Troubles are coming to the commercial real estate sector, not as single spies but in battalions. This does not bode well for regional banks, which are heavily exposed to that sector. More importantly, it does not bode well for next year’s economic outlook — especially if we were to have a regional bank-induced credit crunch.
It would be a gross understatement to say that the COVID pandemic has upended the commercial real estate sector. It has done so by permanently changing work habits; no longer do many employers believe that their employees need to work from the office on a full-time basis. As a result, office vacancy rates have skyrocketed nationally to over 16 percent — a level exceeding its 2008 peak. Meanwhile, vacancy rates in major cities like Chicago, Dallas, Houston, Los Angeles and San Francisco are more in the 25 percent range.
The next shoe to drop for the commercial real estate sector has been the spike in long-term Treasury bond yields. As investors have become increasingly concerned about how the government will finance its budget deficit (at 8 percent of GDP), they have sent the 10-year Treasury bond yield toward 5 percent. This will make it all the more difficult for property developers to roll over the $270 billion in their maturing debt next year. Not only will these developers have declining revenues as a result high vacancy rates, they will now need to pay interest rates at least 5 percentage points higher than the rates they were paying on their original loans.
As if commercial real estate developers did not have enough problems, earlier this month WeWork filed for bankruptcy. With 600 locations in major cities, WeWork’s bankruptcy will add to the office vacancy problem in general and to that of Boston, New York and San Francisco in particular.
With all of these shocks, it is not surprising that commercial real estate prices are already almost 20 percent below last year’s levels. And as property developers begin defaulting on their loans, more price declines are expected. According to Morgan Stanley, we could see commercial property prices falling by as much as 40 percent from their earlier peak by the time this cycle plays itself out.
All of this is singularly bad news for the regional banks, especially as these banks are nursing large mark-to-market losses on their large Treasury bond portfolios. It is estimated that commercial real estate constitutes as much as 18 percent of their loan portfolio.If property developers were to start defaulting on their loans in a meaningful way, we could have what Columbia professor Stijn Van Nieuwerburgh calls a doom loop in many U.S. cities. That could involve serious problems for local government finances and the failure of at least 200 regional banks.
The importance of the regional banks for the U.S. economy cannot be overstated. According to Goldman Sachs, banks with less than $250 billion in assets originate roughly half of loans made to businesses and corporations for capital expenditures. These smaller banks also account for 60 percent of all U.S. mortgages, 80 percent of all commercial real estate loans, and 45 percent of all consumer loans.
The last thing that an already slowing U.S. economy needs is a credit crunch in the regional bank sector that would crimp aggregate demand. Unfortunately, it is difficult to see how such a crunch can be avoided given the sharp spike in long-dated U.S. Treasury bond yields and the troubles in the commercial real estate sector.
In 2008, the Federal Reserve got caught flatfooted by the Lehman bankruptcy despite all the early warning signs of a brewing subprime and housing market crisis. Especially in light of this year’s failure of Silicon Valley Bank and First Republic Bank and of all the signs pointing to an impending wave of commercial property loan defaults, the Fed’s credibility would be dealt a heavy blow by its failure to anticipate an all too likely regional banking crisis next year.
American Enterprise Institute senior fellow Desmond Lachman was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging-market economic strategist at Salomon Smith Barney.
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Author: Desmond Lachman, opinion contributor