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Commercial Real Estate And The Next Financial Crisis
2008's financial crisis was caused by bad real estate loans. Good job we learn from our mistakes. Right?
If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem.
- J. Paul Getty
The banks have a problem. Specifically the smaller, regional US banks.
It's not just the issue of interest rate rises, which the Federal Reserve knows full well will knock a good number of them out of business—although that's not helping. There's another part of their loan portfolio that's looking decidedly sick.
How Not To Invest In Bonds, For Banks
First, a quick recap. Banks were force-fed QE money from the 2008-09 GFC and COVID stimmy days like geese destined for foie gras being stuffed with fat-saturated corn.
Oozing cash from every conceivable orifice, they did what any sensible bank would do when promised by the Fed that interest rates would stay near zero for years, and invested trillions in long-dated government treasuries: The safest of the safe. Right?
Turns out the Fed told a terminological inexactitude, aka fib, or else just didn't know its humerus from its gluteus maximus. Either way, when inflation turned out not to be so transitory, up went interest rates and down went the price of government bonds. Now the banks are under water on those bonds, and may continue to be until they mature—years down the line.
When customers want to withdraw their money, the banks have to sell those distressed assets, crystallizing their losses. If too many customers yank their funds: Goodnight. That's what already happened to Silvergate, SVB, and a few others. The Fed launched the Bank Term Funding Program (BTFP) to buy those bonds at their maturity value, not market value, to tide banks over. This $25 billion initiative is currently being tapped to the tune of over $100 billion.
So that's the general picture, and it's Not Good. Unfortunately, it's going to get worse.
How Not To Invest In Commercial Real Estate, For Banks
Aside from nice, safe government bonds, one of the things banks—especially those smaller, regional banks—invest in is nice, safe real estate. You know, those commercial properties that will never go out of fashion because there will be demand for office space so long as there are employees who need somewhere to work. Right?
Oh yes, COVID. The gift that keeps on giving. People figured out they didn't like working with other people, who are unhygienic and annoying, and preferred to skip the lengthy, costly, and inconvenient commute to stay home with their cat and work in their pajamas instead. Meanwhile, businesses save money because they don't have to rent so much space. It's win/win.
Landlords? It's not so great for them. And if too many landlords have problems, then it's a "lose" for the banks too.
And a lot of landlords are having problems. The average vacancy rate for large commercial real estate buildings has increased to 19%, as work-from-home hours have risen over 500% since before the pandemic. Meanwhile, with interest rates soaring, refinancing that debt is going to be expensive. In many cases, too expensive. TL;DR they're going to be paying more but revenues are lower. Ruh-roh.
Here's Pomp with an explainer:
Analysts are divided on how serious these problems will be. There are non-apocalyptic scenarios. It's worth mentioning that the biggest banks will get through this, burned but alive.
That's because it's the smaller, regional banks who hold two-thirds of this CRE debt. Given the strain that already exists on that subset of the banking sector, this isn't good news for them at all.
Around $1.5 trillion in commercial mortgage debt is due by the end of 2025. Fitch Ratings estimates that a third of pooled securities commercial mortgages coming due by the end of this year will not be able to be refinanced. A lot of landlords are signaling their intention to walk away from these un-refinancable properties—in other words, to default.
As the Fed raises interest rates even further, the problem is set to get worse. The Fed has already asked banks to work "prudently and constructively" with good clients as problems emerge, while at the same time acknowledging that there will be CRE losses. The market is already displaying signs of dismay.
Of course, every crisis also represents an opportunity. But there are indications commercial real estate prices might need to fall a lot further before they're considered attractive again.
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