November 5, 2024
A coming crunch in the commercial real estate market could have significant consequences for a banking system already reeling from recent turmoil.

A coming crunch in the commercial real estate market could have significant consequences for a banking system already reeling from recent turmoil.

Commercial real estate — a sector including office buildings, apartment complexes, retail, industrial storage, and more — faces a potential crisis over the next several years due to rising interest rates and falling values.

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That could spell trouble for banks that sunk lots of money into commercial real estate loans over the past several years. After the collapse of Silicon Valley Bank, which parked too much of its money in bonds that lost value when interest rates climbed, experts searching for the next potentially overlooked threat have set their sights on the commercial real estate market.

“If you go back to 2021, the end of 2021, we had very low interest rates, investors had strong appetites to put money into commercial real estate and other investments, and as a result, the cap rates were low and property values were high,” Jamie Woodwell, head of commercial real estate research at the Mortgage Bankers Association, told the Washington Examiner. “In a lot of ways, we had just come through one of the greatest stress tests the commercial market could ever go through.”

The fourth quarter of 2021 saw a booming commercial real estate market and a flurry of loan activity that tied money up in buildings that, today, could be worth far less than just 18 months ago. The Federal Reserve kept interest rates near zero at the time, making commercial real estate a more attractive option for banks and investors.

Joel Griffith, senior fellow for economic policy studies at the Heritage Foundation, blamed “cheap money and excessive money printing” for the burst of commercial real estate investment.

“Why were commercial real estate values increasing at a time when we had vacancy rates increasing?” Griffith told the Washington Examiner. “That’s because of the Fed.”

Now, a timing issue could cost banks and investors billions of dollars in commercial real estate losses.

This year, as much as $270 billion in commercial real estate loans held by banks, according to data from Trepp, are set to mature — that is, the terms of the original loan will expire, and the loan holder will have to refinance.

But with interest rates much higher, rent revenues lower, and the value of the underlying property lower now as well, the commercial real estate sector could see a wave of defaults.

“If a bank then had to sell the property if the loan goes into default, the real risk is if the bank is unable to sell the property at a value to cover the mortgage,” Griffith said. “The more defaults on the mortgages you have, the more bank foreclosures, and then the bank has to sell those properties. And if a property goes into default because the vacancy rates just mean there’s not sufficient cash flow for a company to make the mortgage payments, the chances of the bank to actually recoup what they’re owed on the mortgage just declines substantially.”

Small and mid-sized banks have particularly large exposure to the commercial real estate market, with some estimates suggesting those regional banks hold as much as 80% of commercial real estate loans.

For banks with between $1 billion and $10 billion in assets, for example, income-producing commercial real estate investments make up nearly a fifth of their assets, according to the Mortgage Bankers Association.

Fed Chairman Jerome Powell sought to downplay fears of commercial real estate problems earlier this month in a hearing before the Senate Banking Committee just days before the SVB collapse.

He said he did not foresee a “big spike” in commercial debt and acknowledged only “pockets of concern” related to the commercial real estate market, including impending deadlines for commercial real estate holders to refinance.

“I’ve seen those come and go before. Generally, markets can absorb them,” Powell said.

Neel Kashkari, president of the Minneapolis Federal Reserve, similarly downplayed the risk of a broader catastrophe.

“There are a lot of commercial real estate assets in the banking sector and there are some losses that will probably work its way through the banking sector. So, that process will take time to fully become clear,” Kashkari said Sunday. “But, fundamentally, the banking system has a lot of capital to be able to withstand those pressures.”

For some of the biggest commercial real estate markets in the country, however, demand for office and retail space is evaporating. Property values have tanked alongside it, and more businesses have started struggling to pay their commercial leases and mortgages.

More than 20% of office space in Washington, D.C., sat empty at the end of last year, according to CBRE.

In Portland, Oregon, more than 21% of its metro offices remained vacant last quarter.

Midtown Manhattan closed out last year with roughly 18% of its office space empty. The pace of new office leases had slowed by 30% from the previous five-year average.

Some cities have seen an even more dramatic exodus of office tenants.

San Francisco’s controller issued a dire warning in June that office vacancy rates could climb above 40%, and reach as high as 53%, in some parts of the city by 2024 if conditions don’t change.

Overall, the average vacancy rate for offices across the country is set to peak at 19% this year, with only a slight decrease in the years to follow, according to Moody’s Analytics.

Several factors have driven businesses out of their office buildings. Remote work has endured well beyond the lockdown phase of the pandemic and shows few signs of disappearing.

A McKinsey survey from June 2022 found that 58% of people said they have the opportunity to work from home at least one day a week; more than a third of people said they can work from home five days a week.

In some cities, crime has caused retail and other businesses to flee and left streets lined with empty storefronts.

And as more businesses go fully remote or leave for space in safer and cheaper markets, the restaurants, coffee shops, and bars that cater to downtown workers often see their customer base dry up and also have to close.

Investors are now less interested in putting their money into commercial real estate, and banks are less keen to lend to those that are.

The value of the offices, hotels, shops, and other properties that make up the commercial real estate market has also dropped — but by precisely how much is not yet clear.

“The slowdown in transaction activity also makes it harder to get a good window into where property values are,” Woodwell said. “Property values have come down from where they were the middle of last year.”

Some banks may therefore have major unrealized losses sitting on their books that won’t become evident unless the bank is forced to sell their commercial properties,

“It’s not as if these properties are trading back and forth every day on a marketplace, but that doesn’t mean they haven’t lost their value,” Griffith said.

Delinquency rates, or the rate at which commercial real estate loan holders have begun to miss payments, have started ticking up.

CLICK HERE TO READ MORE FROM THE WASHINGTON EXAMINER

Last month, delinquencies on commercial real estate mortgage-backed securities “moved sharply higher” to 3.12%, according to Trepp.

Office properties experienced the most dramatic rise in delinquencies, nearly doubling in February 2023 from the average of the past 12 months.

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