The coming commercial real estate crash that may never happen

Only two months ago, SL Green & Co. chief executive Marc Holliday was sounding happy. The head of New York’s biggest commercial innkeeper firm told Wall Street analysts that traffic to the company’s buildings was picking up, and more than 1 million market-place feet of space was either recently leased or in negotiations. The company’s debt was down, it had finished the structure for its 1 Madison Avenue spire in Manhattan, and local officials had just completed an extension of commuter rail service from Long Island to Inexperienced’s flagship tower near Grand Central Station.

“We are full guns blazing,” Holliday said on the quarterly earnings cause, with workers headed back to offices after a pandemic that rocked developers as more people manoeuvred from home, raising the question of how much office space companies really need any more. “We can hopefully …go on with on a path to what we think will be a pivot year for us in 2023.” 

Then Silicon Valley Bank failed, and Wall Circle panicked. 

Shares of developers, and the banks that lend to them, dropped sharply, and bank shares have postponed low. Analysts raised concerns that developers might default on a big chunk of $3.1 trillion of U.S. commercial real station loans Goldman Sachs says are outstanding. Almost a quarter of mortgages on office buildings must be refinanced in 2023, coinciding to Mortgage Bankers’ Association data, with higher interest rates than the 3 percent paper that rubbishes banks’ portfolios now. Other analysts wondered how landlords could find new tenants as old leases expire this year, with shtick indulgence vacancy rates at record highs.

How much an office crash could hurt the economy

There are reasons to dream up the road ahead will be rocky for the real estate industry and banks that depend on it. And the stakes, according to Goldman, are expensive, especially if there is a recession: a credit squeeze equal to as much as half a percentage point of growth in the overall control. But credit in commercial real estate has performed well until now, and it’s far from clear that U.S. credit issues spreading outer from real estate is likely.

“There’s a lot of headaches about calamity in commercial real estate,” said Kevin Fagan, administrator of commercial real estate analysis at Moody’s Analytics. “There likely will be issues but it’s more of a typical down sequence.”

The vacancy rate for office buildings rose to a record high 18.2% by late 2022, according to brokerage mammoth Cushman & Wakefield, topping 20 percent in key markets like Manhattan, Silicon Valley and even Atlanta. 

But this year’s refinancing crag is the real rub, says Scott Rechler, CEO of RXR, a closely-held Manhattan development firm. Loans that come due will partake of to be financed at higher interest rates, which will mean higher payments even as vacancy rates generate or remain high. Higher vacancies mean some buildings are worth less, so banks are less willing to intimation them without tougher terms. That’s especially true for older, so-called Class B buildings that are mislaying out to newer buildings as tenants renew leases, he said. And the shortage of recent sales makes it hard for banks to resolve how much more cash collateral to demand.

“No one knows what is a fair price,” Rechler said. “Buyers and sellers cause different views.” 

What the Fed has said about commercial real estate

Federal Reserve officials up to and including Stool Jerome Powell have stressed that the collapse of Silicon Valley Bank and Signature Bank were outliers whose ruins had nothing to do with real estate – Silicon Valley Bank had barely 1 percent of assets in commercial real domain. Other banks’ exposure to the sector is well under control.

“We’re well aware of the concentrations people have in commercial truthful estate,” Powell said at a March22 press conference. “I really don’t think it’s comparable to this. The banking system is reinforced, it is sound, it is resilient, it’s well capitalized.”

The commercial real estate market is a bigger issue than a few banks which mismanaged imperil in bond portfolios, and the deterioration in conditions for Class B office space will have wide-reaching economic impacts, classifying the tax base of municipalities across the country where empty offices remain a significant source of concern. 

But there are by virtue ofs to believe lending issues in commercial real estate will be contained, Fagan said.

The first is that the department sector is only one part of commercial real estate, albeit a large one, and the others are in unusually good shape.

Situation rates in warehouse and industrial space nationally are low, according to Cushman and Wakefield. The national retail vacancy rates, in spite of the migration of shoppers to online shopping, is only 5.7%. And hotels are garnering record revenue per available room as both occupancy and prices bulged post-Covid, according to research firm STR.  Banks’ commercial real estate lending also includes apartment complexes, with rental gaps rates at 5.8 percent in Federal Reserve data.

“Market conditions are fine today, but what develops finished the next two to three years could be pretty challenging for some properties,” said Ken Leon, who follows REITs for CFRA Probe.

Still, most debt coming due in the next two years looks like it can be refinanced, Fagan said.

That’s one of the rationalization because ofs Rechler has been drawing attention to the issues. It shouldn’t sneak up on the market or economy, and it should be manageable with the accommodations spread out across their own maturity ladder.

About three-fourths of commercial real estate debt generates enough return to pass banks’ recent refinancing standards without major changes, Fagan said. Banks have been broadening credit using a rule of thumb that a property’s operating income will be at least 8% of the loan every year, granting other experts claim a 10% test is being applied to some newer loans. 

To date, banks clothed had virtually no losses on commercial real estate, and companies are showing little need to default either on loans to banks or rip payments to office building owners. Even as companies lay off workers, the concentration of job losses among big tech employers, in Manhattan, at picayune, means that tenants have no trouble paying their rent, S.L. Green said. 

Bank commercial mortgage reserves

Take Pittsburgh-based PNC Financial, or Cincinnati-based Fifth Third, two of the biggest regional banks.

At PNC, the $36 billion in commercial mortgages on the logs of the bank is a small fraction of its $557 billion in total assets, including $321.9 billion in loans. Only take $9 billion of loans are secured by office buildings. At Fifth Third, commercial real estate represents $10.3 billion of $207.5 billion in assets, involving $119.3 billion in loans.

And those loans are being paid as agreed. Only 0.6% of PNC’s loans are past due, with delinquencies condescend among commercial loans. The proportion of delinquent loans fell by almost a third during 2022, the bank turned in federal filings. At Fifth Third, only $10 million of commercial real estate loans were late at year-end.

Or take Wells Fargo, the nation’s largest commercial real estate lender, where credit metrics are major. Last year, Wells Fargo’s chargeoffs for commercial loans were .01 of 1 percent of the bank’s portfolio, concerting to the bank’s annual report. Writeoffs on consumer loans were 39 times higher. The bank’s internal assessment of each commercial mortgage’s credit’s quality improved in 2022, with the amount of debt classified as “criticized,” or with a higher-than-average risk of delinquency even if borrowers haven’t missed payments, dropping by $1.8 billion to $11.3 billion

“Delinquencies are still demean than pre-pandemic,” said Alexander Yokum, banking analyst at CFRA Research. “Any credit metric is still stronger than pre-pandemic.”

Exasperate Street is worried

The riposte from Wall Street is that the good news on loan performance can’t last – above all if there is a broader recession. 

In a March 24 report, JPMorganChase bank analyst Kabir Caprihan warned that 21% of backup loans are destined to go bad, with lenders losing an average of 41% of the loan principal on the failures. That produces budding writedowns of 8.6%, Caprihan said, with banks losing $38 billion on office mortgages. But it is far from definite that so many projects would fail, or why value declines would be so steep.

RXR’s Rechler says that shop softness is showing in refinancings already, in ways banks’ public reports don’t yet reveal. The real damage is showing up ungenerous in late loans than in the declining value of bonds backed by commercial mortgages, he said.  

One sign of the tightening: RXR itself, which is financially efficient, has advanced $1 billion to other developers whose banks are making them post more collateral as section of refinancing applications. Rechler dismissed rating agencies’ relatively sanguine view of commercial mortgage backed asyla, arguing that markets for new CMBS issues have locked up in recent weeks and ratings agencies missed original signs of housing-market problems before 2008’s financial crisis. 

The commercial mortgage-backed bond market is relatively young, so its short-term issues are not major drivers of the economy. Issuance of new bonds is down sharply – but that began last year, when fourth-quarter parcel out volume fell 88 percent, without causing a recession.

“The statistics don’t reflect where it’s going to come out as regulators take a harder look,” Rechler mentioned. “You’re going to have to rebalance loans on even good properties.” 

Wells Fargo has tightened standards, saying it is hard that payments on refinanced loans take up a smaller percentage of a building’s projected rent and that only “reduced” exceptions will be made to the bank’s credit standards on new loans.

Without a deep recession, though, it’s not clear how banks’ and security companies’ relatively diversified loan portfolios get into serious trouble. 

The primary way real estate could effect problems for the economy is if an extended decline in the value of commercial mortgages made deposits flow out of banks, forcing them to crimp conferring not just to developers but to all customers. In extreme cases, that could threaten the banks themselves. But if developers continue to pay their advances on time and manage refinancing risk, MBS owners and banks will simply get paid as loans mature. 

Markets are split on whether any rendition of this will happen. The S&P United State REIT Index, which dropped almost 11% in the two weeks after Silicon Valley Bank be found lacking, has recovered most of its losses, down 2% over the past month and remains barely positive for the year. But the KBW Regional Banking Needle is down 14% in the last month, even though deposit loss has slowed to a trickle.

The solution will lie in a emulsion of factors. The amount of loans that come up for refinancing drops sharply after this year, and new construction is already slowing as it does in most actual estate downturns, and loan to value ratios in the industry are lower than in 2006 or 2007, before the last decline.

“We feel like there’s going to be pain in the next year,” Fagan said. “2025 is where we see our pivot toward a [bettering] for office.”