The fallout from empty offices is coming. Here’s where investors could see the pain
As concerns about regional banks roiled the market, investors weighed another threat: commercial real estate. The theory goes like this: Office values are falling — and more to come. Employees have been slow to return to offices, and companies may be looking to cut costs as the economy weakens and exits office leases. If that happens, it will put further pressure on the value of office space, which is already being challenged by rising interest rates. Furthermore, in addition to the pressure on real estate values, there is also the tightening of credit conditions due to the recent turmoil in the banking sector. There is no doubt that this situation is a toxic combination for the capital-intensive real estate industry. There is a large amount of debt that needs to be refinanced every year. One in four office mortgages will need to be refinanced this year alone, according to the Mortgage Bankers Association. Funds are also needed to build or upgrade existing properties or to make new acquisitions. For now, many experts say the housing market isn’t causing trouble for banks, but concerns about the financial system could worsen conditions in the housing market as liquidity is dwindling. Delinquency rates remain low, but have started to rise in the office sector. Some new examples of landlords handing back property keys include Brookfield’s decision in February to leave two Los Angeles office buildings. Around the same time, Pimco’s Columbia Property Trust defaulted on about $1.7 billion in mortgage notes on seven buildings in San Francisco, New York, Boston and Jersey City, New Jersey. Most recently, Blackstone defaulted on Nordic mortgage-backed bonds. Still, Lotfi Karoui, chief credit strategist at Goldman Sachs, said investors shouldn’t jump to comparisons to the global financial crisis or savings and loan problems of the 1980s and 1990s. In an interview, he said it was a different situation. “Most of the challenges we’re seeing in the office property space today are not symptoms of years of lax underwriting standards,” Karui said. “In fact, it’s the opposite.” Debt-service coverage ratios and loan-to-value ratios tightened sharply after the 2008 crisis, he said. “From a credit quality standpoint, I think you’ll be in a relatively good position,” he said. Instead, the pain is being felt in the shift toward debt structure in 2020 and 2021, when many borrowers switch to variable-rate loans when interest rates are lower. Now, those borrowers are dealing with a “higher secular” funding environment. “It’s an asset class, almost by design, that’s much more sensitive to the level of funding costs,” he said. A closer look at loan concentration Large banks have a low concentration of CRE loans. Deutsche Bank recently estimated that office loans make up less than 5% of total lending at each of the large banks it covers, averaging less than 2%. However, sensitivity to the CRE market has increased as attention has shifted away from the larger banks. CRE is the largest loan portfolio segment at half of the banks. However, in a recent report, Moody’s Analytics highlighted that the group of CRE lenders is very diverse. “Overall, banks were the largest lenders, accounting for 38.6% of loans. However, the 135 U.S. regional banks (generally considered to have about $10 billion to $160 billion in assets) held only 13.8% of income-generating asset debt, ” wrote Moody. “The top 25 banks that the Federal Reserve considers ‘large’ hold 12.1%. 829 community banks (with $1 billion to $10 billion in assets) hold 9.6% and the remaining 3.2% are spread among 3,726 banks with less than $1 billion in assets small local banks.” Even CRE itself is a broad pool of assets, with the most stressed types of office structures only a part of a broader segment. When a bank’s construction and development loans exceed 100% of risk-based capital, or if the ratio of CRE to risk-based capital exceeds 300% and the 3-year CRE growth rate exceeds 50%, Wall Street corporate regulators consider the bank to be heavy CRE Jenny explain. Its analysts reviewed the FDIC’s fourth-quarter data to look at concentration figures for all publicly traded banks and compare the banks’ exposure to the guidelines. Janney found 50 banks with construction and development loans above the 100% threshold, including eight banks above 150%. It said banks with more than $10 billion in assets were unlikely to fall into this category, a level where only nine banks exceeded the 100% mark. However, more than half of the listed banks exceeded the CRE concentration index. In some cases, banks have gone beyond the norm. Gianney identified 56 banks with CRE ratios above 500%, 15 of which were between 600% and 699%, and two more than 700%. The table below details some of the banks in the last two categories. “Our data is intended to provide investors with a resource to compare banks,” analyst Brian Martin wrote in a March 28 note, as long as they have processes/procedures in place. But it does provide investors with a potential tool to identify possible risks. Equally important is the upcoming earnings season, which begins on Friday. Earnings expectations for many regional banks have declined since that day, as analysts look to assess the impact of the recent turmoil on their financial performance. A number of factors are weighing on the sector’s performance. Estimates for First Republic Bank fell nearly 40%, Many customers withdrew their deposits from the bank last month. But it’s worth noting that the valuation of New York Community Bancorp, which has a high concentration of CRE, has fallen nearly 15 percent since early March. Baird analyst David George “We expect office lending to have a significant impact on credit losses over the next few years, but are not overly concerned at current valuations,” they said in a research note on Thursday. “Investor-owned office properties are likely to come under pressure in the coming years given rising office vacancies due to the mixed work environment and expectations of continued leasing in key metro markets.” George expects the impact on the banks under his coverage to be manageable. “With these stocks trading at ~40% discount to post-crisis P/E, our concerns about EPS downside drivers of less than 5% have eased,” he said Office REITS hit hardEven if the threat of regional banks is contained, real estate stocks have been severely damaged. William Blair analyst Stephen Sheldon said that REITs he covers, including outperform ratings CBRE Group, Jones Lang LaSalle, Cushman & Wakefield and Colliers International have fallen an average of 14% over the past three months. By comparison, the S&P 500 has risen more than 3% over that period. On average, the basket of stocks is off its 52-week high, he said. About 35% lower, noting that this equates to an average 2023 adjusted price-to-earnings ratio of about 10. CBRE 1Y mountain CBRE stock has outperformed some real estate stocks. The index is down about 9% since the start of the year.” The next few quarters are likely to be choppy, but we believe current valuations already price in buy-side expectations for earnings that are well below current sell-side consensus, and we believe earnings could turn out to be better than feared,” he said in a note The article reads a Thursday research note. Even if a company does not refinance, its costs rise sharply if its debt is floated. For those who are refinancing, they are less likely to cash out during the deal Any value, and that’s what many REITs rely on. Each company’s performance will depend on the type of property it owns, where it’s located, when its debt comes due, and management’s views on whether it sticks through a down cycle. Decision type. Morgan Stanley recently estimated that real estate values could fall about 40% from peak to trough. Deutsche Bank analyst Matt O’Connor wrote in a recent research note: “Given that leases are typically 10 years, office is long-tailed. “That said, we’re entering our fourth year of COVID-related corrections. That means losses could start to show up a little bit in 2023 and become more meaningful in 2024-26. Certain types of CREs have fared better, said Manus Clancy, senior managing director at data provider Trepp. He said real estate values for industrial and multi-family buildings were down about 15% to 20%, below mall and office values. A 30% to 35% drop. There is some demand, he said, such as facilities at life sciences companies. Offices are worse off in cities where remote work is more entrenched. These include San Francisco, Seattle and downtown Chicago, he said etc. The biggest concern, Clancy said, is seeing how many other firms join Brookfield, Blackstone and Pimco in returning the keys to office properties. Trepp’s CMBS delinquency rate fell 3 basis points in March to 3.09% from the previous month, but the office segment “Continuing to move higher. We’re in a moment where the banks are saving money now because they’ve seen what happened with Signature and SVB,” Clancy said. “They see a run on deposits and what they don’t want to do is hoard illiquid assets that might be difficult to sell if their banks experience a run.” So the banks literally cut off the artery of lending. current commercial real estate. …the market is really struggling. This is not just empty talk. ” Consequences for life insurance companies Another industry that is likely to be involved is life insurance companies. The long-term nature of commercial mortgage lending has made life insurance companies a major player in the real estate market. According to Moody’s, life insurance companies hold about 14.7% of the $4.5 trillion in CRE debt outstanding. However, Evercore ISI analyst Thomas Gallagher said pressure on life insurance stocks, which peaked in late March, was “excessive.” Gallagher said he expected any The situation will take time to resolve, and any losses will be “very limited.” MET 3M Mountain insurance giant MetLife’s shares were pressured by its forays into commercial real estate. Including the office, the average is below 50% (loan-to-value ratio), which should mean that most life insurers reschedule most of the maturing loans on their own or do automatic loan deferrals, with very few foreclosures,” he said. Insurance stocks include Equitable Holdings, Corebridge and MetLife. Gallagher said the three insurers are among the most vulnerable to commercial mortgage lending. The stocks hit 52-week lows on March 24, but It has since recovered some of its losses. However, the group has struggled this year. As of Wednesday’s close, shares were down more than 12% year-to-date, with Corebridge down more than 20% and MetLife down 17%. —CNBC’s Robert Hum and Michael Bloom contributed to this report.
