The downfall of Silicon Valley Bank and a regional banking crisis has sparked worries regarding a potential crash in the Commercial Real Estate ( CRE ) market.
The COVID-19 pandemic has accelerated the trend of remote work and has led to a shift in the way we live and work. As a result, the demand for commercial real estate has decreased significantly, which has caused prices to plummet and investors to pull out of the market.
Companies have realized that employees can be just as productive, if not more so, when working from home. This has led to a decrease in the need for large office spaces, which has affected the demand for commercial real estate. Additionally, the rise of e-commerce has caused a decline in the demand for brick-and-mortar retail spaces, which has further impacted the CRE market.
Another factor contributing to the collapse of CRE is the oversupply of commercial real estate. Developers have built more commercial properties than the market can support, leading to an excess of supply. As a result, the value of these properties has decreased, and many investors are left with properties that are difficult to sell or lease.
But the most significant factors contributing to the collapse of CRE is the series of rate hikes implemented by the Federal Reserve. Since the beginning of 2022, the Federal Reserve has raised interest rates seven times to combat inflation in the US economy and make borrowing more expensive for businesses and consumers. The hikes have ranged from 25 basis points to 75 basis points each time. Federal Reserve Chair, Jerome Powell, has announced that the interest rates will continue to increase until inflation reverts to the annual 2% target.
Jerome Powell, Chairman, Board of Governors of the Federal Reserve System
As a consequence of these rate hikes, the cost of borrowing has risen by almost 300 basis points over the past year. The higher cost of debt is putting increased pressure on new real estate developments due to the difficulty in finding financing sources that fit within the project’s capital stack. Additionally, it is leading to a reduction in building valuations across various commercial sectors.
As per a report by Trepp, some regional banks that are part of the current national banking crisis are occupying office spaces in properties that secure hundreds of millions of dollars worth of commercial mortgage-backed securities (CMBS). These banks are utilizing these properties as their head offices as well as branches. First Republic Bank, KeyBank, and Charles Schwab Corporation are listed among the top tenants of CMBS office loans to watch by Trepp, with loan sizes ranging from $170 million to $565 million.
Banks are in trouble as commercial real estate loans worth a staggering $270 billion are set to mature this year. A huge chunk of this debt, around $80 billion, is linked to office spaces, which is a major concern. While the too-big-to-fail banks have other fallback options, smaller and regional banks are heavily invested in loans, particularly in commercial real estate. Typically, office building owners would refinance their $80 billion debt, but this is no longer a viable option due to high-interest rates and volatile building values. In fact, current office building values are much lower than when these loans were issued, making the situation even more concerning.
Major cities have office occupancy rates of approximately 50%. If office building owners begin to default on their payments or face foreclosure, it could have adverse effects on banks. The banks would eventually have to acknowledge these losses, which could further weaken their capital position, already in a precarious state.
CRE Debt by Category:
Multifamily (apartment buildings, student housing, etc.) is by far the largest category. CRE debt outstanding by CRE category as percent of total CRE debt:
In February, distressed commercial real estate debt in the United States surged to its highest level in 14 years, reaching 5.2%. This increase can be attributed to the ongoing trend of rising interest rates and the persistent shift towards remote work, which has put pressure on landlords and the banks that have lent money to them. This development is potentially concerning for both parties involved.
The following information is sourced from a report by investment manager Cohen & Steers, which references data from the American Mortgage Bankers Association, the FDIC, and the Federal Reserve, regarding banks’ exposure to CRE debt.
The size of Commercial Real Estate CRE debt. (in Billion Dollar)
The above chart provide a breakdown of the types of commercial real estate (CRE) debt that banks are exposed to:
- $4.5 trillion in CRE mortgages on income-producing properties, which refer to properties that are finished and have tenants. These are the types of CRE mortgages that are most discussed when landlords default.
- $467 billion in construction loans.
- $627 billion in loans for owner-occupied properties that the Federal Deposit Insurance Corporation (FDIC) categorizes as commercial mortgages.
In addition, there are revolving lines of credit, senior unsecured bonds, and warehouse facilities that banks extend to nonbanks to temporarily finance their mortgage issuance until they can be securitized.
According to the analysis by Cohen & Steers, out of the $4.5 trillion of CRE mortgages on income-producing properties, banks held $1.73 trillion (38.4%), with the remaining 61.6% held or guaranteed by investors and government entities. This means that the $1.73 trillion in CRE debt is divided among 4,132 banks.
Looking at the broader picture, which includes owner-occupied property loans and construction loans, banks hold a total of $2.25 trillion or 45% of all CRE mortgages. Specifically, the top 25 banks hold $700 billion (14%) of CRE debt, which is around 4% of their total assets. The next 110 banks with assets ranging from $10 billion to $160 billion hold $800 billion (16%) of CRE debt, while the remaining 4,000 smaller banks hold $750 billion (15%) of total CRE debt.
The last two categories of banks, namely regional and smaller banks, account for 4,110 banks, and they have a relatively higher exposure to CRE. On average, these banks have 20% of their total assets exposed to CRE. Among the 4,000 small banks, a few of them have an exposure to CRE that exceeds 50% of their assets. If they face any issues related to CRE, they may end up joining the list of failed banks like California-based Silicon Valley Bank (SVB) , New York’s Signature Bank, Silvergate Bank and Credit credit Suisse.
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It is important to note that commercial real estate (CRE) bubbles, like any other asset bubble, can have serious economic consequences if they burst. When property values decline, owners may default on their mortgages, which can lead to financial losses for banks and investors, potentially causing a ripple effect throughout the broader economy.