CRE’s Value Erosion: A Market on The Edge

The global commercial real estate (CRE) market, valued at $50.8 trillion (Savills), is facing unprecedented challenges, with rising delinquency rates and declining property valuations putting both small and large banks at risk. 

This issue of our newsletter delves into the factors contributing to this crisis and the potential opportunities it presents for investors capable of weathering the storm.

What’s in Today’s Email:

• The CRE Market at a Crossroads: Analyzing the factors driving the current crisis in the CRE market, including the economic slowdown and the shift towards remote work, which have led to the highest loan delinquency rates since 2008.

• Banking on the Brink: Understanding the growing insolvency risks faced by small banks and the hidden vulnerabilities of larger institutions, as commercial property foreclosures surge.

• Opportunities Amidst Chaos: Exploring the high-risk, high-reward strategies some investors are employing to capitalize on distressed CRE bonds, and the potential pitfalls of these speculative moves.

The global commercial real estate (CRE) market is going through a robust shake up, with steep declines in valuations and increasing defaults.

US investors alone currently hold approximately $3 trillion in commercial real estate loans. Delinquency rates on these loans, as of Q2 2024, have risen to 1.42% - the highest since the aftershocks of the 2008 financial crisis.

The reasons behind this uptick are both structural and cyclical. The historical transition towards remote and hybrid work models post-pandemic, as well as the evolution of retail from smaller stores to large warehouses amidst a surge in online shopping, represent the structural aspect, while the slowing economy - including the recent downward revision of US employment data that increased fears of an upcoming recession - added a cyclical dimension to the problem 

Against this backdrop, commercial real estate valuations have taken a substantial hit. Office buildings in particular, once the crown jewels of urban development, are now facing a grim reality. Over $38 billion worth of US office buildings are on the brink of default, foreclosures, or other forms of distress, the highest level since 2012.

Adding fuel to the fire, more than half of all single-asset-single-borrower (SASB) bonds are set to mature before or in 2028. With bonds backed by malls and offices already defaulting in major cities like Chicago, Los Angeles, and New York, the market is witnessing a race to the bottom, with some of these bonds already trading for less than 20 cents on the dollar. 

Driven by a marked shift to remote or hybrid work, this staggering decline in office space valuations - which led to an estimated $664.1 billion in lost value across US office markets - isn’t just a financial issue. It is also a societal shift, with vast ramifications, from local public finances to - potentially - the stability of the broader financial system.

The Rising Tide of Banking Insolvency

The crisis in commercial real estate is not just a story of collapsing buildings and plunging valuations; it’s also a tale of looming financial disaster for (especially smaller, more local) banks and investors. The portfolios of U.S. foreclosed and seized properties reached a staggering $20.5 billion in Q2 2024, a 13% increase from the previous quarter and the highest since 2015.

Small banks, those with assets under $10 billion, are particularly vulnerable, having seen the largest quarterly increase in seized commercial properties since 2000. This is a harbinger of worse to come, with delinquent CRE loans now standing at a perilous $9.3 billion for the country’s largest banks - JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, Goldman Sachs, and Morgan Stanley.

The implications of these rising delinquencies are dire. A working paper by the US National Bureau of Economic Research (NBER) points out that with a 10% default rate on CRE loans, US banks could face aggregate losses of up to $80 billion. If the default rate doubles to 20%, as is not unthinkable in this increasingly fragile environment, the number of banks in danger of insolvency could skyrocket. Over 480 banks, with an aggregate $1.4 trillion in assets, could find themselves with mark-to-market (MTM) asset values below their liabilities - a situation that could trigger a cascade of smaller bank failures reminiscent of the 2008 crisis, perhaps smaller in size, but potentially more widespread.

Larger banks, while seemingly better capitalized, are not immune. Their exposure to CRE is often indirect - through credit lines to Real Estate Investments Trusts (REITs). In times of stress, these REITs draw heavily on their credit lines as a first line of defense to acquire assets or smooth out payments, exacerbating larger banks’ exposure to the faltering commercial real estate market. This hidden vulnerability means that even large banks could be blindsided by the unfolding drama.

Credit lines are off balance sheet and incur lower upfront capital requirements. As long as REITs do not make use of their credit lines, the exposure to the bank remains off their balance sheet. However, once the drawdown cycle commences, it becomes a liability to the bank, and as a result, it increases the threshold of additional required capital (a spirited debate is currently ongoing with regards to capital requirements for US banks, amidst the implementation of the Basel III agreements).

In the US alone, over 95% of REIT holdings are in commercial real estate and approximately 1,100 REITs own more than $4 trillion in assets across the U.S. Why is this a problem? Beyond the obvious exposure that banks have on and off the books, about 50% of American households - or close to 170 million people - are invested in REIT stocks. If the underlying factors already sagging the CRE sector continue to deteriorate, then it is not hard to imagine what may happen to average Americans with REIT exposure.

Betting on Collapse: The Perilous Path of Opportunity

All data seems to be pointing to a period of great uncertainty for CRE.

Amidst the turmoil, however, some investors are flocking into distressed bonds, betting on the - in our view - slim chance that properties will be sold off at higher-than-expected prices. Others are placing their chips on buildings that might just manage to make interest payments for a few more years, before their likely default. 

Some contrarian investors are rushing to snap up bonds from properties that, while still profitable, have been tainted by the growing stigma surrounding commercial real estate.

But these strategies are not without significant risk. As Deutsche Bank has warned, provisions for credit losses are expected to surge more than 30 basis points on its average loan book this year. For South Korean investors, the pitfalls of betting on US office buildings have already been made painfully clear - nearly 7% of overseas investments in individual properties had defaulted by the end of 2023, a figure that likely only scratches the surface. 

The competition for cheap opportunities in this crowded market is fierce, but stakes have never been higher. In California, for instance, which accounts for nearly 30% of all commercial foreclosures in the US as of March 2024, the level of market stress is especially elevated. The collapse of these markets is not just a regional issue but a signal of the broader challenges facing the global economy. As more and more properties are foreclosed upon, the cycle of distress deepens, potentially driving valuations lower and pulling more banks and investors into the vortex.

Conclusion

Against the backdrop of a deteriorating global macroeconomic picture, with the US Federal Reserve’s July meeting minutes and Chair Powell’s Jackson Hole speech strongly pointing to a September meeting 25-basis point cut, there is no question that commercial real estate is in the midst of a cyclical crisis. 

Our sense is that rate cuts will not come early enough to avoid a substantial fallout from loan defaults and their ripple effect on bank balance sheets. The concern now is not whether the market will recover, but who will survive the fall. 

The scars left by this crisis will reshape the landscape of commercial real estate for years to come, with far-reaching consequences for banks, inventors, and the broader economy.

The most intriguing question, however, revolves around structural challenges that arose as a result of a broad rethinking of white collar work, as well as the paradigm shift in retail behavior, which now overwhelmingly favors e-commerce.

Nonetheless, wherever there’s difficulty, there’s opportunity. Depressed valuations in the CRE market invite those with sufficient available capital to take advantage of fleeting opportunities. Whether a single commercial building becomes available at 97% discount, or you have an opportunity to get exposure through private credit, perhaps it is worth taking a more “comfortable” position on the capital structure built on disciplined and detailed credit analysis?

All in all, time is ticking - as we approach the steep $1 trillion commercial maturity wall by the end of 2024.

Will a quarter be enough for all problems to clear? We wouldn’t bet on it…