Commercial Real Estate, The Next Crisis?

Issue 67

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Today’s Bullets:

• What is CRE?

• Occupancy problem

• Regional banks…again?

• How can you protect yourself?

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Inspirational Tweet:

We’re hearing a lot of chatter recently about CRE risks, especially for regional banks. And why not, regional banks have had their issues recently and seem primed for more trouble. Plus, with occupancy rates falling and interest rates rising, this could make for an explosive mix for the CRE market.

But before we get ahead of ourselves, let’s take a look at what makes up this CRE market, who is really exposed to it, and what the implications may be.

So, grab a cup of coffee and settle in for a nice and easy real estate breakdown today with The Informationist.

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🤓 What is CRE?

First of all, what exactly is the Commercial Real Estate or CRE market, and what are its components?

To keep it simple, the CRE market can be divided into six main sectors: Office, Retail, Industrial, Multi-Family Property, Hospitality, and Special Purpose.

To break it down further:

Offices can be high-rises in urban centers or cities or office buildings/centers in suburbs.

Retail is shopping centers (strip or regional malls) and stand alone stores or big-boxes, like Home Depot, Best Buy, or Krogers.

Industrial is what it sounds like, warehouses and distribution centers, as well as manufacturing centers.

Multi-family property is made up of high rise or mid rise apartments, apartment complexes, or even senior living facilities.

Hospitality is made of of the variety of types of hotels, whether a Hilton high rise or a Hilton Garden Inn.

And Special Purpose would be healthcare and hospitals, college and university campuses, as well as self-storage facilities.

And who owns all this CRE?

As you may have guessed, anyone with deep pockets, such as high net worth individuals, institutional investors (think: pension funds, private equity or hedge funds, or endowments), and REITs or Real Estate Investment Trusts, which are like mutual funds for real estate.

Also, many companies own the real estate they are using themselves. For instance, if you’ve ever read the story (or seen the movie The Founder) about Ray Kroc and McDonalds, you know that one of the key aspects to McDonald’s financial success was owning the real estate the fast food restaurants sat on—a portfolio estimated to be worth over $40 billion today.

Makes sense.

After all, real estate is known to appreciate in value over time, even if we have minor recessions or major meltdowns, aka The Great Financial Crisis of 2008. It always bounces back.

So, what’s all the chatter about CRE being in trouble, then? Why are investors suddenly laser focused on this sector? I mean, didn’t we iron out all the leverage and poor lending wrinkles of 2008?

While this is generally true, the CRE market has some nuances that can affect its health, unlike the housing market. And because of this, we may have a little bit of a GFC echo ahead of us.

Let’s dig a little further to see why.

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👻 Occupancy problem

As we all know, ever since 2020 there has been a bit of a work from home or WFH craze. People who were banned from going to the office set up their own offices at home and parked it there for a year.

Or two.

Now three. And counting…

We won’t get into a debate about the effectiveness and efficiency of WFH, but suffice to say, many people spent a lot of money setting up their home offices to have access to and get as much done as they possibly could.

As a result, they’re reluctant to head back to the office full-time. I mean, why commute, spend money on gas, and waste time on the road, when you can take Zoom calls in pajama bottoms or shorts?

Amiright?

GMA

Oops?

Even so, most companies are embracing a partial WFH policy. Why?

It makes employees happy, companies can save on office space—cutting back their cubicle footprint—and they don’t have to stock up quite as much on coffee and snacks in the office kitchen.

The result is what is being called a hub-and-spoke office model, where the headquarters or hub is where employees gather and collaborate, and the spokes allow for people to work from anywhere they choose.

The impact to the Office portion of CRE?

The overall national vacancy rate for offices in Q1 2023 was 16.8%. And San Francisco's office vacancy rate just hit a record high of 29.4% (prior to 2020, San Francisco occupancy rate was basically 100%).

And the resulting financial impact to all this non-occupancy across the nation’s cities?

A recent NYU and Columbia University study titled Work from Home and the Office Real Estate Apocalypse projected the overall value destruction of the US office sector could reach over $500B by 2029.

That’s half a trillion dollars.

The path we are on:

OK, so this pain seems focused on Offices and, perhaps soon, Retail.

So, what does this mean for the investors, the owners of all this office space?

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🧨 Regional banks…again?

As the valuations of these office buildings fall, we have to ask the question, how does that affect the owner of that building, the landlord?

It’s not like a house, where if the value falls, so be it. You just sit and wait for it to rise again. Live your life, as is.

First, many landlords use floating-rate debt to finance office buildings, and hence, their borrowing costs have begun to skyrocket. And many those who used fixed rates are soon facing maturity on that debt and will have to finance at much higher rates.

Yet another impact to the economy from The Fed’s policy of jacking up rates over 5% in a year. 🚀

And so, with occupancy rates down, thanks to WFH and companies not renewing leases or renewing on smaller footprints—meaning lower overall income—and interest rates rising—meaning higher overall costs—landlords are facing large losses.

The answer for an increasing number of them?

Default.

Just walk away from the property, eat the one-time loss, and move on.

And it’s not just San Francisco, where the owner of Hilton San Francisco Union Square and Parc 55 stopped mortgage payments $725M of loans and walked away (click through the Zerohedge post above for more on that).

But this is exactly what PIMCO Columbia Property Trust did on $1.7B of mortgages and Brookfield Corp did on $161M of properties last week.

So, will this continue?

Considering over 4% of all commercial office loans are 30+ days delinquent, and the overall US CMBS delinquency rate jumped to 3.62%—up over .5% in one month—this trend seems to be picking up steam.

But if the landlords just walk away, then who is exposed to the pending losses? Who fares to lose the most?

Well, it’s like that old adage, if you owe the bank $1 million it’s your problem, but of you owe the bank $100 million it’s the bank’s problem.

So, who do these landlords owe? Who are they walking away from?

You got it.

Regional banks.

As credit tightens, borrowing availability falls and rates rise, building values fall—some quite steeply, especially with much lower occupancy rates, all while the lower rate mortgages mature.

A perfect 💩 storm, so to speak.

By Trepp’s estimates, $448 billion of CRE loans mature in 2023, of which $270 billion are from banks, and an eye-watering $2.56 trillion are maturing in the next 42 months.

$1.4T of these loans are from banks.

Ouch.

And so, with already depleted reserves from poorly managed and underperforming reserve assets, i.e., US Treasuries, and now melting loan portfolios, The Reckoning Part 2 may be coming to a regional bank near you.

*Note: I’ve written all about the regional banking crisis and what happened there. If you have not read those posts or want to revisit them, they can be found here:

SVB, the FDIC, and Are You Really ‘Insured’?

Interest Rate Risks are Collapsing Banks

Bottom line, there’s an extremely high likelihood that a number of regional banks will feel the pending credit crunch.

And this is not even considering a coming recession. Remember the Retail part of CRE? We could soon see retailers shutter stores, pull out of strip centers, and walk away from leases. And what happens to those loans? 😱

The real question is just how severe this credit crunch gets, and whether we see that other big bad C-word.

Contagion.

Then all bets are off, and it will be up to the Treasury and Fed to come swooping back in to the rescue—by firing up the money printer, monetizing debt, injecting liquidity into to the markets, and saving the oh-so-fragile financial system once again.

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🧐 How can you protect yourself?

I’ve been saying it for months now, I would be extremely selective about where my money is deposited and just how much I have at any one bank.

As many of you know, I am sitting on a large percentage of cash allocation in my portfolio, as I fully expect the US economy to soon slip into a recession. I want to be ready to take advantage of any resulting market weakness.

But in the meantime, I make sure that all these deposits are fully covered by FDIC insurance.

I also hold a large percentage of my personal portfolio in hard monies, like gold, silver, and Bitcoin. I expect these allocations to perform quite well, if and when the Fed has to ultimately step in and shore up the markets again with large amounts of QE.

But that’s me, and everyone’s situation is different. I encourage you to dig in carefully with your investment advisor and match your investments to your personal liquidity needs, appetite for risk, and long-term goals.

Because whether it’s a CRE-flavored 💩 storm, some other credit event, or just a plain vanilla deep recession, I want to be prepared.

Don’t you?

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That’s it. I hope you feel a little bit smarter knowing about CRE and office market and feel armed with questions to ask your own advisor. If you enjoyed this newsletter and know someone you think would like it too, please share with them!

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✌️Talk soon,

James