(Bloomberg Opinion) – If market participants are dabbling in the potential repercussions of a Silicon Valley bank failure, wait until they consider the banking industry’s exposure to a rapidly weakening commercial real estate sector. please give me.
It seems like every few days there is news that a large property is in default. In the past few weeks, a landlord of offices managed by Pacific Investment Management has defaulted on about $1.7 billion in mortgages on seven of his buildings, including San Francisco, Boston and New York. Prior to that, Brookfield’s business had defaulted on loans tied to his two office towers in Los Angeles. A $1.2 billion mortgage on a San Francisco complex jointly owned by former President Donald Trump and the Borneo Realty Trust has been placed on a watchlist of potentially at-risk loans.
If the Silicon Valley Bank narrative hastens the arrival of the next recession, expect more real estate to default sooner or later. This is bad news for lenders who are increasing their lending to real estate. Since mid-2021, their on-book real estate loans and leases total surged more than his $725 billion (16%) to a record $5.31 trillion, according to the Federal Reserve. reached.
Last year’s 11.2% increase matched the previous four years combined and was the largest increase since 2006. Not only that, commercial real estate loans accounted for nearly 24% of his all bank loans, the most since the financial crisis. To BNY Mellon strategist Jon Veris. One of the reasons banks have so much exposure, he said, is that it’s getting harder for investors to take the risk. The commercial mortgage-backed securities market is down 75% from $240 billion in annual issuance in 2007 to just $60 billion in 2020, he notes. Here’s what Veris wrote in his research notebooks before Silicon Valley Bank collapsed.
“In textbook monetary policy, rate hikes are aimed at tightening financial and credit conditions and lowering economic activity. It could, and often leads to strains in the financial sector.We focus on commercial real estate (CRE) loans as one area of the financial system where vulnerabilities exist.”
Commercial real estate is a risk that Peter Boockvar, chief investment officer at Bleakley Financial Group LLC, has been warning clients about for months. In a research note late last year, Boockvar introduced readers to numbers. In his example, in 2020 he paid $50 million for an apartment property and has an investor who took out a three-year loan at 70% of the property’s value. Assuming the property was purchased at his 5% capitalization rate, the annual gross rent would be about $2.5 million. That’s more than enough to cover around $960,000 a year for a loan with an interest rate of less than 3%, and other expenses like insurance, taxes, maintenance, and property management.
But no one expected interest rates to rise so quickly. The investor is facing a refinancing this year at well over 7% interest rates. According to Boockvar, this would result in annual interest costs of about $2.63 million. Even if an investor were to be able to raise his rent by 10% in 2021, or a similar amount last year, the rental income would only rise to about $3 million. That leaves about $400,000 in all other expenses, and property taxes alone wipe out that $400,000 in some states alone, he notes.
Sure, these are back-of-the-envelope calculations, but they’re true and show the problems that lie ahead for both real estate investors and lenders. Loan stress could escalate rapidly in commercial real estate as interest rates rise. This is because refinancing loans becomes more costly and harder to find as banks try to reduce their exposure.
Asset value declines are not yet to come — they are already here. A widely followed index of commercial real estate prices released by the National Real Estate Trust Council plunged 3.5% last quarter. This was the biggest drop since 2009 and only the second quarterly drop since. The decline was led by offices and apartments.
So where’s the risk for banks? Most of the time it’s with smaller banks that specialize in real estate and some of the larger lenders. Wells Fargo & Co. suffered the largest commercial real estate losses in the Federal Reserve’s 2022 stress test, while M&T Bank Corp. and Huntington Bancshares Inc. percentage and their capital base.
Last year, M&T significantly increased its bad debt rules, but mostly for consumer and corporate debt, not real estate. The bank has cut its exposure to projects under construction in recent years, which it says has reduced stress in the hotel sector. However, assisted living and offices are now areas where problems may start to escalate.
The good news is that lenders are beginning to tighten their standards when it comes to extending commercial real estate credit. The latest quarterly loan officer survey by the Federal Reserve showed that 57.6% of respondents reported tightening standards. The bad news is that this may have come too late, as standards were significantly relaxed after the pandemic hit.
It’s fair to ask if what’s happening in commercial real estate right now could set the banking industry into a repeat of the savings and loan crisis of the late 1980s and early 1990s. It’s too early to give an answer, but what we’ve learned from subsequent episodes is that you can’t have a healthy economy without a healthy banking system. The Silicon Valley Banking Crisis suggests that perhaps the banking system is not as healthy as we thought.
— With help from Paul J. Davies.
To contact the author of this article: Robert Burgess [email protected]
© 2023 Bloomberg LP