U.S. commercial real estate is casting a skyscraper-sized shadow over lenders around the world, raising fears of a potential crisis. Germany's biggest lender, Deutsche Pfandbriefbank, is struggling to reassure investors over worries about its exposure to the sluggish market. And banks from New York to Japan are dealing with similar fallout, with worries that a broader contagion could send elevators soaring.
what happened?
Commercial real estate dominates the overall real estate market, and its umbrella includes not only traditional downtown office buildings but also retail, industrial, and multifamily properties, all of which have experienced a major boom over the past decade, fueled by low financing costs that have made it easier for developers, investors, and banks to finance and invest in new properties.
But then two things happened. First, pandemic-era work-from-home practices changed office work patterns, causing record-high vacancy rates and reducing demand for office buildings (and related sectors like hotels, retail, and apartments in commercial areas). Second, central banks aggressively raised interest rates to tame inflation that had reached skyscrapers. This made real estate investments much less attractive compared to much safer cash accounts, putting financial strain on both owners and tenants and ultimately reducing demand.
Prices have continued to fall since then, just as I warned. The exact extent of the damage is difficult to gauge because the deals (the few that are still happening) were done privately and often contain short-term clauses that complicate valuation. But it's clear that central business district office buildings (light blue line) were hit the hardest, losing almost half their value, according to Morgan Stanley research. For categories like apartments and retail, the declines, while painful, have been less dramatic, and surprisingly, industrial property has barely fallen at all.
Property prices for various commercial property types. Source: Morgan Stanley.
Overall, commercial real estate prices are down about 20%, similar to the 21% drop during the U.S. savings and loan crisis in the early 1990s, but less sharply than the nearly 40% drop during the global financial crisis of 2008-2009.
Of course, there's no guarantee the decline will stop here. Property prices tend to move in slow cycles as supply and demand take time to adjust. But there are some encouraging signs that the worst may be over. Transaction volumes are increasing, lending standards are easing, and economic conditions are improving.
So what's the problem?
The problem is that it could take years for this to actually happen, and the true impact of the price crash is likely not yet fully upon us.Furthermore, problems arise and risk is faced by both borrowers and lenders.
Borrowers may default when they need to refinance. Up to $1.5 trillion in commercial mortgages will mature over the next two years. That's a quarter of all commercial mortgages in circulation, the highest since 2008. The problem is that these loans will need to be refinanced at significantly higher interest rates than they were before — two to three times higher due to aggressive rate hikes. Borrowers caught in this bind may struggle to secure refinancing and may be forced to scramble for alternative sources of credit, raise capital, or sell. For the less resilient of these borrowers, default may become a reality.
Lenders are facing a dangerous rise in defaults. Smaller banks in the US are especially vulnerable, holding around 70% of outstanding commercial real estate (CRE) loans. These loans make up 44% of banks’ overall loan portfolios. In contrast, larger banks are in a more cushioned position, with CRE loans making up just 13% of their loan balances. And, of course, if these borrowers default, lenders can take control of those properties, but that’s not much comfort, since in many cases they’re worth much less. So banks around the world are building up more reserves to protect against those losses, raising eyebrows in the process because it suggests we may be approaching that stage.
Of course, this problem isn't unique to US banks: banks across the country and beyond are riding the bull market in commercial real estate. For example, for European banks, commercial real estate accounts for 9% of all lending (and about 15% of loans where borrowers are behind on payments).
So, are we heading towards a crisis?
Of course, this is not an easy question to answer. Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen expect commercial real estate stress to cause some damage to certain lenders, but they don't believe it poses a major “systemic” economic risk to the U.S. or global economy. In other words, some small commercial banks may struggle, but there won't be a 2008-style catastrophe that brings down the economy, the stock market, and the global financial system.
The problem is, that's what people were saying right before the Global Financial Crisis. To take just one example, then-Federal Reserve Chairman Ben Bernanke said that subprime mortgages and weakness in the housing market posed no systemic risk to the financial sector, just months before it caused the entire financial system to collapse.
My point is that it is important to be humble and cautious when assessing risks to the financial system, and here are some things that trouble me right now:
Small commercial banks are the heart of the U.S. economy. They provide essential credit to small businesses, which account for roughly 40% of the U.S. economy and the job market. When these banks come under stress, it can ripple through the entire economy. It's hard to know how much trouble CRE really is in. It's a niche and opaque market. And the more opaque the market, the more likely investors are to “sell first and ask questions later.” The crisis isn't just about fundamentals, it's also about trust. Silicon Valley Bank was facing manageable liquidity problems, but the sudden mass withdrawal of depositors escalated the problem into a deadly crisis. Perceptions have a profound effect on financial institutions, and can turn a solvable problem into a system-wide threat. Exacerbating factors like illiquidity, forced sales, and mismatches between asset values and liabilities can make the situation worse quickly. And the interconnectedness of the financial system means that problems in one area can rapidly affect seemingly unrelated sectors. There are two dangerous feedback loops at play here. The first is the relationship between banks and commercial real estate prices. When small banks face defaults, they cut back on lending, which stresses property owners and exacerbates the bank's problems. Another is the relationship between bank stock prices and their fundamentals: when prices fall, banks' regulatory ratios worsen, which dampens sentiment and leads to lower stock prices, and so on. The safeguards put into the financial system after the 2008-2009 crisis remain largely untested. And much of this market's lending, along with its risks, has shifted to “shadow banks” — private equity funds, private lenders, hedge funds, and so on. These entities are less regulated and less transparent, making risk more difficult to assess. And finally, good news can also be bad news. A strong economy can support inflation, which means that the epicenter of tension here — rising interest rates — won't change dramatically, at least not until the economy is under some kind of threat. And the longer interest rates remain high, the greater the risk of commercial property defaults.
Overall, I agree that the most likely scenario is that stress from this market will be relatively contained and will not lead to a repeat of the Global Financial Crisis, but I also believe that investors are significantly underestimating the risk of such a scenario unfolding.
And the ultimate warning sign is that private market powerhouse Blackstone is on the cover of Forbes magazine. You know what that means…