Fundamentals in the commercial real estate market (CRE) market have deteriorated notably since last March, when the sector came under scrutiny due to the high concentration of CRE loans in smaller regional banks. At the time, we highlighted the potential for bank failures and declining commercial property values to spur a self-reinforcing debt/deflation spiral. Signs of lingering stress in the banking sector have not alleviated that risk, in our view. While policymakers have taken some steps to alleviate pressures, more decisive action is likely required to contain systemic risks emanating from the intersection of banking sector weakness and acute distress in lower-quality CRE assets. Here, we’ll share our assessment of the strains on CRE, revisit the feedback loop between lenders and CRE valuations, and share why we think policymakers should take assertive action to prevent a runaway debt/deflation cycle.
The deteriorating fundamentals for CRE
Our standalone outlook for CRE fundamentals is weak; as long as lending remains tight, which adds to workforce reductions and a slowing economy, we expect continued asset price deflation. Even prior to recent bank closures, we were anticipating a 15%-20% peak-to-trough decline in CRE valuations in 2023 as the market priced in higher interest rates and tighter lending conditions. While net operating income growth remains positive for many properties, the pace of expansion has slowed considerably from double digits at the end of 2022 to mid-single digits currently. Demand for commercial space is softening, especially for office assets facing secular pressures. For example, on 22 August 2023, financial services firm Charles Schwab announced it will cut its workforce and reduce leased office space. The potential bankruptcy of WeWork, the Class B[i] office property technology company, suggests that even creative solutions for the older, non-class A office spaces may be unsustainable.
Signs of a bank-led credit crunch started to emerge in the CRE sector during 2022 as financial conditions tightened rapidly. The credit crunch appears to have spread to other sectors of the economy, and we are seeing initial signs of rising delinquencies on commercial mortgages on properties of all types. For now, the office sector is showing the most stress, but we expect asset revaluations during a period of highly constrained lending to lead to difficulties in other property types next year.
The fundamental weakness in the office segment highlights the importance of asset quality in an increasingly bifurcated CRE landscape. Class A office properties in prime central business district locations continue to attract tenants and capital, albeit at reduced volumes. However, class B and C buildings in secondary areas without modern amenities are facing plunging demand, with many sales transactions of such properties occurring at discounts of 50% or more compared to recent valuations. Earlier this year, a building in downtown San Francisco sold at a price 75% below the value sought when it hit the market in 2020, according to Bloomberg News. The divergence between property types has been exacerbated by the lack of financing options for distressed properties.
Linkages between banking sector weakness and CRE distress
The banking channel remains a key transmission mechanism for more widespread distress within CRE. Additional shocks from bank failures and capital impairments have the potential to transform the challenging backdrop for CRE into a systemic debt/deflation spiral, in our opinion. With CRE loans representing up to 30% of assets for regional banks, we think the linkage is highly material. We believe the adverse feedback loop we discussed in March is worth reiterating:
1) Failed banks must sell assets, crystallizing trading losses and eroding their capital positions.
2) With impaired capital levels, banks tighten lending standards and reduce credit availability.
3) CRE values drop sharply, leading to widespread negative equity positions and rising delinquencies.
4) Additional loan distress brings on higher capital charges related to non-performing assets.
5) This further depletes bank capital and repeats the cycle.
Policy options to short circuit the doom loop
Government authorities have taken some constructive steps to prevent a systemic debt/deflation spiral, such as encouraging banks to pursue flexibility in restructuring distressed CRE loans to avoid triggering losses and impairment charges. However, given the potential scale of the problem, more forceful measures to directly stabilize banking sector capital levels may be warranted to reduce systemic risk transmission. Options include regulatory forbearance, suspension of certain capital requirements, and public capital injections if necessary. In our view, the policy priority should be interrupting the doom loop between banks and CRE asset values to prevent the self-reinforcing debt/deflation psychology from emerging.
Challenges poised to intensify in 2024 and beyond
Unfortunately, strained bank capital levels will likely prolong the ongoing credit crunch in commercial real estate. Higher capital requirements restrict banks' ability to absorb even modest losses, leading to a faster pullback in lending. This reduction in credit availability will likely place additional downward pressure on CRE valuations. In turn, further declines in collateral values appear destined to result in a new wave of credit losses for banks with heavy exposures to distressed CRE loans.
These dynamics suggest the systemic stresses emanating from the intersection of challenged bank capital positions and acute weakness in commercial real estate could intensify in 2024 and beyond. Policymakers may eventually need to weigh direct capital injections to stabilize institutions versus the risk of cascading damage to CRE markets, regional economies, and broader financial stability. In our view, acting sooner rather than later to bolster banking sector capital buffers and arrest the self-reinforcing debt/deflation cycle may ultimately prove less costly than delaying forceful interventions. The systemic risks from strained bank balance sheets appear poised to grow over time absent decisive policy action.
While the outlook for commercial real estate is challenging, the Mortgage and Structured Finance team sees attractive opportunity in other areas of the securitized market. Click below to learn more.
[i] According to BOMA, Class A is the highest ranking for commercial office real estate. These are typically prestigious buildings competing for premier office users with rents above average for the area. Buildings have high quality standard finishes, state of the art systems, exceptional accessibility and an established market presence. Class B buildings compete for a wide range of users with rents in the average range for the area. Building finishes are fair to good for the area and systems are adequate. Class C buildings competing for tenants requiring functional space at rents below the average for the area.
This blog post is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Loomis, Sayles & Company, L.P. Information, including that obtained from outside sources, is believed to be correct, but Loomis Sayles cannot guarantee its accuracy. This material cannot be copied, reproduced or redistributed without authorization. This information is subject to change at any time without notice. Market conditions are extremely fluid and change frequently.