The Real Estate Slow Burn...
Amidst the return of the inflation boomerang and the weaponizing economy, and as ‘Forward Confusion’ continues to spread, investors overlooked the simmering crisis in Commercial Real Estate. However, the issue of vacant office buildings in American cities, transforming them into post-Covid wastelands, will impact the US economy in the coming quarters and beyond. Some pundits suggest that this surge in empty commercial real estate could lead to an utopian turnaround, but the potential for an "Urban Doop Loop" triggered by CRE should be widely acknowledged as a possible catalyst for a broader economic meltdown in a still inflationary environment. According to a new report from Moody's Analytics, there are more dormant office towers in the United States than at any point since 1979. This rise in vacancies is driven by a combination of remote and hybrid work trends, prompting companies to reduce their corporate footprints. Additionally, companies are relocating from ‘blue’ progressive cities and high-taxed states to red ones while downsizing their space.
While Bidenomics has fostered a 'higher for longer' narrative in many areas, one enduring trend is the lower for longer occupancy rates for office space in particular in ‘blue cities’.
Despite this trend, there's an unsettling calm prevailing in the commercial real estate sector for the time being. This comes as the Federal Reserve's interest rate hiking cycle is expected to endure, suggesting that the challenges are approaching, possibly after the presidential election. While recent positive economic data may have triggered some pockets of optimism, the persistently high office vacancy rate spells trouble for landlords and developers, exacerbated by the difficulties in refinancing amid the Fed's tightening cycle. The total outstanding commercial mortgages set to mature by year-end surged from $658 billion to $929 billion from the beginning of last year to mid-March.
The high amount of debt that has been extended and modified instead of refinanced has helped to mitigate a potential default wave and sharp increase in losses on CRE loan portfolios. This strategy has been driven by the willingness of lenders and borrowers to modify and extend maturing loans rather than pursue refinancing or foreclosure. Essentially, the issue has been postponed until after the presidential elections and is part of the ‘Forward Confusion’ narrative spread by Wall Street. However, stresses are mounting in the office segment, with the percentage of fully paid-off tower loans at maturity dropping below 60%. Meanwhile, the maturity payoff rate for loans backed by other property types has reached near-decade highs. In a nutshell, it has all been about ‘EXTEND AND PRETEND’ with about 47% of the non-bank CMBS loan maturities in 2023 were pushed into 2024.
The key question now is how long this game of musical chairs will last in the CRE market. While extensions and modifications are not uncommon, the low likelihood of funding costs returning to pre-COVID levels raises concerns about the sustainability of this trend. Modifications will likely persist in the near term due to the uneconomical nature of refinancing for most commercial real estate borrowers and the reluctance of lenders to pursue foreclosures in an illiquid property market. With the politically correct FED most likely unable to cut rate in 2024, the higher-for-longer theme suggests increasing risks in the CRE space for 2025. However, there has already translated into a subsequent rise in the delinquency rate of office mortgages securitized into CMBS.
The increasing delinquency rates in the office market will have a particularly harsh impact on the banking sector as a whole, and regional commercial banks in particular. This is because they hold over 65% of the CRE loans.
A recent study by the National Bureau of Economic Research suggests that as many as 385 American banks could fail solely due to commercial real estate loans. These would mainly be small regional banks, which typically allocate a third of their assets to commercial real estate loans.
According to a report from the American Banker, five banks in the US together hold half a trillion dollars in CRE loans. Interestingly, JPMorgan Chase, the bank with the largest amount of CRE loans, also has exposure to $49 trillion in derivatives as of December 31, 2023, according to the Office of the Comptroller of the Currency.
Almost a year ago, Credit Suisse, a major global bank with $540 billion in assets, failed and was merged with UBS. In the US, Silicon Valley Bank, Signature Bank, and First Republic Bank also collapsed around the same time. These were the second, third, and fourth biggest bank resolutions since the Great Depression. This banking turmoil represented the most significant test since the global financial crisis of ending too-big-to-fail, whereby a systemic bank can be resolved while preserving financial stability and protecting taxpayers. While progress has been made in ending too-big-to-fail, further work is needed. Authorities managed to avoid deeper financial turmoil last year, but taxpayers were again burdened with significant public support to protect more than just insured depositors. Unlike many failures during the global financial crisis, significant losses were shared with shareholders and some creditors of the failed banks. However, taxpayers were once again on the hook as extensive public support was used to protect more than just the insured depositors of failed banks. The Credit Suisse acquisition, backed by a government guarantee and liquidity nearly equal to a quarter of Swiss economic output, ultimately entailed significant contingent fiscal risk and created a larger, more systemic bank. Using standing resolution powers rather than emergency legislation could have mitigated this. In the US, invoking an exception to protect all deposits in two failed banks increased costs for the deposit insurer, with the industry needing to recoup over time.
Not only is the commercial real estate sector experiencing a slow burn, but the residential real estate market is also grappling with higher interest rates. Housing starts peaked two years ago at 1.803 million units and have been declining since then, reaching a 15.6% decrease by the end of March 2024, returning to pre-pandemic levels.
New home prices have declined by 20% from their peak in October 2022, returning to levels seen before the Federal Reserve initiated its latest interest rate hike cycle in July 2021. Historically, lower home prices have rarely been good news for the performance of the US banking sector, including both large and regional banks.
US New One Family houses prices (blue line); US Bank sector index (BKX) (red line); US Regional Bank sector index (KRX) (green line).
To provide perspective, this current downturn in prices is unprecedented compared to the 2008 housing downturn. At the same point in the 2008 cycle, prices were only down 10%, and by the end of that cycle, 24 months after the peak, they had declined by 22%.
While the focus remains on the Commercial Real Estate market, the housing downturn has been overshadowed by the narrative spread by the financial media. Builders slashing prices for new home sales serves as a leading indicator of impending stress for the real estate market and indirectly affects the banking sector. Not only are builders offering discounts on new home prices, but they are also extending discounts on mortgages for new home buyers. For instance, Lennar, one of the leading US homebuilders, is offering a 3/2/1 buydown rate through its Lennar Mortgage service, with rates starting at 1.99% in year 1, 2.99% in year 2, 3.99% in year 3, and 4.99% for the remaining term, resulting in a 5.318% APR.
The additional cost for the homebuilder due to discounts offered is not reflected in official data. Consequently, while the homebuilder's operating margin remains historically high at 25 years, it is expected to experience a significant drop sooner rather than later. Historically, the relative performance of the homebuilder sector compared to the S&P 500 has been closely correlated with the sector's operating margin. In summary, like the banking sector, the homebuilder sector, and everything related to it, appears to be obvious sectors to avoid in the upcoming quarters.
Relative performance of S&P Homebuilder index to S&P 500 (blue line); S&P Homebuilder index operating margin (red line).
Read more and discover how to position your portfolio here: https://themacrobutler.substack.com/p/the-real-estate-slow-burn
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