Regional banks and commercial real estate are inevitably linked. As commercial properties, most notably office space, work through the current crisis of sliding valuations and high interest rates, it is important for brokers to understand how intertwined these two sectors are in the current economy.
The following are a few different ways of looking at the connection between the two. According to the bank assets and liabilities report from the Federal Reserve, commercial real estate makes up 6.57% of assets of the top 25 largest U.S. commercial banks, while it makes up 30.15% of the assets of the banks outside the top 25. The Wall Street Journal reported last year that small- and medium-size banks currently hold 67.2% of all outstanding commercial real estate loans and 37.6% of loans overall.
Here is one more statistic: Research from the investment bank Morgan Stanley finds that regional banks account for 70% of the more than $2 trillion in commercial real estate debt maturing through 2025. Refinancing these loans are a major headache for banks and an existential threat for some landlords.
Trouble discerning price
Part of the problem is that it is extremely difficult right now to discern the market value for commercial real estate. That is because there isn’t always a liquid market, nor is there always a good comparison to determine value. Not being able to determine a property’s market value could be a ticking time bomb. It is not unlike what the market experienced during the financial crisis of 2008 when AAA-rated residential mortgage-backed securities turned out to be overpriced and had to be marked down.
This time, the difficulty of assessing the value of property has arisen from two main reasons. The first is the COVID-19 pandemic and the changes to behavior that resulted. Working from home became popular, and once that genie had been let out of the bottle, it has been hard to get workers back in the office. People also increased their level of online shopping and home entertainment, creating substantial problems for malls and movie theaters. When you can order something from your couch and have it come by the next day, it’s hard to justify going to the mall.
The second main reason is the Fed raising interest rates 11 times since March of 2022 to combat inflation. Seemingly overnight, rates skyrocketed. People who have joined the industry since 2009 have only ever seen the Fed funds rate hover between about 0% and 2.5% and they may not be quite sure how to handle anything else.
Tumbling valuations
While investors are expecting the Fed to start cutting rates this year, we have seen that inflation is stickier than many expected, casting some doubts on the number and timing for rate cuts. It is also highly unlikely that rates end up anywhere near zero. In this environment, potential sellers are unwilling to sell properties at distressed prices. For example, earlier this year Blackstone aborted a plan to sell a Canary Wharf office building in Boston due to negative sentiment and worries about the future of the district.
That may change as the number of distressed properties multiply and valuations plummet. According to MSCI, a provider of research and services to the investment community, office buildings accounted for 41% of the nearly $80 billion of U.S. properties deemed as being in distress. The multifamily market had more than $67 billion of potentially distressed assets, making it the largest group in the potentially distressed category.
Recent activity has highlighted just how far some commercial properties have fallen in value. Bloomberg reported that earlier this year brokers were marketing debt backed by a Blackstone-owned office building at a roughly 50% discount.
Aon Center, the third-tallest tower in Los Angeles, sold in December for about 45% less than its last purchase price in 2014. And the Federal Deposit Insurance Corp. took a 40% discount on about $15 billion in loans it sold that were backed by New York City buildings. Ironically, Bloomberg also reported earlier this year that commercial dealmaking has begun to increase as more potential sellers were no longer able to wait for the markets to improve.
Recession dangers
No one knows how bad it will get. But former U.S. Treasury Secretary Larry Summers said he expects to see more small- and mid-size regional banks fail due to issues related to commercial real estate exposure. Current Secretary of the Treasury Janet Yellen told the Senate Banking Committee that high commercial real estate vacancies are expected to create stress for smaller banks, but she doesn’t think there is a systemic risk to the national financial system.
One looming concern is if the economy plunges into a recession. So far, the Fed has been able to engineer a soft landing — raising rates, slowing the economy, but not causing a severe downturn. However, as mentioned earlier, the most recent economic data shows that inflation is not going down as fast as the Fed would like.
There are also signs that the consumer is in much worse shape than recent economic reports show. Credit card debt has reached an all-time peak of $1.13 trillion at the end of 2023 and auto debt delinquencies are at a 30-year high. Inflation is also eating into the buying power of consumers. At some point, if we see this filter into the economy, it will be another nail in the coffin for commercial real estate.
Banks showing weakness
The banking sector was dealt a blow in March when New York Community Bank reported a surprise loss tied to credit quality. The bank announced a $252 million loss for the fourth quarter of 2023, including a provision for credit losses of $552 million, much of it tied to real estate, according to The Associated Press.
Moody’s downgraded the bank’s credit rating to junk status. The troubles sent jitters through the financial sector, with worries that 2023’s banking crisis, in which certain banks failed or were bought out, would return.
What the 2023 regional bank crisis and the 2008 financial crisis taught us is that confidence — and assets — can erode quickly. It takes seconds for depositors to move money from a regional bank to a money center bank. While New York Community Bank has said that 72% of it’s deposits are insured or collateralized, does a depositor still want to go through issues related to a potential bankruptcy?
Important questions remain: What happens if financial weakness spreads to other banks and depositors start moving money out of the regional banks into the money centers? What happens if the regional banks are forced to unload problem commercial loans for whatever they can get? There won’t be much lending for a while if the biggest lenders are swamped with bad loans.
There are potential silver linings if lenders modify loans to avoid foreclosures. The longer they can extend loans, the better chance lending conditions will improve. If interest rates come down and the economy stays strong, we could avoid this potential cataclysm. Bigger banks will, of course, do better; they have more diversified books of business and they are considered too big to fail. It’s the regional banks that may be in the most difficult position and face the most challenging future. ●
