The Commercial Real Estate Time Bomb Just Went Off
"The dirty little secret in commercial real-estate is that loans don't really get repaid," says research analyst Brian Foran. "They get refinanced."
Prior to the steepest, fastest rate-hike cycle in decades that kicked off almost two years ago, in March 2022, commercial real estate (CRE) had been a consistent moneymaker for banks and a way for developers to get rich.
For the longest time, CRE had all the major factors in its favor. Interest rates stayed low, which made finance costs cheap. Prices and rents generally rose, which added to cash flows and property values. And best of all, because CRE properties are not publicly quoted or traded, there isn't any volatility — or at least none the public can see.
With a combination that attractive, there was no point in ever paying back a real estate loan. The preferable method was to pay interest in perpetuity — rolling the loan at the end of every term — while using cash flows and rising property values to acquire even more real estate.
In this manner banks made money on the loans and developers made a killing while expanding their mini-empires.
This worked for years and years — long enough for huge amounts of leverage to build up. Then CRE property values fell off a cliff after the pandemic, and interest rates shot up in 2022. Both sides of the trade, the cheap financing side and the rising property values side, got simultaneously wrecked.
Troubles did not surface right away, though, because the banks kept their CRE issues buried through a process nicknamed "extend and pretend," as in, extend the life of the loan and pretend things are fine.
Because a commercial real estate loan is a transaction between professionals — a bank officer on one side, a developer on the other — both parties have an interest in working things out and hiding signs of distress.
Then, too, banks can put an optimistic tilt on the property values of the buildings they lend against, and problematic loans can be kept under wraps, sometimes for years, before they get reported as losses.
In many cases the bank will assume that a bad loan can turn good again, and just continue making that assumption until they have pushed the envelope as far as they can.
At some point, though, the extend-and-pretend losses become a big enough problem, or enough of a regulatory scrutiny issue, that the banks have to disclose the true state of their loan portfolios.
It is this combination of factors — the leverage inherent to CRE transactions that grew massive over the years, the ability of banks to "extend and pretend" to hide problems, and the disastrous combination of rising rates and falling property values that hit in 2022 — that came together to make CRE a ticking time bomb.
The bomb is going off now. Banks are being forced to reveal the extent of CRE loan losses on their books. What begins as a trickle could turn into a flood.
Note this is a wholly different issue than the one that caused Silicon Valley Bank to fail, and two other banks in its wake, in March 2023.
The Silicon Valley Bank collapse was about mark-to-market losses on government securities in the wake of fleeing customer deposits due to a smartphone-enabled bank run.
Silicon Valley Bank's customer base was primarily venture capitalists and tech startup founders who all knew each other and talked to each other; when word got around that Silicon Valley Bank could have funding issues due to losses in its held-to-maturity bond portfolio, capital flight at the speed of a smartphone tap made rumors of insolvency a self-fulfilling prophecy.
The CRE crisis is different, and possibly more dangerous.
This is about banks taking hundreds of billions of dollars' worth of losses, if not more, on CRE loans unlikely to be repaid against buildings that have declined in value by 40% to 50% or more, some of them unsellable at any price.
Then, too, this crisis squarely lands on regional banks because regional banks are so heavily reliant on CRE loans as a profit source. The larger banks have credit cards and auto loans and institutional financial services to fall back on, not to mention fortress balance sheets; the regional banks have none of that.
On March 21, 2023, in a piece titled "For Thousands of Banks, the Cost of Capital is Too Darn High," we explained why there are far too many regional banks in the United States and why, in an echo of the late 1980s and early 1990s savings and loan crisis, thousands of these banks are likely to go under in the coming years.
The Federal Reserve and the network of Federal Home Loan Banks can try to help out the regional banks with low-cost financing and emergency lending facilities, just as they did with the Bank Term Funding Program (BTFP) in the aftermath of the Silicon Valley Bank collapse.
But the Fed can't bail out the banks in the sense of making their CRE losses go away or making their business models viable versus not. The Fed can only slow the reckoning, not stop it.
From $100 Billion to $1.2 Trillion
How big will the CRE problem turn out to be? Credible estimates vary by a factor of 10 or more.
"In the spring, it was deposits running out the door," says Jefferies analyst Casey Haire in reference to the Silicon Valley Bank collapse of last year.
But this new round of CRE pain "is preparing to be a $100 billion bank and credit risk," says Haire, further noting that "the magnitude of credit loss is an open question."
Barry Sternlicht, a billionaire real estate developer and CEO of Starwood Capital Group, has a darker assessment.
"The office market has an existential crisis right now," says Sternlicht. "There's $1.2 trillion of losses spread somewhere, and nobody knows exactly where it all is."
To get a sense of what Sternlicht is talking about, consider the transaction history of The Aon Center, the third-tallest office tower in Los Angeles.
The Aon Center recently sold for $147.8 million, Bloomberg reports — a 45% decline from its 2014 purchase price.
Premier buildings in premier cities are seeing their values nearly cut in half relative to transactions from a decade ago.
And if things are that bad in Los Angeles, think how much worse they are in second- and third-tier cities; then consider the degree to which regional banks have been overly rosy in their loan-to-value property assessments for going on 15 years now (since 2009).
Blow-Ups on Three Continents
Okay, but if CRE loans are a long-time-hidden problem, why are the concerns showing up all of a sudden? Why now?
Financial crisis events are comparable to earthquakes.
You can have a recognizable fault line, and worrisome tremors, and keen observers spotting the danger, and yet no major event — no "big one" — for a surprisingly long period of time.
Then the "big one" hits seemingly out of nowhere in what appears to be a random process – but is actually the cumulative result of thousands of hidden stress points building up pressure below the surface in a manner the eye cannot see.
For the commercial real estate problem, Jan. 30 was a day of miniature blow-ups on three separate continents.
New York Community Bancorp (NYCB), a regional bank that had acquired assets from the failed Signature Bank last spring, disclosed shocking losses in its CRE portfolio, creating a swing from hundreds of millions in expected quarterly profits to a $252 million loss. The quarterly dividend was also cut from 17 cents to 5 cents to preserve capital for future loan losses; investors recoiled, and the share price plunged 38%.
Aozora Bank (AOZOY), the 16th largest bank in Japan by market value, surprised shareholders with negative earnings due to unanticipated losses in its U.S. commercial real estate portfolio, causing the share price to immediately fall 20% before hitting exchange limits.
Frankfurt, Germany-based Deutsche Bank (DB) had a good quarter overall, but reported loss provisions for its U.S. commercial real estate portfolio much larger than expected and four times larger than the prior quarter, citing refinance issues (the inability of developers to roll over their loans due to falling property values and increased cash requirements) as the "main risk" to its American CRE loan book.
In theory, optimists could wave off a single instance of CRE bad news. But three separate reports from three separate banks in three separate countries, all pointing to the same problem? Not so much.
The economist Rudiger Dornbusch is known for Dornbusch's Law, which goes like this: "Financial crises take longer to arrive than you think, and then happen faster than you expect."
It will be interesting (to say the least) to see if Dornbusch's Law applies here.
Until next time,
Justice Clark Litle Chief Research Officer, TradeSmith
TradeSmith is not registered as an investment adviser and operates under the publishers' exemption of the Investment Advisers Act of 1940. The investments and strategies discussed in TradeSmith's content do not constitute personalized investment advice. Any trading or investment decisions you take are in reliance on your own analysis and judgment and not in reliance on TradeSmith. There are risks inherent in investing and past investment performance is not indicative of future results.
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