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"A Credit Crunch" - The Next Shoe to Drop:  Commercial Real Estate

"A Credit Crunch" - The Next Shoe to Drop: Commercial Real Estate

March 28, 2023

A credit crunch can have several negative effects on the economy and individuals, including:

  1. Reduced economic growth: A credit crunch can limit the availability of credit to businesses, which can reduce their ability to invest in new projects, hire new employees, and expand their operations. This can lead to lower economic growth and higher unemployment rates.

  2. Increased borrowing costs: As banks become more cautious about lending, they may increase interest rates or require higher collateral, which can make borrowing more expensive for individuals, businesses, and governments. As is the primary focus of this blog post.

  3. Financial instability: A credit crunch can lead to financial instability as borrowers struggle to repay their debts, leading to defaults and bankruptcies. Typically beginning with the banking system itself.

  4. Reduced consumer spending: When credit is tight, consumers may reduce their spending, which can lead to a reduction in demand for goods and services, further slowing economic growth.

  5. Stock market decline: A credit crunch can cause a decline in stock prices as investors become more risk-averse and sell their shares.

Overall, a credit crunch can have a significant impact on the economy and can lead to a range of negative outcomes for individuals and businesses.

One of the new economic realities is real estate (commercial first, then residential), which is being underpinned by the ongoing flight of capital from uninsured deposits (and insured) in regional banks in the United States to the big six banks (J.P. Morgan Chase, Bank of America, Wells Fargo, Citi Bank, U.S. Bank and PNC) , treasuries, gold and even riskier assets, like crypto.

What does this mean for you? Especially with the Bank of England following the ECB, the Fed and SNB this week with a hike in interest rates.

Bank rates are touted by news media as the things to look at, and they are certainly worth knowing about, however they only tell the initial part of the story. 

My primary concern with the run on the regional banks following the downfall of Silicon Valley Bank is what that meant for the everyday person. Regional banks in the United States make up a large percentage of lending in commercial real estate, residential mortgage lending and general credit facilities to everyday people. The reality is that if even a small percentage of deposits left the regional banks (which they did) the amount of credit available to give to businesses and individuals will go down, creating a "Credit Contraction' or a "Credit Crunch".

This has a larger effect than people realize on the overall economy. It's unlikely these deposits will flow back to the regional banks quickly. What does this mean for businesses?

If businesses are unable to get credit to operate and grow, they are likely to reduce cost, sometimes dramatically. This will mean that commercial real estate, which is already suffering from the pandemic with low occupation rates, will continue to see occupation decline.  

So, who cares because I'm not a commercial real estate holder?

Which may seem fair, but the knock-on effects will result in bad news for everyone. With interest rates high, and commercial real estate value primarily calculated on free cashflow (how much rent/lease money they hold after expenses, maintenance, and debt repayments), the commercial real estate holders may default.

We have already started to see this with Blackstone and Brookfield defaults - and I don't see that slowing over the coming years.

This will result in the assets being revalued before the debt is due to be repaid in full. If you bought an office building in 2015 for $100m, with 75% occupancy producing net free cashflow every month. The bank probably agreed with the valuation and allowed you to borrow against that. If you default on the $100m property in 2023 with net negative cashflow and a 25% occupancy rate. The bank won't agree with that valuation and will mark down the value of the real estate.

In this event, the bank lender must assume the loss on the debt versus the value. So some of the CRE sponsors or borrowers the bank lent to may collapse, and so the bank will have to to write it down or off. This again, isn't too bad, unless it happens at scale. Which it is starting to do. The value of these assets are enormous, and if banks must write down these loses, they will take a big hit.

This affects us all as banks will cease lending, some will fail, deposits come under more threat and the central banks will have to step in in a big way. Assuming they can.

Now, I'm not saying this is going to happen. But I am explaining how this could play out (in the worst way) if we don't get a handle of the economic situation soon.

Either way, a new economic reality is upon us for the coming years in commercial real estate.

There are plenty of other ways higher interest rate hikes affect us, and plenty of problems if they don't. Credit contraction has already begun. Many community bank's I work with have already indicated they have shut down any new Commercial Real Estate lending.

The views stated in this letter are not necessarily the opinion of Cetera Advisors LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.