The humdrum business of renting out offices and stores is suddenly in the spotlight as property experts and economists warn that growing problems in U.S. commercial real estate could trigger a new financial crisis.
Among the people raising alarms is Scott Rechler, chief executive officer of RXR Realty, a large property manager in New York, and a director of the Federal Reserve Bank of New York.
In a Twitter thread last week, Mr. Rechler warned that US$1.5-trillion in commercial real estate debt will mature over the next three years. Most of it was taken out when interest rates were near zero.
“This debt needs to be refinanced in an environment where rates are higher, values are lower,” and markets are less liquid, he wrote. If lenders balk or problems emerge, “we risk a systemic crisis with our banking system, particularly the regional banks which make up 80 per cent of [real estate] lending.”
Somewhat similarly Neil Shearing, group chief economist at Capital Economics, warned that a “doom loop” could emerge in which falling commercial real estate values feed back into the U.S. banking system, choking off lending and creating further declines in commercial property prices.
“Historically, problems in the property sector have been at the heart of major crises,” Mr. Shearing wrote. Examples include the 2007-08 financial crisis, the U.S. savings and loans debacle of the 1980s and 1990s, and the British secondary banking emergency of 1973-75.
The current situation would have to grow far, far worse to match those previous episodes. It does have its worrisome aspects, though. The potential problems start with the plight of office and mall landlords in the United States.
Both groups were already struggling to keep up with the accelerated shift to an online economy that began during the pandemic. Now they are suddenly facing much higher borrowing costs as a result of the big increase in interest rates over the past year.
Office landlords are looking particularly haggard. They have been hit hard by the widespread shift to work-from-home arrangements.
Mall landlords are also feeling some heat as online shopping shrinks retailers’ demand for physical space.
The stresses in the office and retail sectors are taking a toll on even the most sophisticated of operators. Blackstone Inc. BX-N, the giant U.S. asset manager, made headlines late last year when it started to enforce limits on how much investors could withdraw from a private real estate investment trust designed for wealthy individuals.
The need to impose such restrictions speaks to how nervous those investors are growing about the prospects for commercial real estate and how many of them would like to head out the door.
Growing stresses in commercial real estate were further highlighted in February when Brookfield Corp. BN-T, the big Canadian asset manager, defaulted on loans tied to two office buildings in Los Angeles.
Such cases could multiply. In the U.S., the majority of lending to the commercial real estate sector comes from smaller banks that cater to a specific region instead of the entire country. The recent failure of Silicon Valley Bank, one of the larger of these regional institutions, has created concern about whether depositors may start to edge away from smaller lenders.
If depositors were to grow nervous and decide to transfer their savings to money market funds or larger banks, regional banks could be forced to suddenly curtail their lending to the real estate sector.
This would be no small matter. Cumulatively, regional U.S. banks have US$1.9-trillion in loans to commercial real estate operators on their balance sheets, according to Paul Ashworth, chief North American economist at Capital Economics.
The stresses at regional banks and the problems in commercial real estate could interact in nasty ways, Mr. Ashworth warned in a recent note.
“An adverse feedback loop” would begin with regional U.S. banks reining in their lending to commercial real estate operators. These tighter lending standards could cause more defaults in commercial real estate. That would drive down the value of commercial properties, forcing regional banks to increase their provisions for loan losses, triggering an even greater tightening in bank lending standards. And so on.
“In a worst-case scenario, we could have a rolling crisis that lasts for years,” Mr. Ashworth wrote.
Still, it’s far from certain that the worst case will materialize.
For one thing, the commercial real estate sector is made up of several distinct subsectors. While office and retail landlords are struggling, some other areas, such as industrial properties, have held up just fine, while still others, such as hotel properties, are actually seeing conditions improve as the economy reopens and travel resumes.
Taken as a whole, the commercial real estate sector doesn’t look so bad. Delinquent mortgages – that is, those on which payments have been overdue for at least 30 days – are rising in number, but the statistics are still a long way from panic levels.
In February, 3.12 per cent of U.S. commercial mortgages were delinquent, according to data tracker Trepp Inc. That is slightly higher than the 2.98 per cent recorded six months earlier but far below the record 10.34 per cent recorded in July, 2012.
Could heavy exposure to troubled office and mall landlords bring down some regional lenders? Maybe, but analysts aren’t sounding any alarms yet.
According to the Financial Times, the credit research team at JPMorgan recently ran a simulation exercise in which they assumed that regional banks take a 9-per-cent loss on their total office exposure and 6 per cent on retail. They concluded that the losses would barely dent the banks’ capital ratios, although they would weigh on earnings for as long as the losses persist.
This sounds painful. It doesn’t sound like a new financial crisis, though. At least, not yet.