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Today we look at the state of the commercial real estate (CRE) sector. Things seem to be getting worse and worse. If this part of the economy continues to deteriorate, it will have a major impact on banks, especially the regional banking system. This, in turn, could be a major headwind for the economy as a whole.
It seems like every day a new CRE property defaults or goes into foreclosure. On Monday this week, my email feed was notified that $211 million worth of CMBS for a mixed-use entertainment center in Los Angeles had been placed into special administration due to an imminent default on maturity. Additionally, the owner of a DC office building acquired for $174.5 million turned it over to its lender in lieu of foreclosure. These types of events are becoming fairly common.
Then there's the tale of the 600,000 square foot office building at 1740 Broadway in New York, purchased by Blackstone (BX) in 2014 for $605 million. What's it worth today? Just under $200 million, and Blackstone recently handed the building's remaining $308 million loan over to a special servicing company. Even the most senior creditors on this loan's CMBS will receive significant write-downs. This means that for the first time since the global financial crisis over 15 years ago, investors holding the highest rated tranches of this type of CRE debt will suffer losses.
According to Trepp, 20% of CMBS for office properties maturing in 2023 were delinquent and had not been paid off or extended by the end of last year. Eleven% of CMBS for retail properties were in a similar predicament. By the time it's all over in 2024, the situation for CMBS is likely to be significantly worse. Values for much of the CME sector continue to decline, and interest rates remain much higher than when these properties were last financed. Just over $75 billion of CMBS debt for office properties is due through 2025.
And it's not just CMBS debt that is seeing rising delinquencies, stress, and loan modification rates: Delinquencies on CRE collateralized loan obligation (CLO) loans were up 440% year over year as of February.The good news is that big banks like JPMorgan Chase (JPM) and Citigroup (C) have relatively small exposure to CRE debt compared to their overall loan book.
However, a recent report found that of 157 U.S. banks with more than $10 billion in assets, 67 have CRE exposure of more than 300% of their total capital. The Federal Reserve considers a ratio above 300% to be excessive exposure. Among banks with less than $10 billion in assets, 1,871 have at least 300% CRE exposure and 794 have CRE exposure of more than 500% of their total capital.
As you can see above, some of the larger regional banks (holding roughly 30% of total CRE debt) are heavily reliant on CRE loans. I recently covered Bank OZK's (OZK) heavy reliance on the CRE space. Given rising delinquencies and continued value declines across many segments of the CRE sector, it is hard to imagine that a significant increase in charge-offs over the coming quarters and years would not take a significant hit to regional bank earnings. A large number of smaller banks may also fail over the next few years.
Banks have already taken more than $500 billion in “unrealized losses” on their bond portfolios due to soaring interest rates, which was a key factor in the collapse of Silicon Valley Bank in the first half of 2023 and two of the five largest bank failures in U.S. history.
Continued deterioration in the CRE sector could lead to the failure of other regional banks. At the very least, rising losses on CRE loans could lead many financial institutions to reduce lending, sparking what's known as a “credit crunch.” This would be yet another major headwind for the U.S. economy, which is already seeing a significant slowdown in economic activity from 4%-plus GDP growth in the second half of 2023.
At the end of the day, the CRE sector continues to deteriorate and things may get significantly worse before they get better, which is one of the main reasons I remain cautious about both the economy and markets going forward.