Commercial Real Estate Might Be Banking's Next Threat

Expect to see many more properties default sooner rather than later if the Silicon Valley Bank saga speeds up the onset of the next recession.

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Just wait till they consider the banking industry's exposure to the fast declining commercial real estate sector if market investors are already shaking their heads over the potential repercussions of Silicon Valley Bank's failure.

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Every few days, it seems, there is news of a significant property falling into default. An office landlord under the supervision of Pacific Investment Management Co. recently missed payments on seven properties in cities like Boston, New York, and San Francisco totaling around $1.7 billion. A Brookfield Corp. company had previously defaulted on debts related to two Los Angeles office towers before that. A watchlist of loans that may be at risk includes a $1.2 billion loan on a San Francisco complex that is jointly held by former President Donald Trump and Vornado Property Trust. 

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Expect to see a lot more properties default in the near future if the Silicon Valley Bank saga speeds up the onset of the next recession. Because lenders have increased their funding of real estate, this is bad news for them. According to the Federal Reserve, since mid-2021, the total amount of real estate loans and leases on their books has increased by more over $725 billion, or 16%, to a record $5.31 trillion.

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The 11.2% gain in 2017 was the highest since, gasp, 2006 and equaled the growth of the prior four years put together. Additionally, according to BNY Mellon strategist John Velis, commercial real estate loans account for nearly 24% of all bank loans, which is the highest percentage since the financial crisis. Banks' high exposure is partly due to the difficulty in shifting the risk to investors. According to Velis, the market for commercial mortgage-backed securities saw a 75% fall in annual issuance from $240 billion in 2007 to just $60 billion in 2020.

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Chief Investment Officer of Bleakley Financial Group LLC Peter Boockvar has been cautioning his investors about the danger associated with commercial real estate for months. Late last year, Boockvar led his followers through the figures in a study note. He used the example of an investor who spent $50 million for an apartment building in 2020 and borrowed 70% of the price of the building over a three-year period. The property would generate about $2.5 million in gross annual rent, assuming a 5% capitalization rate at the time of purchase. That will more than cover other costs like insurance, taxes, maintenance, and property management in addition to the roughly $960,000 in annualised rate on a sub-3% loan.

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But, no one anticipated that interest rates would increase as quickly as they did, and this investor will now need to renew for the year with rates much above 7%. According to Boockvar, this would raise annual interest costs to about $2.63 million. Rental income would only increase to roughly $3 million even if the investor was successful in increasing rents by 10% in 2021 and a comparable amount the previous year. That leaves about $400,000 for all of those other costs, and he points out that property taxes in some areas alone can completely deplete that amount. 

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Even if those calculations are speculative, they are accurate and show the difficulties that lenders and real estate investors will face in the future. As interest rates rise, loan stress in commercial real estate can quickly spiral out of control because banks are forced to limit their exposure, which drives up the risk of loss for lenders and drives up the cost and difficulty of refinancing existing loans. 

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Property values are already falling; they are not going to become worse. The National Council of Real Estate Fiduciaries' internationally regarded index of commercial real estate values fell 3.5% last quarter, the most since 2009 and just the second quarterly decrease since then. The office and residential buildings saw the biggest drop.

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Beginning To Lag

For only the 2nd attempt since the economic meltdown and the most since 2009, the value of commercial real estate decreased in the fourth quarter.

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So where do banks run the risk? the majority at small banks and a few big lenders who focus on real estate. Wells Fargo & Co. had the most dollar-value losses on commercial real estate in the Federal Reserve's 2022 stress tests, but M&T Bank Corp. and Huntington Bancshares Inc. had the largest losses in terms of overall loan losses and capital bases.

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M&T significantly increased its bad loan provisions last year, although mostly for consumer and corporate debt as opposed to real estate. In recent years, the bank has reduced its exposure to ongoing construction projects and said that this has reduced stress in the hotel industry. The areas where issues could start to spread, though, are currently assisted living facilities and offices.

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The good news is that lenders' requirements for approving financing for commercial real estate have started to become more stringent. In the Fed's most recent quarterly loan officer survey, 57.6% of participants indicated that requirements were being tightened. The bad news is that standards substantially loosened after the pandemic started, so this may have come too late. 

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Too late?

More senior loan officers at banks report stricter lending criteria for loans for commercial real estate.

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It's reasonable to wonder if the current commercial real estate situation could be preparing the banking sector for a recurrence of the savings and loan crisis in the late 1980s and early 1990s, when a recession was caused by a widespread souring of real estate loans and investments. It's too soon to respond, but what we've learnt from this and other incidents subsequently is that a sound financial system is essential for a sound economy. The Silicon Valley Bank issue raises the possibility that the banking system may not be as stable as previously believed.