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When the big American banks report earnings in the coming days — starting with JPMorgan and Citi today — investors will nervously scour them for signs of commercial real estate pain.
After all, seemingly everybody from the Federal Reserve on down has warned of a CRE reckoning in recent months. That is partly because rates have jumped 500bp in the past 18 months, and some $270bn of US CRE loans come due this year, according to Trepp (or $1.5tn in the next three years, according to Morgan Stanley).
But it is also because homeworking during the Covid-19 pandemic has caused demand — and values — for urban office space to tumble. Some flagship buildings in San Francisco and New York have traded down 75 per cent and 30 per cent of their pre-Covid levels, respectively. Ouch.
So, as the horror stories pile up, there are now two key questions hanging in the air: just how bad will this CRE implosion be? And who will take the pain?
On the second issue, the picture is still mixed. Non-bank lenders, who have the bulk of CRE loans, are already reporting difficulties: Blackstone recently sold a Wall Street tower for $1bn; in 2017 it was valued at $1.55bn. Regional banks are heavily exposed as well — and increasingly breaching regulators’ guidance around how much CRE loan exposure is prudent.
But counter-intuitively, the large banks do not seem to be badly hit, at least not yet. Yes, entities such as Wells Fargo are hiking loss reserves. But the latest stress tests from the Federal Reserve project a mere 8.8 per cent average loan loss if CRE prices fall 40 per cent. This is lower than the 9.8 per cent reported in 2022.
This may just reflect a time lag effect or, in other words, “pretend and extend” tactics. But it almost certainty highlights another point: the aggregate CRE picture conceals vast — and widening — variations on the ground.
A new report from McKinsey outlines the problem further. The consultancy argues that the pandemic unleashed a long-term shift in working practices. This will reduce demand for office space in the hardest-hit big cities by 20 per cent in 2030 compared with 2019 in a “moderate” economic scenario — and 38 per cent in an adverse one. Office prices are projected to fall by 26 and 42 per cent in these respective scenarios, creating at least $800bn in losses in the biggest cities. Retail values will suffer significant losses as well.
But there are notable differences between cities. Although office demand is projected to fall in New York and San Francisco by 16 and 20 per cent, it will rise slightly in Houston. There are also big distinctions between neighbourhoods: New York’s Financial District is performing far worse than the city’s Lower East Side, since the latter is more mixed use.
Most striking of all, there are stark differences even between buildings. In New York, so-called “Class A” buildings (which tend to be modern, digitally connected, green and well-suited for hybrid work) rose by 3 per cent in value between 2020 and 2022; “Class B” buildings (unrenovated legacy properties) fell by 8 per cent.
“Now that hybrid work has reduced the total amount of space that employers need, they can spend their budgets on smaller amounts of higher-quality space rather than larger amounts of lower-quality space,” McKinsey notes. “Many employers see high-quality space as a way to encourage office attendance.”
There is, in other words, a stark reversal underway of the pattern seen in the last decade in which a rising tide of cheap money lifted all real estate boats. Some buildings are doing (relatively) well; but there is also an ocean of stranded assets out there.
This has two big implications for investors looking at lenders. First, it no longer makes much sense to analyse a CRE portfolio in the aggregate; the detailed composition of portfolios is key. Sadly, granular details on this are not always available. However investors should start to demand this from the banks, and others.
Second, investors also need to track the behaviour of developers and city-level politicians. A key conclusion from the McKinsey research is that properties and districts which are “hybrid” — ie, those which can be used flexibly — perform best today. They are therefore most likely to retain value in the future.
One way to avoid a CRE crash is to embrace maximum flexibility. An obvious answer for New York’s stranded legacy office space, say, would be to convert these buildings to accommodation for young professionals, who still seem eager to live in the city but face a shortage of affordable housing.
This common-sense solution currently faces myriad obstacles: ridiculously rigid zoning laws, poor urban planning, a lack of imagination among developers and rising risk-aversion among lenders. So investors need to monitor for any signs that these obstacles are being tackled.
Better still, investors should demand that the big banks and other lenders use their formidable lobbying power to persuade American politicians to urgently relax permitting processes and embrace this new hybrid environment. Humans have already been forced to become far more flexible in this post-pandemic world; it is time for our buildings to catch up.