Commercial Real Estate Crisis Is a Ticking Time Bomb... And It's About to Go Off

Empty Spaces, $1.5 Trillion Wall of Debt, and Hundreds of Banks at Risk of Collapse

"Commercial real estate is a reflection of the economy, and right now, the economy isn't so great."

~ Sam Zell

Over 30 million.

That's the total of empty office space in San Francisco. If that number sounds too massive to comprehend, just picture this for perspective…

The Pentagon has about 6.6 million square feet of office space. So there’s about 4.5 times the office space of the Pentagon worth of empty space in San Francisco alone.

Industry insiders estimate that nearly 36% of offices in San Francisco are currently vacant.

But this issue isn’t limited to San Francisco. It’s widespread across the country…

A recent study from the real estate firm Cushman & Wakefield found that about a fifth of office spaces are empty throughout the U.S.

That’s a staggering 20%. Even higher than the vacancy rate during the 2008 global financial crisis.

Meanwhile, commercial real estate (RE) foreclosures recently jumped 117%.

The Perfect Storm of Problems

Now, the trouble with all that, high vacancies (especially ones this high) and foreclosures, is that they mean less money coming in to cover loans.

That's a real problem for landlords and also for the banks that issue these loans.

This is made worse by the Fed, hiking interest rates to the highest in 22 years, making loan repayment even harder.

That, in turn, puts pressure on overall commercial RE values.

Recent data shows that commercial property prices have declined by 21.4% from their peak in March 2022. And within that sector, office prices showed the biggest drop, plummeting by 35%.

This, of course, makes banks more hesitant to hand out loans for commercial RE projects.

The more prices drop, the tighter the banks squeeze, and the deeper the prices fall.

It's a vicious cycle, resulting in even more delinquencies or defaults in loan payments.

But what truly makes this the perfect storm of problems is...

There’s $1.5 trillion of debt maturing on commercial real estate by 2025. Yes, that's a trillion. With a "T."

This is $750 billion a year that commercial real estate investors are on the hook for over the next two years. 

That means owners will have to pay off or refinance their debts at a time when low occupancy has knocked down building values, interest rates have gone up, and banks are being more cautious with lending.

They call it a maturity wall and it's for a good reason. Many landowners won't find a way over.

Just a Matter of Time 

Here’s what you have to understand though. We’re well past the point where the troubles with U.S. commercial real estate were just a "landlord problem." Now, it's an America problem.

You see, most of the $1.5 trillion in U.S. office space debt I mentioned above is owed to regional banks.

As a group, regional banks are responsible for 70% of all commercial RE loans across the nation.

And, with such a high level of exposure, it's no wonder you can already feel the panic in the air, considering the state of affairs.

Case in point: New York Community Bancorp (NYCB). Back in February, the nation’s 28th-biggest bank with over $114 billion in assets under management reported major losses tied to souring commercial real estate loans. NYCB’s credit rating got downgraded to junk status, and its share price nosedived by a massive 74% just this year.

But it’s not just NYCB. Numerous other regional banks are trading at or near their lowest levels in two years, with their credit ratings decimated.

The reason for this is that regional banks are, as the name suggests, regional. They focus on the financial needs of individuals and businesses in certain geographic areas. (Unlike big-name national or international banks like Citigroup or JPMorgan Chase, which have a wider reach).

What this also means is that any economic or financial event hitting the area can have an outsized effect on related bank loans. That's what happened with NYCB.

But with NYCB, while investors nearly got wiped out, at least it didn't collapse. Unfortunately, many regional banks, along with their investors and depositors, may not be as lucky.

Christopher Wolf, managing director and head of North American banks at Fitch Ratings, recently said, "You could see some banks either fail or at least dip below their minimum capital requirements."

So, what he’s saying is these banks are basically toast. Because if you don’t have enough liquidity to keep your business going, well, that’s still failure, just with more steps compared to a failure caused by a bank run.

But how many is “some”?

A recent study from Klaros Group, a consulting firm, found that 282 regional banks have both high levels of commercial real estate exposure and large unrealized losses from the rate surge.

That's the same toxic double whammy that pushed First Republic and Signature Banks over the edge last year, remember?

These banks went under because they couldn’t raise enough money by unloading their investment portfolios (which were deeply underwater due to the Fed's rate hikes) to pay back the depositors who were rushing for the exits.

It's a good bet that it's not just these 282 banks that are at risk of a similar fate. There are probably many more that weren't part of the study.

Here's what we know for a fact though: U.S. banks as a group are currently sitting on $480 billion in unrealized paper losses on securities.

It’s an impressive figure, far surpassing the "paper" losses witnessed during the 2008 crisis. That's what the chart above also shows.

Simply put, the U.S. banking system is operating at a huge loss.

Note: When interest rates rise, bond prices fall, which creates "paper" losses on bonds already held by a bank. This isn't necessarily a big problem if the bank can hold these bonds to maturity. But if it’s forced to sell the bond before it matures, as was the case with First Republic and Signature banks, these paper losses turn into real ones quickly.

If you set this against the backdrop of the ongoing disaster in commercial real estate, it’s like a ticking time bomb waiting to explode.

Put another way, it’s only a matter of time until the next banking crisis hits.

Now, if you're anything like me, you'll probably start Googling the name of said study, trying to find out if your bank is one of the 282 banks mentioned in it.

Forget about it...

Klaros decided not to name the institutions in its analysis to avoid causing panic and bank runs.

This tells me they probably suspect it's a much bigger problem than they're letting on.

Regards,

Lau Vegys