In the wake of the recent spate of bank closures that shook the foundation of the banking sector, commercial real estate (CRE) has been thrust into the spotlight as a ticking time bomb. Since the onset of the pandemic, office and retail property valuations have plummeted as occupancy rates continue dropping amid shifts in work patterns and consumer behavior.
With the Fed’s efforts to curb inflation pushing borrowing costs to levels not seen since 2007, experts fear that the commercial real estate industry may be in for a turbulent ride. “You have fundamentals under pressure from work from home at a time when lending is less available than [it has been] over the last decade,” stated Rich Hill, the head of real estate at Cohen & Steers. Taken together, these factors could send CRE valuations into a free fall, leading to defaults and bankruptcies, according to Hill.
The situation is being compounded as cautious lenders take a more conservative approach when it comes to CRE loans. Banks have been tightening terms on loans, including requiring higher levels of collateral and larger equity stakes. This has made it more difficult for firms to raise funds.
While the Federal Reserve’s efforts to contain the banking sector’s losses have gone a long way toward restoring confidence in the sector, economists are warning of a difficult road ahead for CRE. “There’s always an off-sides,” noted Jamie Dimon, CEO of JPMorgan Chase, referring to the indirect effects of the recent banking crisis. “I think everyone should be prepared for rates going higher from here,” he warned in response to questions about the potential fallout from CRE.
As the effects of the regional banking crisis continue to reverberate, the commercial real estate sector’s plight has become increasingly precarious. Despite the Fed’s efforts to prop up the banking sector, CRE may be facing a downward spiral as investors, lenders, and borrowers struggle to cope with the downturn.
Indicators Pointing Toward Challenges Ahead
Warning signs of a looming downturn in the CRE sector have been flashing since the start of the pandemic – and the recent banking crisis has only added fuel to the fire. According to S&P Global Market Intelligence, delinquency rates for commercial mortgages increased 12 basis points to .77% in the first quarter of the year – the highest level since the third quarter of 2021. “Delinquency rates increased for every major capital source during the first quarter, foreshadowing additional strains that are likely to work their way through the system,” noted Jamie Woodwell, an executive with Mortgage Bankers Association (MBA). In May, the delinquency rate rose another 53 basis points to 3.62% – the largest increase since June 2020 according to the CRE research firm Trepp.
Meanwhile, vacancy rates for office and retail properties have risen to historic highs as firms trim their physical footprints and opt for more flexible work-from-home arrangements. Up 100 basis points from a year ago, vacancy rates for office buildings stood at 16.7% amid a growing number of tech layoffs and a shift away from traditional office settings. Analysts say the trend is likely to extend further in the months ahead.
Further complicating the matter, a recent report by MBA indicated that total commercial and multifamily debt outstanding had reached a record high of $4.25 trillion, after rising $74.2 billion in the first quarter of the year. A look into who holds the debt helps put into perspective the potential fallout from a CRE collapse. Banks held the largest share at 38%, with $1.6 trillion in CRE mortgages on their books. Of that debt, small and mid-sized banks are heavily exposed, holding about 80% of the total.
With the banking sector already on fragile footing and interest rates inching higher, concerns over the potential for a CRE domino effect are growing. Experts are warning that tightening lending standards amid regulatory changes and the high-interest rate environment could plunge CRE lending into a downward spiral. Given the sharp drop-off in CRE lending in the first quarter of the year, there’s a growing fear among analysts that a recession could be in the offing. “We’re likely going into a real-estate recession,” Guggenheim Partners’ investment chief Anne Walsh, warned in a recent interview. “Lenders will be very choosy about what loans they are willing to make,” she added.
According to Trepp, about $270 billion in debt is scheduled to mature in 2023, with office loans accounting for $80 billion of that total. With some estimates pointing to CRE valuations falling as much as 40% from peak to trough, refinancing risks could create a major headache for lenders. Property owners may be forced to take on additional debt, sell properties at a loss or simply walk away from their obligations in the face of mounting losses. For banks that hold these loans, it could lead to billions in losses and further destabilize the sector.
Plummeting valuations combined with a tight credit market could push CRE into a “doom loop” according to Neil Shearing, chief economist at Capital Economics. He noted that as questions about the sector’s health reach fever pitch, customers may pull their deposits out of banks, resulting in a capital crunch. This could lead to further loan defaults and a ripple effect hitting the broader economy – ultimately dragging CRE into a spiral of debt.
CRE’s Potential Spillover Effect on the Broader Economy
Given the close ties between CRE and the broader economy, economists are particularly concerned by the potential fallout from a CRE downturn. Prolonged structural declines in the CRE sector could trigger a chain reaction where deposits start flowing out of banks, compelling them to reduce lending not only to developers but to all customers.
Like the deluge of bank runs earlier this year that caused three of the four largest bank failures in U.S. history, the sudden withdrawal of deposits could leave banks bare and unable to fund new mortgages and other loans. Bank lenders could be forced to abruptly call in their outstanding loans, leaving borrowers without access to capital and setting off more deposit outflows. This could have serious consequences for the broader economy say some analysts, pushing firms into a liquidity crisis as credit becomes harder to come by. According to Goldman Sachs, a credit crunch equal to a 0.5% drop in GDP could be in the offing – a potentially seismic effect for an economy already on shaky footing. The credit crunch of 2008 is a painful reminder of the devastating impact that inadequate access to credit can have on the economy.
Growing vacancies in the commercial real estate sector and a shrinking tax base are also likely to put a strain on local and state budgets, according to the Institute of Taxation and Economic Policy. Empty offices and retail stores could lead to major drops in local taxes, as fewer businesses mean less revenue for municipalities. With commercial real estate accounting for over a third of property taxes across many major metropolitan areas, a further drop in CRE valuations could have a major impact on local budgets.
For billionaire CRE developers like Ross Perot Jr, the current downturn may be a sign of things to come. Earlier this year, Perot warned that a potential CRE meltdown could be in the offing if the industry is unable to secure a construction loan. “What’s happening in the office sector is apocalyptical: We’re creating this huge class of zombie buildings, buildings that no one wants to put any money into because the capital structure is broken,” he said in a June interview with Fortune.
Preparing for Potential Commercial Real Estate Downturn
Unlike the recent banking crisis, which has been met with sweeping government intervention, there may not be much that can be done to cushion the blow from a potential CRE downturn. The CRE market is much larger than a few banks that can be bailed out and the sector’s close ties to the broader economy could mean that intervention efforts would have to be even wider-reaching.
As the risks and uncertainties surrounding the CRE sector continue to mount, many advisors are recommending a conservative approach to investing. Diversifying recession risks with defensive assets like gold could help to hedge against further losses in the event of a downturn, according to State Street Global Advisors.
Between 1973 and 2020, there have been eight recessions. In all but two of those recessions, gold outperformed the S&P 500, underscoring the metal’s defensive qualities. In the two recessions where it didn’t outperform the S&P 500, gold only trailed by a relatively small margin – once due to the Volcker Shock in 1979–1980, and once when central banks were net sellers of gold in 1990. Neither the 20% interest rates of the Volcker era nor the central bank gold sales of the early 1990s are applicable today.
With central banks’ demand for gold hitting a record high in the first quarter of 2023 and gold futures trading near all-time highs, the metal looks well-positioned to provide a defensive buffer against a downturn, according to analysts.
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