The Great Reset
The health of the banking sector is always top of mind for commercial real estate investors. The significant credit exposure to commercial office space, which will necessitate major refinancing over the next two years poses challenges, and the refinancing landscape will be a key factor to watch.
While it has the potential to create financial stress, the response of regional banks to the strong probability of lower interest rates this year and a rebound in property values may present opportunities.
The market’s attention is currently directed toward a diverse set of factors, ranging from technological advancements (AI) to macroeconomic indicators (earnings, inflation) and global geopolitical events. The absence of a significant focus on high-profile foreclosures or bank closures indicates a relatively stable environment in the banking sector.
After two years of reducing holdings, U.S. banks have been increasing their purchases of mortgage-backed securities (MBS) and collateralized mortgage obligations (CLOs), and have done so for the past three months, according to the Federal Reserve.
Over a two-year period during the central bank’s rate tightening cycle, banks and Wall Street firms sold about $800 billion in debt securities. After the selling subsided, there was a reversal with banks and Wall Street firms adding $41 billion in debt obligation purchases, powering the credit market boom in the fourth quarter of 2023.
That buying pressure, based on the assumption of six Fed rate cuts, brought the 10-year Treasury yield down to 3.8% from 5%, before the reality of a Fed pause last month fueled new selling pressure, sending the yield back to its current level of 4.28%.
So, banks have averted disaster. A hard landing has not occurred – at least not yet – and the Fed’s 2% inflation target has been difficult to achieve, with recent inflation readings trending slightly higher.
“In the wake of the Great Recession, it was typical to see dozens—if not hundreds—of bank failures each year. This slowed significantly from 2015 to 2020, when the U.S. saw an average of fewer than five bank failures per year. Zero banks failed in both 2021 and 2022. Bank collapses were similarly uncommon in the early 2000s. From 2001 to 2007, the U.S. saw an average of just 3.57 bank failures per year. For all of 2023, there were five failures, still well below the long-term norm,” Forbes reported.
The actions of market participants in response to the nearly $1.5 trillion in U.S. commercial real estate debt due before the end of 2025, with a substantial portion ($929 billion, or 20%) due by the end of 2024 will be a key determinant of the industry and the future of the banking sector.
Commercial property prices have fallen 21% since their peak in 2022, according to MSCI Real Assets, before the Fed began raising interest rates: “Office prices have had the biggest decline, falling an average of 35%. An estimated $85.5 billion of debt on commercial property was considered distressed at the end of 2023, with an additional $234.6 billion of potential distress,” MSCI reported.
Borrowers of all sizes are asking the same question: who will lend to them?
“Refinancing risks are front and center” for owners of properties from office buildings to stores and warehouses, Morgan Stanley analysts including James Egan wrote in a note last week. “The maturity wall here is front-loaded. So are the associated risks.” The investment bank estimates office and retail property valuations could fall as much as 40% from peak to trough, increasing the risk of defaults.
Issuers of commercial mortgage-backed securities (CMBS), CLOs, and investor-driven lenders (private credit) are currently the most active lenders, packaging distressed and potentially distressed loans into bundled securities and reselling them.
Many industry experts, however, believe the larger economy can manage a reset in commercial real estate. While 2024 will most certainly be a challenging year for many, every downturn is followed by a resurgence, wrote EisnerAmper in its Commercial Real Estate Investment Outlook 2024: The Bumpy Road to Recovery.
“Those investors who have enough cash to last the next 12 to 18 months will weather the storm. By the end of the year, money should begin to flow as the systematic and market risks become more measurable and credit spreads narrow.”
Despite the short-term challenges, the real estate market has proven robust after each downturn, generating strong long-term profits. Moreover, transaction volume is expected to increase into 2025, the report noted.
Just as the March 2023 regional bank scare provided one of the most significant buying opportunities in recent years, the upcoming great reset in the commercial real estate market may result in a similar pullback that allows investors to buy into today’s market.
