Commentary
The commercial real estate (CRE) market has been balancing on the threshold of a major readjustment since 2021. That’s when the first of the extremely low interest rate, three-year loans were becoming due.
How Long Can Banks Hold Underwater Loans?
So far, the banks’ main solution to that problem has been to kick the can down the road a bit by extending maturing loans at the same low interest rates for another three years and hoping that interest rates fall.But how long can financial institutions afford to earn less-than-market rates on their portfolios?
It’s not just one or two classes of commercial real estate that are in danger of becoming nonperforming assets if they are forced to refinance at the current high interest rates, which are 50 percent or more above what they were in 2021, depending on the class of property. Endangered commercial real estate properties include office buildings, multifamily properties, retail centers, and hotels, among others.
Plenty of Blame to Go Around
But even though much of the blame lies with the return of higher interest rates that have put the financial viability of commercial real estate in jeopardy, there’s plenty more blame to go around.First, the Federal Reserve, the non-federal financial institution that controls interest rates, held rates unreasonably low for almost a decade, which anchored CRE yield and valuation calculations to what were normalized but historically unrealistic low rates. From 2012, CRE interest rates have been in the 4 percent to 6 percent range. Thus, the Federal Reserve kept rates artificially low, thereby distorting the market and the normal economic conditions that typically apply.
Lockdown Triggered Urban Exits
However, the government’s extended lockdown policy as a response to the COVID-19 pandemic had a much greater impact on the health of urban office properties, apartment buildings, retail centers, and even hotels. As office tenants’ employees left in droves to work remotely, the need for office space dropped precipitously. Apartments, retail centers, and hotels also saw huge drops in occupancy, rents, and attendance. For the next few years, aggregate rents fell and space remained under-used and under-occupied, resulting in falling revenues for these commercial properties.The market reaction has been stunning. On the one hand, apartment vacancies rose in many urban areas, but that has been followed by a four-fold increase in the transformation of office buildings into apartment buildings in cities such as Washington, New York, Dallas, and others.
In other cities, such as San Francisco and Los Angeles, high taxes, the explosion of homelessness, and crime are additional factors driving major corporate businesses and residents to flee the city. California has long attracted homeless people because of its generous social benefits, but decriminalizing theft up to $950 has resulted in a dramatic rise in urban crime among retailers. High tax rates only add more incentive for businesses to leave California’s major urban areas for more business-friendly states.
Commercial Real Estate Foreclosures Rising
As a result, banks are seeing a rise in commercial real estate foreclosures, which means they are coming under greater stress. The question is, how much will banks be affected by underperforming loans and even rising CRE foreclosures? The trend is, in fact, alarming. By just March of this year, the number of CRE foreclosures had reached 625, a 117 percent increase from last year. Also, in March 2024, California saw the highest number of commercial foreclosures for the month, at 187, a 405 percent increase from last year.The upshot is that CRE banks are holding loans on commercial buildings and retail centers across the country with current values that are only a fraction of the loan amount on the paper that banks are holding. The damage varies, but ultimately, it may not matter much. Banks will find it increasingly difficult to manage the crisis.
Hundreds of Banks at Risk
By some assessments, the risk of widespread commercial bank failures remains low. But the truth is, that depends on the definition of “low.” By some estimates, as many as 300 banks are at risk from their exposure to CRE loans. Many CRE loan portfolios are completely underwater, not just in terms of loan yields against current interest rate yields but in collapsing values of office buildings and apartment buildings. Consequently, other industry observers think that we’ll see hundreds of commercial bank failures and a continued consolidation of the banking industry.That realization is what’s driving some real estate investment trust (REIT) shareholders to liquidate their positions, especially in REITs invested in the office building, multi-family, and retail center asset classes. The rising outflow of investor cash is forcing REITs to draw from liquidity sources to meet the demand.
As one might expect, in March, Federal Reserve Chairman Jerome Powell addressed the issue and said openly that there “will be bank failures” in the future as a result of the collapse of CRE values and yields.
Great Financial Crisis 2.0?
The question is, “How bad will it be?”At some point, commercial borrowers may decide to walk away from the properties, like the residential borrowers did by the millions in the 2008–2009 financial crisis. That had a ripple effect or contagion on the entire U.S. economy. That triggered a credit crisis in which lending became very tight, leading to a recession and a dramatic fall in economic activity.
Those memories are still in investors’ minds today. For some experts, that’s a bigger danger than the coming bank failures themselves. Is the perception of failure more dangerous than what’s really happening?
The answer remains to be seen.
Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.
