Commercial Real Estate Could Trigger the Next Big Bank Shock

The worst thing that could happen is for the government to 'help'

A sign advertises retail space in a trendy West Village neighborhood in New York City on April 11, 2017. Spencer Platt/Getty Images

Commentary

Charlie Munger, believed by some to be the real “brains” behind Berkshire-Hathaway, the multinational investment behemoth helmed by Warren Buffett, recently told The Financial Times, “We have a lot of troubled office buildings, a lot of troubled shopping centers, a lot of troubled other properties.”

He also said “there’s a lot of agony out there” in real estate.

His comments are well-founded.

Crain’s New York Business reports that there is 94 million square feet of available office space in the borough of Manhattan alone. The business periodical reported that the amount of available office space is up nearly 75 percent since March 2020, when COVID-19 first forced business shutdowns.

Alignable, a B2B networking and referral site for small and medium-sized businesses nationwide, reports that a poll of 4,205 randomly selected small businesses showed that 40 percent of them couldn’t pay April rent, including nearly half of the restaurants it surveyed. That breaks the previous record for a month, also from 2023.

Gone and Not Coming Back

It was assumed that, after the pandemic, commercial occupancy would resume as usual, but that’s proving not to be the case. There seem to be a number of causes.

First, workers got settled into a work-from-home motif, which had been trending forward for years, well before the pandemic. Workers like not having to spend the time and money commuting, to say nothing of the 5 to 7 percent of take-home pay that one spends to keep up a professional wardrobe.

Second, crime in major cities has increased decidedly since the pandemic. While New York City has a relatively low per capita crime rate relative to other major cities, the stochastic nature of some of the crimes there earns easy headlines among the two major tabloids, four local TV network affiliates, the headquarters of all three major broadcast networks, and Fox News, which also is headquartered there. Violent crimes that happen in purportedly “safe” neighborhoods such as Wall Street and Times Square tend to terrify the workers who formerly commuted in.

In New York City, much of the high level of office vacancy is attributable to overly optimistic building plans adopted before the pandemic. Although the attack on the World Trade Center destroyed 10 million square feet of commercial office space, about a quarter of it was replaced with the new Freedom Tower at One World Trade Center.

And building continues apace, notwithstanding that the assessed value of office properties have declined by “$28.6 billion citywide on the FY 2022 final assessment roll, the first decline in total office property market values since at least FY 2000,” according to the New York State Comptroller.

The Federal Reserve’s near-zero interest rate since the 2008 Financial Crisis has flooded the sector with new office space. Even as rates began to normalize, the trade group New York Building Congress estimates that the amount of office space built from 2021 to 2024 will total 17 million square feet, much of it based on the economics that existed in the post-crisis low-rate environment.

Where This Could End Up

My mother used to say, “People grow too soon old and too late smart.”

Buffett himself has written that it was Munger, now 99 years old, who changed his investment strategy from buying “fair companies at wonderful prices to buying wonderful companies at fair prices.” In that respect, Munger seems to have grown both old and smart, but smarter faster than most of us.

But what can we intuit from his recent warning on real estate?

Well, we’ve just seen a first quarter in which four regional banks collapsed, largely as a consequence of mismanaged interest rate risk; specifically, matching customers’ demand deposits against bank reserves of long-term Treasurys. Banks knew, or should have at least considered the possibility, that the ultra-low interest rates of the past several years were likely to explode, even as the Biden administration dismissed rising prices as “transitory inflation” in 2021. But clearly, several of the regional banks did not see that coming and did not brace for the rising interest rate shocks. They missed it. And so did the regulators.

So, what’s to say either the bankers were any better stewards of their commercial real estate loan portfolio? Or the regulators?

Most likely, they were not.

Real estate is heavily leveraged, meaning that nominal “owners”—usually spread among several partners and partnerships, but not always—tend to finance most of a building’s purchase price (or building costs) with bank loans. Those loans tend to be sanguine; not much (if any) of the repayment is devoted to paying down the principal amount of the borrowed funds, but tends more toward servicing interest payments, usually for a decade or more. Investors are mostly looking for after-tax cash flows.

For the most part, office landlords are able to meet debt service payments because their pre-pandemic tenants are still paying their rents. But as those leases expire, they are less likely to be renewed, or—if they are—rents received will likely be less than the pre-pandemic rents. It is then when banks will be put under pressure and the refinancing of the mortgage debt associated with the property will become a considerable challenge. Real estate investment trusts, again, here in New York, have suffered considerable downside shocks to their stock price, and a few have suspended their dividends to preserve cash.

The Japan Precedent

Toward the end of the 1980s, Japan’s banks engaged in what bankers call “extend and pretend” loans; that is, rolling over real estate debt that could not be repaid even as the value of the mortgaged property had declined. Banks didn’t take the write-downs of their bad loans, which would have adversely affected bank earnings.

As the 1990s commenced, though, Japan’s central bank intervened to raise interest rates to slow what it viewed as an “overheated” economy. That, in turn, tended to “turbocharge” the decline in property values and put Japan into what has now come to be known as “Japan’s Lost Decade," a period of slow growth and price deflation. Nearly 30 years later, it still vexes Japanese fiscal and monetary policy makers.

What to Do Now

Ronald Reagan once said, “The most dangerous words in the English language are, ‘We’re from the government and we’re here to help.’” We should study Japan’s failures during their real estate crisis and avoid doing what Japanese policymakers did.

It’s critically important that U.S. policymakers simply allow the marketplace to work. That will include letting losses shake out when, where, and as they occur, without fear or favor (something that was not done, we believe, with the decision to rescue Silicon Valley Bank, which we also believe made the circumstances worse than if the Fed and the Federal Deposit Insurance Corp. had simply acted as we suggested as the crisis unraveled).

People will suffer financial losses; jobs will be lost. The “millionaires and billionaires” so often targeted for financial punishment by activist progressives will incur some losses and may even be bankrupted. And while government can and should try to ameliorate the suffering that results from bad decisions, it should not attempt to inoculate the economy from them. That means assistance with government safety nets such as unemployment insurance, not billions of dollars in bail-outs.

Accepting the losses—when, as, and to the extent they come, and managing them as they occur—will be a critical element in avoiding something akin to Japan’s “Lost Decade.” Failing to do so, and stepping in with big bail-outs, will give the illusion of financial stability for a while, like a Potemkin Village of financial stability, but doing so will blow up the deficit and Federal Reserve balance sheet (as it did for Japan), and usher in a lengthy period of stagnation and malaise. It will spread the misery.

Creative destruction is as necessary to the maintenance of a healthy economy as much as the shedding of a snake’s skin is necessary for its growth. But to achieve that, we need to let the chips fall where they may, when they may, and as they may.