We all still have a little PTSD from the financial crisis in 2008. One seemingly stable part of the American economy, housing, plummeted the entire global financial system into a tailspin that took over a decade to recover from. We now better understand the domino effect that mass real estate defaults can have on our larger economy and are understandably fearful of another such event happening again. That fear is the likely reason that everyone, from economists to pundits to that guy at the dinner party who thinks he is an economist, is warning that commercial real estate defaults could be the next big systemic lynchpin. The alarm bells started ringing when two smaller banks went under last month and haven’t stopped since.
On the surface, the numbers look bad. “Over 700 billion dollars of commercial real estate loans are coming due this year.” Ok, that is a lot and with the high interest rates many might not be able to afford to refinance. “Commercial real estate loans make up an average of 28.7 percent of small banks’ liabilities, over four times that of larger banks.” Wow, that is a big percentage and enough to trigger a default or at very least a bank run that would further threaten those banks.
But if you keep digging those numbers are too simplistic and therefore not a good representation of what is actually going on. Marcus & Millichap released a report about commercial real estate and banks and some of the numbers they provided tell a much different story. First, it finds that, unlike what happened in residential mortgages in 2008, commercial loans are much less likely to be underwater during downturns since they have a lower loan to value. Unlike the 80 percent that most lenders will lend on a residence, commercial real estate loans average closer to 65 percent of the value of the property. This gives much more leeway for borrowers if values drop and protects lenders if they need to foreclose and sell an asset to recoup their costs.
Next the report takes aim at that daunting amount of loans coming due this year. It turns out that that $728 billion dollar amount being thrown around in articles is just an estimate made by the Mortgage Banks Association. Other organizations, including the capital market firm MSCI have put that number at closer to $400 billion. Plus, those loans likely have a lot less than 65 percent loan to value now. “The majority of the impending loan maturities originated five to seven years ago, and over the last five years CRE property revenues have increased by about 25 percent on average across the sector,” the report states.
Next up is the idea that the struggles of office properties as remote work catches on will be the spark that ignites the fire. Of the total loan numbers being thrown around the office only represents about a quarter of the value, 26 percent to be exact. The rest of the loans are on multifamily, retail, industrial, and hospitality properties, all of which have rather strong fundamentals.
Finally, we have the prevailing thought that we are already starting to see mass defaults. I can see how someone might think this, every day there is another article or five about a certain property going into special servicing, especially if the owner is a recognizable name. But so far defaults are really rare. “Trepp noted more CMBS loans fell into special servicing, representing 5.2 percent of total CMBS CRE debt,” the report goes on to say. Five percent is certainly higher than average but still not something that I think would endanger the entire value proposition of owning large buildings.
There is certainly a non-zero chance that commercial real estate could weigh on the already struggling banking sector. But the way I see it we are far from the kind of large failure that everyone keeps warning us about. It is important to remember that “everything is probably fine” is not the kind of content that will generate web traffic so we are stuck with a lot of media companies fanning the flames of fear for their own fortune. The commercial property industry must be smart during this difficult time of high interest rates but being scared out of the market by uninformed opinions is never a good investment strategy.
Overheard
Mapped
Here is an article with a great map showing the percent change in office vacancy from 2020 to 2023. While places like San Francisco have seen vacancies increase by over 25 percent, other metros like Houston and Minneapolis have a less than 4 percent growth in vacancy since the pandemic started.
Good reads
iRegret
It looks like iBuying, or instantly purchasing homes in bulk in order to flip them, has not stood the test of time. The most prolific iBuyer, Opendoor, is now cutting back its workforce by 22 percent to “better align our operational costs with the anticipated near-term market opportunity.”
Bloody succession
The show Succession might be getting a lot of attention right now but its plot is nothing compared to the real life story of Anthony Zottola, the man who hired a hitman to murder his father so he could take control of the family’s lucrative real estate empire.
Uninsured
Life insurance companies were always an important part of the commercial real estate ownership and lending landscape but now it looks like many life insurance companies are turning their backs on commercial real estate due to the poor long term outlook of the sector.