Key takeaways: The regional banking crisis has sparked fears of a potential commercial real estate crash. One factor contributing to these concerns is the persistence of the work-from-home trend, which could threaten some CRE loans. Also, about 25% of office building loans may require refinancing within the next year at increased rates, with lower-grade properties with high vacancy rates being the most vulnerable. But it's not all doom and gloom. The industrial, retail, and hotel sectors are more stable and less vulnerable to current threats. Could the problems in the banking industry harm commercial real estate?
The collapse of two major US banks over a single weekend—and the shockwaves it caused throughout the already-uncertain economy—has many commercial real estate investors asking this question. And unfortunately, there is no clear answer. While some experts see a silver lining in the situation, it's clear that bank failures can significantly impact various aspects of the real estate industry, particularly the commercial property sector.
REITs are worried about the impact of the recent bank failures on their business dealings with Silicon Valley Bank and Signature Bank. These banks lease large properties across the country, and if these properties become vacant due to the banks' collapse, it could disrupt the income flow of REITs and force them to deal with premature lease terminations.
The situation is even more complex because the failed banks had significant loans in the CRE market. Specifically, Silicon Valley Bank held CRE loans worth $2.6 billion, with 21% of these loans for office buildings and 35% for multifamily properties.
In addition, signature Bank, which mainly provided commercial banking services, also had a significant role in CRE lending, adding to the concerns of REITs.
Several REITs—including Cousins Properties in Atlanta, Alexandria Real Estate Equities in Pasadena, California, and Hudson Pacific Properties in Los Angeles—have reported holding letters of credit issued by Silicon Valley Bank (SVB) that amount to hundreds of millions of dollars collectively.
While they can replace these letters with new ones from other financial institutions, the process won’t be easy. Additionally, many REITs have investments linked to failed banks and other business relationships indirectly connected to these banks are also in danger.
The vacancy rate for office buildings had reached a record high of 18.2% by the end of 2022, with key markets like Manhattan, Silicon Valley, and Atlanta exceeding 20%.But more than this, the real issue this year is the refinancing cliff—that is, loans that come due will have to be refinanced at higher interest rates.
This will result in higher payments even as vacancy rates rise or remain high. As vacancies rise, some buildings will decrease in value, so banks are less willing to finance them without stricter terms. This is especially true for older Class B buildings that are losing tenants to newer buildings. Additionally, the need for more recent sales makes it easier for banks to determine a fair price, as buyers and sellers have different views.
Federal Reserve officials continue to emphasize that the recent failures of Silicon Valley Bank and Signature Bank are unrelated to the real estate sector, with Silicon Valley Bank having only 1% of its assets in CRE. The exposure of other banks to commercial real estate is manageable.
According to them, it does not pose a significant threat to the banking system, which remains strong, sound, resilient, and well-capitalized. However, the CRE market is a more significant concern than the few banks that mismanaged their bond portfolios.
Moreover, the worsening conditions for Class B office space may have far-reaching economic consequences, including reduced tax revenue for municipalities nationwide, as empty offices remain a significant concern. But can these problems be contained? Many experts think so.
Firstly, the office market is only one part of the CRE industry. Other areas, such as warehouses, retail, and hotels, are in good shape. For example, warehouse and industrial space vacancy rates are low, retail vacancy rates are only 5.7%, and hotels are seeing record revenue per available room.
In addition, according to Federal Reserve data, banks also lend to apartment complexes, and rental vacancy rates are currently 5.8%.Although market conditions could become challenging for some properties in the next two to three years, most debt due in the next two years is likely financeable. Around three-quarters of CRE debt generates sufficient income to meet the recent refinancing standards of traditional lenders.
(As a general guideline, a property's operating income should be at least 8% of the loan amount each year for a bank to approve a loan. However, a stricter standard of 10% is being used for newer loans, according to analysts).So far, banks have incurred almost no losses on commercial real estate. Moreover, despite staff layoffs, businesses show minimal inclinations to default on loans or rental payments to landlords.
Let’s take two of the biggest regional banks—PNC Financial (headquartered in Pittsburgh) and Fifth Third (based in Cincinnati)—as examples.
PNC has $557 billion in total assets, with only $36 billion comprising commercial mortgage real estate loans. Of the $321.9 billion in loans, only $9 billion are secured by office buildings. Fifth Third has $207.5 billion in assets, with $10.3 billion in commercial real estate and $119.3 billion in loans. Both banks have a good track record of loan repayments. PNC's delinquency rate is only 0.6%, with even lower delinquencies among commercial loans. Fifth Third had only $10 million of delinquent commercial real estate loans at the end of last year.
Wells Fargo, the US's largest commercial real estate lender, also has excellent credit metrics. For example, in 2022, the charge-offs for commercial loans were only 0.01% of the bank's portfolio, while the write-offs for consumer loans were 39 times higher.
In addition, in 2022, the bank's internal assessment of each commercial mortgage's quality improved, and the amount of debt classified as criticized decreased by $1.8 billion. (Criticized loans are a new classification of loans referring to those that exhibit initial indications of greater risk, such as an office building that has recently lost a significant tenant or a developer who is making payments but is facing financial difficulties). Despite the challenges brought by the pandemic, delinquency rates remain lower than pre-pandemic levels, and all credit metrics are stronger than before.
But Wall Street's counterargument is that the positive trend in loan performance may need to be revised, especially in the event of a broader economic recession.
In March, a report from JPMorgan Chase warned that 21% of office loans were likely to default, resulting in a 41% loss of the loan principal for lenders. This could lead to potential write-downs of 8.6%, resulting in $38 billion in losses for banks with office mortgages. However, how many projects would fail and why value declines would be so significant is still being determined.
According to analysts, the market's weakness is already apparent in refinancing, which still needs to be reflected in banks' public reports. However, the real damage is becoming evident not in delinquent loans but in the declining value of bonds backed by commercial mortgages. RXR, a financially stable commercial real estate developer, has provided $1 billion to other developers whose banks require them to post additional collateral for their refinancing applications.
However, some analysts dismiss rating agencies' relatively optimistic view of commercial mortgage-backed securities, arguing that
(1) the markets for new CMBS issues have recently become stagnant and
(2) rating agencies missed early warning signs of problems in the housing market before the 2008 financial crisis.
While the commercial mortgage-backed bond market is comparatively small, and its temporary problems don't have a considerable influence on the economy, there's been a decline in the issuance of new bonds. For context, however, it's important to note that this trend began last year when fourth-quarter deal volume fell by 88% and didn't cause a recession.
It cannot be easy to see through the fog right now. After all, the pandemic has significantly and long-lasting impacted CRE. Many businesses either closed down or switched to remote or hybrid work arrangements, resulting in a reduction in demand for commercial space or a move to smaller offices. The tech sector was also recently struck by widespread layoffs.
As a result, landlords face multiple challenges, including increasing vacancies, slow rental growth, and leases guaranteed by now-defunct banks. The situation is further compounded by the potential of a looming recession, continuously rising rates, and increased costs across all sectors.
It’s easy to become pessimistic in the current market. But on the bright side, the delinquency rates for CRE loans are still low—just 3.1% in February, lower than last year. LTV ratios are stable and fall within the range of 55% to 60%, while the debt service coverage ratios range from 2 to 2.5.
And despite the Federal Reserve's hawkish stance, inflation expectations are below 2.5%, based on the five-year, five-year forward calculation. Refinancing activity is expected to increase as debt markets recover from the current uncertainties. Although the current climate is challenging, there are still positive indicators. CRE stakeholders can rely on them to help the industry recover.
However, it's essential to exercise caution and patience as the situation may worsen before it improves. Investors are advised not to make impulsive decisions and to continue with business as usual, except for transactions directly related to the collapse of the banks in question.
