Blain’s Morning Porridge – 4th April 2023: The approaching Real Estate (CRE) storm will be a crisis – but is hardly unexpected!
“I’ve seen him naked. There’s no way he could be scarier with his clothes on.”
This morning – Fears of a full-on Commercial Real Estate Crisis are mounting as rising rates, a dearth of credit and a record redemption schedule combine into a perfect storm – but the market is already expecting it, so what will be the credit event or no-see-um that tiggers a market meltdown?
The indictment of a small, statistically insignificant US property developer for paying off a floozie with company cash and falsely accounting for it shouldn’t be this interesting – but it will be…. Any maybe not for the sordid revelations you are hoping for…
Many market observers are watching US property – a $5 trillion market – for signs of imminent catastrophe! The rising cost of the debt financing on prime Commercial Real Estate (CRE) is roiling and scaring the market – many bank analysts reckon CRE will create a genuinely capital damaging credit impairment impact on smaller US bank lenders, but also upon the shadow-banking “Alternatives” space of credit hedge funds which have been happily funding property deals in search of returns – they are about to discover just how illiquid office blocks in empty cities are.
I was idly scanning news about commercial real estate and came across the following illustration of the problem:
- The former Bank of America building at 555 California in San Francisco has been placed on a loan servicer watch-list of real estate deals it considers likely crisis points. In just 2 years the cost of a $1.2 bln 2-year mortgage on the building taken out in 2021 has risen 38%! The owner has just filed to extend the loan. US Property developer Vornado owns 70% of the building. It wrote down its property portfolio by $600mm last month.
The other 30% of 555 California is owned by a certain Donald J Trump. As I say… fascinating. How many developers and real estate barons will find themselves in trouble as the CRE markets implode… ?
The problem isn’t the tenants of the SF building – they are good for their rents. It’s the rising cost of the mortgage to over $6 mm per month, and what can the landlord do to absorb crippling debt service costs as rents remain under pressure. The fact San Francisco is struggling with a 28% office vacancy rate and is the “the most empty downtown in America”, according to CBRE, the property giant – makes achieving any kind of sale… challenging. Mr Trump won’t be able to focus his “incredible” business acumen on turning the tower around – what with him being fully engaged in staying out of pokey on the other side of the country.
According to a recent report by JP Morgan over $450 bln of US CRE lending is due to mature this year. In normal conditions that would not be a problem – but these are not normal times: refinance when you can, not when you have to, being the number one rule in finance.
Refinancing in property has got very, very difficult. The Fed has hiked interest rates from 0.05% in April 2020 to 5%, a brutal dose of financial reality for inexperience developers who got caught up in the frenzy generated by ultra-low rates since 2008 and those old enough to have forgotten what normal rates feel like.
The deposit run that sank Silicon Valley Bank, and less well known Signature Bank, is also significant. Signature was the 10th largest CRE lender in the US! It apparently dominates office lending in NY – which is a major part of the US CRE office market. When one CRE lender sneezes the rest catch flu.
A recent report from Bank of America highlighted it’s the smaller US banks that provide 70% of US CRE debt, while 20% comes from shadow banking alternative funders. Ask them what they want to lend on an office block now… It will be no surprise that credit conditions for borrowers just got massively tighter, lenders are less willing to lend, thus current CRE investors are stuck with property they have to refinance at punitive rates – thus it’s nailed on there are going to be significant defaults, and thus further rising pain on CRE valuations creating a vicious terminal death spiral for struggling borrowers – and lenders!
Looking back to the Global Financial Crisis that began in 2007 on the back of residential mortgages wrapped up CLOs and CLOs of CLOs, the first signs of trouble was Bear Stearns shuttering a number of asset backed investment funds, followed swiftly by French banks. It confirmed the worst fears of smarter investors, who had recognised how crazy the home financing market had become, and were shorting the system that had enabled it.
Some think the same thing is happening again. More than a few observers reckon the gating on prime US CRE funds run by funds like Blackstone and Starwood last year were a similar red light – investors finding they simply could not get money out as rising interest rates crushed fund performance. Since then other Property Backed deals managed by prime names have defaulted. Blackstone’s $69 bln REIT (Real Estate Investment Trust) was the largest – and primarily sold the tax-adverse US high-net-worth investors. Last year the value of US property funds tumbled 20%. Blackrock, CBRE and other real money funds gated UK property funds last year also – crushed by illiquidity and drawdowns.
Rising interest rates, tighter credit conditions as CRE lenders panic, plus Covid, Working from Home and the reluctance of commuters to go back to the office has hit the office sector particularly hard. Over 80% of office workers spend at least one day per week WFH, with knock-on effects across retail, hospitality and service sectors. Retail is being crushed by crashing consumer discretionary spending.
But CRE is more than just offices and retail; other areas like hotels and logistics are thriving (despite the problems at Amazon).
In the last few months and increasing number of the growing banking apocalypse commentariat has pointed to the CRE sector as the most likely credit contagion vector which will turn last month’s mini-US banking crisis into a wholescale market meltdown, spelling the next phase of the Global Financial Perma-Crisis.
I’m pretty sure CRE is going to get interesting, but I’m not so sure it will be the known threat to sink us all. It’s too plainly visible. The central banks stand ready to protect depositors and thus the smaller banks for runs – although they will be challenged if the flood of money out of banks into money market funds is accelerated by CRE fears. It’s the no-see-ums, the unknown unknowns, that cause the major pain.
The other side of the equation is to not overly worry when others panic. Back during the last crisis in 2007-08 the best investments to make were crashing property deals crushed by sub-prime fears, and banks dragged lower by the fear the collapse of Lehman was just the start of a systemic crisis. Crisis always creates opportunity to buy assets cheap as holders panic – I’m sure that will be the case again.
I’m still trying to figure what the crisis will be. CRE is going to be a threat – but I doubt it will be the only one… We still have major pain to come from inflation, commodities, normalisation and stock markets strike me as overly frothy.. My expectation is the coming crises will be linked to illiquidity in volatile markets and the difficulty of valuations in private debt and private equity – in such markets a bid will be a bid will be a bid…
Watch this space….
Five Things To Panic About This Morning
Out of time, and back to the day job
Bill Blain – Strategist Shard Capital