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While the international banking crisis appears to be temporarily eased, the U.S. commercial real estate market is showing signs of trouble. Recently, Brookfield Asset Management, one of the largest publicly traded real estate companies in the world, defaulted on a USD 161.4 million commercial mortgage-backed securities (CMBS) loan. Earlier this year, Brookfield was accused of defaulting on USD 784 million in debt related to two buildings in Los Angeles, the Gas Company Tower and the 777 Tower.
Similarly, on December 1 last year, Blackstone, the global asset management giant, suddenly announced restrictions on redemptions from its flagship real estate investment trust (BREIT), sparking concerns in the market about the real estate industry. In early March this year, Blackstone was also reported to have defaulted on a EUR 531 million (USD 562 million) Finnish CMBS.
Under multiple impacts, confidence in the U.S. real estate market, especially the commercial real estate market, is becoming fragile. On one hand, the Federal Reserve’s constant interest rate hikes have led to a surge in market interest rates, while on the other hand, recent bank failures have worsened the market’s situation, which was already hit hard by the pandemic. In addition, consumers become increasingly pessimistic about the global economic outlook, making the future of U.S. commercial real estate look even bleaker.
Some analysts believe that based on relevant indicators, the U.S. commercial real estate market is indeed showing signs of weakening. For example, since the outbreak of the pandemic, the vacancy rate of U.S. commercial real estate has continued to rise, from 11.5% in the first quarter of 2020 to 15.4% in the third quarter of 2022. This is especially true for office buildings in commercial real estate, whose demand has significantly decreased due to the rise of remote work and recent cost-cutting measures by tech companies. Secondly, in the fourth quarter of 2022, the commercial real estate loan default rate rose again, up 3 basis points to 0.68% quarter-on-quarter. Although the absolute level is still at a historical low, the marginal change is still a cause for concern. Finally, as of the third quarter of 2022, the leverage ratio of the non-financial corporate sector reached 78.8%, significantly higher than the 75.3% level in the fourth quarter of 2019. High corporate leverage undoubtedly limits its capital expenditure plans, and commercial real estate demand may continue to be under pressure.
Meanwhile, signs of rising pressure are beginning to show in first-quarter bank earnings. Last week, Wells Fargo reported that non-performing commercial real estate loans had surged nearly 50% since December, reaching USD 1.5 billion. Morgan Stanley cited deteriorating commercial real estate and economic prospects as the reason for its significantly increased provisions over the last year. In response, macro strategist Boris Schlossberg of BK Asset Management stated that the real estate industry is one of the most vulnerable economic sectors to interest rate shocks, and liquidity pressures are expected to lead small and medium-sized banks to reduce lending, with most of the loans to commercial real estate developers and managers coming from them. Senior commercial real estate economist Xander Snyder of First American Financial believes that the large exposure to commercial real estate is affecting the stability of the banking industry and will have a greater impact on the economy. He pointed out that statistics show that credit for all commercial real estate has become increasingly scarce this year, and the recent difficulties in the banking industry will only exacerbate this trend.
Data shows that in the U.S., commercial real estate loans account for about 40% of total loans from small banks, and about 13% on the books of the largest lending institutions, which makes it easy for the shadow of the commercial real estate market to spread to various institutions through risk exposure. On April 21st, OZK Bank, headquartered in Arkansas, reported that it had to increase loan provisions by 10% in the first quarter due to its excessive risk exposure in the commercial real estate industry. Its current loan loss reserve is USD 36 million, ten times higher than a year ago. Meanwhile, Christopher Ailman, Chief Investment Officer of the California State Teachers’ Retirement System, revealed recently that he estimates the value of U.S. office buildings has fallen by about 20%, and he is therefore preparing for significant losses in the fund’s USD 52 billion real estate investment portfolio. Finally, a report by Goldman Sachs indicated that the delinquency rate for CMBS on office real estate has begun to rise recently and is expected to rise significantly in the future, as the rising delinquency rate is closely related to the current interest rate cycle.
Finally, this industry has also caused similar concerns outside the U.S. A senior official from the International Monetary Fund (IMF) described commercial real estate as a priority this month. The IMF’s latest financial stability report warns that the toxic combination of declining real estate values, tighter financial conditions, and insufficient market liquidity could make it difficult for borrowers to refinance increasing amounts of maturing loans, leading to a sharp rise in default rates.
With all these being said, researchers at ANBOUND believe that the current pressure on commercial real estate in the U.S. is unlikely to evolve into a new systemic crisis. Firstly, to a large extent, the pressure that commercial real estate in the country is facing is a normal response to the Fed’s tightening policies, rather than arising from the industry’s own fragility or systemic crisis points. Secondly, compared to the residential market, the prices of commercial real estate in the U.S. after the pandemic have not risen excessively, and there are no obvious signs of a bubble. Thirdly, from the transmission path, the proportion of current U.S. commercial real estate loans in bank balance sheets has not reached a high level. At the same time, the financial regulatory measures introduced by the American government after the 2008 financial crisis have limited the disorderly growth of commercial real estate financial derivatives such as CMBS. In the current market, the size of the American CMBS market is still much lower than that of RMBS. Finally, the Fed’s policy and the market’s self-regulation mechanism are taking effect. In terms of policy, the liquidity injected into the market by the Fed through tools such as the discount window is easing the pressure on small and medium-sized banks, thereby reducing the possibility of the commercial real estate market crisis continuing to deteriorate in a low liquidity environment. In the market, after the Silicon Valley Bank incident, the market’s expectation of the Fed’s rate hike has cooled down, and the fall in risk-free rates has boosted the prices of assets such as CMBS, to some extent also easing the pressure of floating losses on the bank and institutional asset sides.
Final analysis conclusion:
Facing multiple challenges, the U.S. commercial real estate market is subject to many unfavorable factors. However, considering the current US financial system, it is still premature to predict that the U.S. commercial real estate market will witness a new systemic crisis.
