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The plucky, somewhat unassuming Canadian insurance company known as Manulife doesn't get much attention, but it sent shock waves through the real estate world this week.
Just before Federal Reserve Chairman Jay Powell announced that the central bank would keep interest rates unchanged at 5.5% from 5.25%, Manulife Chief Financial Officer Collin Simpson revealed that the company had written down the value of its U.S. office investments by 40% from their pre-COVID peak.
“We believe our real estate portfolio is pretty high quality and pretty resilient,” Simpson told Bloomberg, “but the structural forces of rising interest rates and the trend back to the office make it a tough market.” Simply put, working from home hurts.
At first glance, that seems scary — 40% is a big number — but investors should actually be happy. The bit of good news is that Manulife is relatively well-funded and can absorb this hit. The second, and more important, point is that Manulife's move signals that some players are finally starting to be more honest about the plight of U.S. commercial real estate.
This is welcome, but long overdue, as CRE has been caught in a debilitating pattern of “extend and pretend” in recent months as expectations of U.S. interest rate cuts grew, with lenders essentially deferring troubled loans in the hopes of a future miracle bailout from the Fed.
But Wednesday's Fed meeting underscored an important point: Chairman Powell's priority right now is not protecting CRE, but reining in inflation at a time when consumer activity is surprisingly strong and inflation is hovering around 3%. So the trillion-dollar question is how many players will follow Manulife's lead and finally address one of the biggest hangovers from the last decade of low interest rates.
The answer matters because the financial system is currently saddled with a volatile deluge of low-interest CRE loans, of which Newmark research last year suggested more than half came from banks, especially community banks, which were enthusiastic lenders when the Fed pumped out nearly free money during the COVID-19 crisis.
But funding is also available from private lenders and the commercial mortgage-backed securities sector, often packaged as collateralized loan obligations.
But since the pandemic, CRE values have fallen by an average of 33%, according to Goldman Sachs, and in some places by as much as 60%, especially office buildings, and while demand for high-quality space remains strong, the outlook for lower-quality buildings is bleak.
There are signs of pain in capital markets: A sharp rise in CLO delinquencies was revealed this week. Some banks are also under stress: New York Community Bank was recently forced to raise $1 billion in emergency capital due to CRE losses, and Claros Group warned this week that more than 250 smaller banks out of the 4,500 existing U.S. banks are also vulnerable.
But what's shocking isn't how some of the flashpoints have surfaced, but how little of the pain has materialized so far. That's in part because capital markets lenders are deferring bad loans. Newmark recently told clients that “of an estimated $163 billion in CMBS maturing in 2023 (based on original maturity dates), $83.3 billion remains outstanding,” meaning borrowers have exercised their “extension options.”
But banks are also showing patience. Goldman Sachs estimates that $270 billion in commercial mortgages that were due to mature in 2023 have been extended to 2024. As a result, a record amount of low-interest loans will mature this year. Newmark estimates that there is currently about $1.3 trillion in troubled commercial real estate loans, of which $670 billion will mature over the next two years.
About a third of this debt was incurred when interest rates were at their lowest during the pandemic, the report adds. So these borrowers would face a refinancing shock even if the Fed cuts rates this summer, as Chairman Powell suggested Wednesday. The Fed's median forecast calls for rates to be “4.6% by the end of this year, 3.9% by the end of 2025, and 3.1% by the end of 2026.”
So what happens next? A repeat of 2008 seems unlikely. The entire banking system is well capitalized, and since the collapse of Silicon Valley Bank last year, the Fed has been scrambling to build a system to stop the spread of the contagion. So while the 2008 shock was about lender and borrower pain, today's crisis is primarily about creditors.
But the problem is that as long as these “fake extension” tactics continue, uncertainty will hang over the real estate sector, threatening to stifle growth in the U.S. In other words, what’s needed now is for owners and lenders to be more transparent about their losses and not just write them down, as Manulife has done, but also start trading distressed properties, so that we can either demolish or repurpose unwanted buildings to resolve the pandemic-era glut.
In that sense, it's good news that the Fed did nothing on Wednesday. In fact, for my taste, I would have preferred that they had remained a bit more hawkish. Investors need to get used to a world where the price of money becomes more normal and they can't constantly bet on Fed “puts.” If that happens in real estate, or if it does happen, we'll know that the distortions of the last decade are finally coming to an end.
GillianTett@ft.com