for banks. Some examples of these mitigants include significant rent growth since loan origination, above-average risk premium baked into property cap rates post-2008, below-average new construction rates, and lower leverage loans compared to prior cycles. Additionally, CRE is a diverse market of many asset types and varied performance expectations, and even among the most stressed office sector, there are many examples of assets and markets that are performing well. Source: Moody’s
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Debt Risk Focused in Some Downtown Office Markets
Everyone knows office buildings in some downtowns have taken a beating from Covid and the rise of remote work. Perhaps only San Francisco is a better example than New York City, where the amount of offices collecting dust is at a record high: almost 20% are sitting empty, hemorrhaging money and shrinking the city’s tax base.
For some downtowns like San Francisco and New York there is the risk of a so-called doom loop. The crux of the “doom loop” theory is that it’s self-perpetuating. If vacancies rise and property values fall, cities can’t collect as much in tax revenue and overexposed banks have to cut back on lending. That means less public spending on things like transit, sanitation and public safety, and less investment in small businesses.
A dirtier, more dangerous and less accessible downtown is less likely to attract companies and remote workers, meaning vacancies will rise even more and property values will fall further. Wealthy residents could throw in the towel and move their families (and tax dollars) to low-tax states like Texas or Florida. And thus, the cycle repeats itself. The most famous example is the 1970s, when “white flight” and a fiscal crisis sent New York into a slump that it didn’t kick for over a decade. Source: Fortune
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Debt Issues Concentrated in Few Regional Banks
The banking sector, which has high exposure to commercial property, is under pressure from beleaguered property values. The biggest banks are largely safe, but much of commercial property debt is held by smaller regional and local banks. Regional banks hold more than two-thirds of the roughly $2.8 trillion in outstanding loans for U.S. commercial real estate properties.
However, most regional banks have limited exposure to real estate markets with big problems, like downtown San Francisco. For those that do a key issue is interest rates—both for their direct impact on banks and because of the pressure exerted on the commercial real estate sector. High rates have already destroyed about $2 trillion in asset value for banks, according to Piskorski, who contributed to the paper Monetary Tightening, Commercial Real Estate Distress, and US Bank Fragility, which takes a closer look at the number of properties where outstanding debts exceed listed values.
The good news is that the rate of inflation has subsided to within striking distance of the Fed target. Although with the latest Consumer Price Index report showing inflation still above 3%, it’s unlikely that the Federal Reserve will approve cuts in March, leaving the current rate at 5.25% to 5.5%. But more good news is that the economy at large is looking stronger, with upside surprises in measures such as GDP, jobs, and manufacturing, all of which are supportive of commercial real estate. Source: Fortune
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