Is Commercial Real Estate the Next Domino to Fall?

With signs of stress in the banking sector, we are starting to see the impact of 500 basis points of interest rate hikes. Now the markets are buzzing about whether commercial real estate (CRE) could be the next domino to fall. Why are people worried about CRE specifically? One reason is because CRE loans are highly concentrated in small and mid-sized banks.[i] Many investors may remember the steep declines in CRE during the savings and loan crisis in the 1990s (-35%) and the global financial crisis (-45%) and are anxious about a potential repeat.[ii] Here’s my take: on its own, the CRE market is under pressure, but positive cash flow growth and several years of cumulative appreciation appear to be preventing a sudden spike in defaults. However, the current liquidity crisis could turn into a credit crunch with the potential to trigger a debt/deflation cycle that carries some systemic risk.

CRE currently facing headwinds, but cash flow remains in place

Even prior to the bank problems, we expected CRE prices to decline about 15% in 2023 as the market priced in higher rates and rapidly tightening lending conditions. An important factor I want to point out is that net operating income on many underlying commercial properties is still growing. It has decelerated from a low-to-mid-double-digit rate last year to a low-to-mid-single-digit rate currently. But that's cash flow in place. Demand for commercial space remains solid, even in retail, and we’ve seen very little in the way of defaults.

Bank failures can trigger a runaway debt/deflation cycle

One risk is that bank failures could contribute to substantial declines in commercial property values, which could create a more systemic problem. Commercial property values need support from both debt and equity valuations to sustain themselves. What can happen is a miniature debt/deflation cycle, illustrated below.

• It starts with a hit to bank capital. Perhaps a bank is forced to sell high-quality securities from available-for-sale accounts at a loss.[iii]
• With less capital, banks tighten up lending.
• As a result, commercial real estate values decline further, leading to negative equity and loan delinquencies.
• Delinquencies cause loans to be classified as non-performing or sub-performing, triggering an additional capital charge related to other than temporarily impaired (OTTI) assets.[iv]
• This further impairs bank capital and tightens lending requirements, and the cycle repeats.
  
  
  

Commercial real estate loans are currently 12.5% of bank assets (15% if you include multifamily and construction).[v] Most bank exposure to CRE loans is concentrated in smaller banks with assets valued between $10 billion to $250 billion.[vi] In my view, as long as banks can stabilize their capital levels (possibly requiring regulatory relief and policy assistance), the correction in the CRE sector can be contained. But with each passing headline regarding bank problems, I believe it is becoming more important for policy makers to act for CRE to avoid becoming the next “domino” that drives a widespread downturn.

[i] Source: Bank of America Global Research, 15 March 2023.

[ii] Source: National Council of Real Estate Independent Fiduciaries (NCREIF)

[iii] Available-for-sale securities are purchased with the intent to sell before they reach maturity
(if applicable), and are reported at fair value; changes in value between accounting periods are included in accumulated other comprehensive income in the equity section of the balance sheet.

[iv] Impairment charge taken on a security whose fair value has fallen below the carrying value on balance sheet and its value is not expected to recover through the holding period of the security.

[v] Source: Bloomberg, 7 March 2023.

[vi] Source: Bank of America Global Research, 15 March 2023.

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Markets are extremely fluid and change frequently.