Although it is often hard to predict the proverbial next shoe to drop, investors are currently zooming in on growing risks in the commercial real estate (CRE) market and its potential spillover to the banking system and the wider economy. Rising interest rates, a slowing economy and increasing vacancy rates in office buildings have weighed on the sector in the last couple of years. Now, an expected credit crunch on the back of rising cost of funding for banks may further compound its troubles. However, in our view, while the risks in CRE have certainly increased, it does not pose a wider systemic risk.
Challenges mounting for commercial real estate
One of the derivative implications of recent banking stress that the market has honed in on has been demand for and the availability and cost of financing for CRE loans. A growing share of CRE loans from banks have become serviced by regional and local banks in recent years – with around 70% now coming from this population. Given the recent collapses of both SVB and SBNY – both of which has happened to have a large share of CRE as a % of their total loan book – the market has grown concerned that regulations around these banks will tighten and lending will become increasingly restrictive, thus reducing lending access.
At the same time, bank challenges have only exacerbated concerns regarding the recent downturn in CRE values in light of the rapid rise in interest rates. Investors have become increasingly focused on the overall level of outstanding CRE debt and how it will be refinanced – with approximately USD 5.4 trillion in CRE debt outstanding and 1.2trn due to mature in 2023 and 2024 (excluding multifamily CRE). Higher financing costs only add to existing challenges around servicing debt – especially in areas like office and certain segments of retail where cash flows have become challenged due to post-pandemic behavior.
While pressure has grown – headlines are worse than reality
While questions remain about refinancing at higher rates – it’s important to contextualize the size of the problem. It’s worth noting that the office segment — which as mentioned, is one of the most challenged CRE sectors — only represents some 15% of the total value of commercial real estate. About USD 125 billion of office mortgage loans are currently slated to mature over the next 3 years. It’s possible that some of these loans will need to be restructured, but the scope of the issue pales in comparison to the more than USD 2 trillion of bank equity capital. Office exposure for banks represents less than 5% of total loans and just 1.9% on average for large banks. At the same time, CRE-office experts believe any structural stress progression could take several years to unfold as leases come due over an extended period of time.
Big name headlines do also continue to raise concerns among investors — with even giants like Blackstone, PIMCO, Brookfield, Simon Properties being in the news around high-profile CRE defaults. But it’s important to remember that even giant financial services companies have to face underperforming investments at times. In these cases, the more financially prudent thing to do is either try to restructure the loan or hand the keys back to the lender. While these instances especially will generate headlines they are not necessarily representative of systematic issues.
A liquidity crisis similar to 2008 remains unlikely
Without minimizing the current challenges facing CRE, we reiterate that we don’t believe a repeat of the 2008 liquidity crisis is likely — where capital markets essentially closed for financing. In our view, the health of the overall banking system and market liquidity conditions are substantially better than they were during the GFC. Capital in the investment grade and high yield bond markets and in the preferred securities market remain available; investment grade REITs continue to access the unsecured debt market; lines of credit remain open and available to a majority of the REIT market; and mortgage debt on secured properties continues to flow, albeit at higher rates and with more conservative underwriting standards.
The composition of lenders has also drastically improved since the GFC. CMBS, the riskiest type of CRE lending, now accounts for a substantially smaller portion of outstanding debt. That said, access to the CMBS market has declined substantially and the volatility in treasury yields has made it extremely difficult for CMBS underwriters to hedge their exposure.
Bottom line: Defaults likely but CRE exposure should be manageable
While default rates will likely increase, access to capital will become more restrictive and underwriting terms will tighten for the foreseeable future, we believe CRE exposure at banks is currently manageable with potential loss levels even in a hard landing scenario likely causing earnings pressure rather than capital depletion. We do not believe that loss content in bank portfolios will rise to the levels seen in the 2008-09 period when higher losses from construction and land loans were triggered by the housing and mortgage crisis.
Overall, a more severe economic downturn (hard landing) over 2023-24 could pull forward credit issues that would have otherwise been avoided or stretched over a longer period thereby pressuring banks earnings growth and profitability. Accordingly, while we view potential losses as manageable, we would expect a meaningful deterioration in CRE (or, a subsegment such as commercial office) to pressure banks shares due to both earnings/profitability risk as well as elevated concerns about possible contagion spreading more broadly into other asset classes.
