It is widely believed that the path to wealth is paved with real estate. While there is (some) truth to this, it must also be noted that the path is not a straight line (see charts below), and the potholes can be painful. Over the last ten years or so, zero interest rates have propelled real estate to very lofty valuations, which are not easily sustained when rates increase or there is a demographic shift. The shift from near zero rates to the current interest rate environment is unparalleled (over four percent in the ten-year Treasury and over five percent in the federal funds rate) since the inflationary period in the 1970s. As many investors have realized, there has been trouble percolating in the commercial real estate sector (and related securities) for some time, which continues to increase and, as a result, caution is warranted.
Source: Green Street/BCIS
According to Morningstar, office real estate is estimated to make up 15.5% of the $20 trillion commercial real estate market; multi-family housing is estimated at 18.4% and both are under pressure right now. Commercial real estate (“CRE”) lenders and investors could be in for nightmare scenario; some are calling it an impending apocalypse (which we feel is a little dramatic, but the risk and impact cannot be understated). Office properties have been hit particularly hard by overbuilding, higher borrowing rates, lower property valuations, and the work-from-home (“WFH”) movement. Huge companies like AT&T and IBM are downsizing their office footprint like never before. Fluor is cutting its Houston office space by 70%.
Source: Green Street/BCIS
The COVID-19 pandemic made WFH a requirement for a large portion of the U.S. workforce, many of whom have yet to return to the office. Naturally, companies are looking at ways to cut expenses, with a reduction in leased office space being one of the most effective ways to accomplish this. Companies are renewing leases for far less space than they did from 2015-2019, leading the National Association of Realtors to report national vacancies at an all-time high. Recent data by Colliers International states roughly 15% of office space sits entirely empty. Post-pandemic financial districts may never be the same.
According to the Dodge Data & Analytics Supply Track construction pipeline data (as stated by Fannie Mae), the number of apartment units completed across the country may reach a record in 2023. As illustrated in the chart below, nearly 730,000 units are underway with completion dates expected in 2023, though only 164,000 were completed year to date through April. That’s compared to full-year totals of 479,000 units in 2022 and 395,000 units in 2021.
Due to these factors, Fannie Mae believes that while much of the current development underway is concentrated in the largest metros, in most metros it is further concentrated in only a few submarkets, particularly in more dense and urban-focused submarkets. Additionally, most units being developed are more expensive, Class A-type apartment units. We believe this potential oversupply of Class A units may depress rent growth relative to Class B, particularly through 2024. For example, CoStar, Inc., is forecasting that Class B year-over-year rent growth will be 3.3% for the year ending Q2 2024, compared to the projection for Class A of 2.6% for the same period.
Noteworthy, however, is the fact that other areas of commercial real estate such as data centers, warehouses and self-storage have not been as impacted by factors as office space and some multi-family housing have.
For nearly twenty years, CRE investors (owners, developers, originators, etc.) have been financing their CRE properties through several channels: banks, investment funds, commercial mortgage-backed securities, and securities backed by loans on the real estate. The variety of funding has allowed these various players to spread the risk to investors with differing risk tolerances and “shop” for the lowest rate (lower rates helping to increase returns on the investment).
With the increase in rates (and the impact on property valuations) and the uncertainty surrounding demand/occupancy, the commercial mortgage-backed security (CMBS) and collateralized loan obligation (CLO) markets have all but collapsed. JP Morgan estimates 21% of CMBSs will go into default with an 8% loss rate. Higher interest rates are putting some developers and investors into a precarious situation, as investments were entered into with an assumption of lower interest costs, which were required to make the investment profitable and viable. As rates increased at a nearly unprecedented magnitude, many of these investments are struggling and may no longer be viable.
Defaults and foreclosures have been reported in the office segment, and Blackstone recently sold a building on Sixth Avenue in New York City for 33% less than what it paid in 2006. Countless properties like this will be sold at huge discounts and repurposed into residential or other mixed spaces. Some figures put the amount of troubled commercial real estate loans at $600 billion, with $155 billion being at risk of default. Large money center banks are dumping their commercial real estate loans—or at least trying to.
Money center banks like Chase and Bank of America hold a substantially lesser portion of their loan book in real estate compared to regional banks. Regional banks, whom developers have historically relied on for these loans, have already tightened the credit spigot since the Silicon Valley and Signature Bank debacles earlier this year. When over a $1 trillion in commercial real estate loans are up for refinancing over the next three years, subject to higher rates and lower property valuations, regional banks in particular may face increased losses. These losses would inevitably have repercussions in the stock market and broader U.S. financial system. Importantly, banks are better capitalized, and with better quality capital, than they ever have been.
Source: FRB St. Louis/BCIS
Source: FRB St. Louis/BCIS
As the following charts evidence, the lending in the CRE space has begun to drop. While the year-over-year change is still above average, it has decidedly turned lower.
What we find disconcerting, however, is the breakdown of the banks which have been making these loans. Small commercial banks have been making the lion’s share of CRE loans. As the chart below shows, small commercial banks (those not in the top 25 US chartered banks, by size) have significantly eclipsed large commercial banks (the top 25 US chartered banks, by size). Why does this concern us? Small commercial banks are not held to the same capital and liquidity standards that large commercial banks are. Even with the upcoming regulatory changes on capital for super regionals, these smaller banks will not be affected and therefore will be less prepared should the downturn in CRE continue.
Source: FRB St. Louis/BCIS
On the equity side, Boston Properties Inc., the largest workplace developer, has seen its share price fall 25% year-over-year. Publicly listed US REITs are down 20 percent from their 2023 highs (as shown below), but the monthly year-over-year losses of 2023 have begun to soften. Commercial real estate investment trusts, or REITs, have shown some signs of rebounding, as listed equity will usually recover before the physical properties themselves. Investors will be trying to identify price discovery and a bottom in valuations, but the future of office real estate is cloudy, and some say it could take as long as two decades for office values to come back.
Source: MSCI, Bloomberg, BCIS
The 40-year bull market in office buildings is most likely over, with focus now being shifted towards the concern that the office situation will intensify and drop the U.S. into a full-blown recession if office property defaults begin at a larger scale—very similar to the 2008 housing crisis. It’s too early to tell how bad future losses will be, but investors in this space should certainly proceed with caution.
The Federal Reserve isn’t sounding the alarm (we have yet to experience a fire sale), but in our view the office real estate market, at one point or another, will have to suffer the painful reality of mass deleveraging. We are also concerned about smaller banks and their capacity to absorb a continued downturn in CRE and the potential effects this will have on the financial system and CRE lending. While private funds are increasingly the “go to” lender, we believe this facet of the CRE market could have a significant impact. This is a story we’ll continue to monitor as the wall of debt comes up for refinancing.
The views expressed in this publication are those of the author and do not necessarily reflect the views and opinions of Cetera Advisor LLC or Burrows Capital Advisors.
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