Remote work from pandemic times seen to have struck blow to sector
With the United States still trying to get its arms around some recent bank defaults, the next shoe to drop could be the commercial real estate market.
Perhaps the biggest blow to the sector, particularly in large cities, was the shift to remote work amid the pandemic, which started in the U.S. in early 2020.
While workers have gradually returned to offices, it appears that remote work in some form will become permanent, and how high that percentage is will have a huge impact on the viability of commercial real estate, or CRE.
Then there is the issue of higher interest rates, with the accompanying prospect of loan defaults, while landlords have seen a significant drop in revenue from office leases. And most of the banks making CRE loans are smaller, regional institutions, which already have faced depositor withdrawals.
The White House said on April 18 that it is closely tracking the CRE sector after recent strains in banking, given that many smaller and midsized banks have "nontrivial" holdings in the office market.
Jared Bernstein, a member of the White House Council of Economic Advisers, told a Senate Banking Committee hearing that CRE occupancy rates were well below their pre-pandemic level.
"The issue is very much on our watch list," Bernstein said during a hearing earlier this month on his nomination to head the council, when asked by Democratic Senator Mark Warner of Virginia about the effect of the collapse of Silicon Valley Bank on the sector.
Warner noted that about $6 trillion in outstanding commercial debt was related to the real estate market, and that a "massive dislocation" was underway.
Another problem for the industry is that about a third of the $4.5 trillion in CRE debt in the U.S. is due before the end of 2025, Morgan Stanley analysts said.
CRE loans account for about 40 percent of smaller banks' total lending, against about 13 percent for the largest lenders, the Financial Times reported.
The CRE sector is facing a "moment of truth", Mohamed El-Erian, the chief economic adviser at asset management giant Allianz, told Business Insider.
"The moment of truth will play out over several quarters as some $1 trillion of commercial real estate holdings need to be refinanced," El-Erian said.
Jeffrey Fine, Goldman Sachs' global head of real estate client solutions, said recently that the CRE market is in the middle of a "perfect storm" of higher rates, tight credit and rapidly maturing debt.
The market faces a "big rightsizing", Fine said, and he expects a drop in valuations in older properties and office buildings.
Riskiest metro area
The U.S.' largest city, New York, faces the most trouble over CRE, according to myelisting.com, a website that covers the CRE industry.
"New York is the riskiest metro area in the nation for office property valuations, where there are a whopping $16 billion in CRE loans coming due in 2023, a 30 percent increase from 2022," it said.
In Los Angeles, the industrial sector saw a 7.2 percent year-on-year rent gain last year.
However, vacancy rates in the LA office market have increased substantially, and property values have fallen. The city has about $16.9 billion in outstanding office loans, and ranks 14th in the U.S. for office-loan risk.
The International Monetary Fund's recent financial stability report warned how a mix of declining property values, tighter financial conditions and illiquid markets could devastate borrowers looking to refinance loans, leading to sharply higher default rates.