The American offices are half empty. This could be the next big risk for banks [Boss Insurance]

The American Offices Are Half Empty.  This Could Be The Next Big Risk For Banks

London (CNN) From Dallas and Minneapolis to New York and Los Angeles, offices are vacant or underutilized, showing the durability of the work-from-home era. But clear offices and quiet break rooms aren’t just a headache for bosses looking to bring teams together in person.

Investors and regulators, keenly alert to signs of financial system turmoil following recent bank failures, are now focusing on the slowing $20 trillion US commercial real estate market.

Just as lenders in the sector grapple with the turmoil triggered by rapidly rising interest rates, the value of buildings such as offices plummets. This could add to banks’ pain and raise concerns about detrimental ripple effects.

“While this is not yet a systemic problem for the banking industry, there are legitimate concerns about contagion,” said Eswar Prasad, professor of economics at Cornell University.

A worker inside a vacant office and retail building in San Francisco, California, October 10, 2022.

In the worst-case scenario, concern over bank lending to commercial real estate could skyrocket, prompting customers to withdraw their deposits. A bank run is what toppled Silicon Valley Bank last month, rocking financial markets and raising fears of a recession in the United States.

Asked about the danger posed by commercial real estate, Federal Reserve Chairman Jerome Powell said last month that banks remained “strong” and “resilient.” But attention is increasingly focused on the links between US lenders and the real estate industry.

“We are watching it very closely,” said Michael Reynolds, vice president of investment strategy at Glenmede, a wealth manager. While he doesn’t expect office lending to become a problem for all banks, “one or two” institutions could find themselves “caught off guard.”

first american banker, JPMorgan Chase (JPM) CEO Jamie Dimon told CNN on Thursday that he can’t be sure any other banks will fail this year. Yet he was quick to point out that the current situation was very different from the global financial crisis of 2008, when there were “hundreds of institutions around the world with way too much leverage.”

The US market seems the most vulnerable. Still, the European Central Bank and the Bank of England have recently warned of commercial real estate risks as the price outlook deteriorates.

Work from home bill is coming due

Commercial real estate – which includes offices, apartment complexes, warehouses and shopping malls – has come under considerable pressure in recent months. Prices in the United States fell 15% in March from their recent peak, according to data provider Green Street. The rapid rise in interest rates over the past year has been painful, as purchases of commercial real estate are typically financed with large borrowings.

Office buildings were the hardest hit. Hybrid working remains popular, affecting the rents many building owners can charge. Average office occupancy in the United States is still less than half of March 2020 levels, according to data from security provider Kastle.

“You have fundamentals under the pressure of working from home at a time when loans are less available than [it has been] over the past decade,” said Rich Hill, head of real estate strategy at Cohen & Steers. “These two factors will drive valuations down quite significantly.”

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Problems can arise as the economy slows. Hill thinks U.S. commercial property valuations could drop about 20-25% this year. For offices, the declines could be even more pronounced, reaching 30%.

“I’m more worried than I’ve been in a long time,” said Matt Anderson, chief executive of Trepp, which provides commercial real estate data.

The signs of fatigue multiply. According to Trepp, the proportion of commercial office mortgages for which borrowers are in arrears is increasing, and high-profile defaults are making headlines. Earlier this year, a landlord belonging to asset manager PIMCO defaulted on nearly $2 billion in debt for seven office properties in San Francisco, New York, Boston and Jersey City.

What this means for banks

This is a potential problem for banks given their volume of lending to the sector. Goldman Sachs estimates that 55% of US office lending is on bank balance sheets. Regional and community banks – already under pressure after the failures of Silicon Valley Bank and Signature Bank in March – account for 23% of the total.

Signature Bank (SBNY) held the tenth-largest portfolio of commercial real estate loans in the United States at the start of the year, according to Trepp. First Republic (FRC), which last month received a $30 billion lifeline from JPMorgan Chase and other major banks, was the ninth-largest. But both had a much larger share of their property-related assets than larger rivals such as Wells Fargo (WFC)the main American lender in the sector.

Rising commercial real estate prices over the past decade have provided developers and their bankers with some protection. But the pain could increase in the coming months.

About $270 billion in commercial real estate loans held by banks will mature in 2023, according to Trepp. About $80 billion, or almost a third, is spent on office buildings.

Falling valuations will make refinancing more difficult for property owners, who are likely to face demands from banks to increase their equity. Some landlords – especially of older, less desirable office buildings – might decide it’s not worth it given the market climate and simply hand over the keys.

Banks may prefer this option to initiating costly and time-consuming foreclosure processes. But that puts them in the difficult position of owning depreciating properties.

“It’s a scenario we’ll see now very often,” Christian Ulbrich, chief executive of global commercial real estate services giant Jones Lang LaSalle (JLL), told CNN. The question, he continued, is what lenders will do in this situation and whether banks are sitting on such large loan portfolios that they must suffer “significant losses”.

Keeping watch

Banks have less capacity to take financial blows these days. Smaller institutions are struggling with deposit outflows to larger peers and money market funds offering better yields. In addition, banks’ investments in government bonds, once considered low risk, are increasing by a notch. losses as interest rates rise.

The worst outcome, according to Neil Shearing, chief economist at Capital Economics, is that a “catastrophic loop” develops. Questions about the health of banks highly exposed to commercial real estate loans induce customers to withdraw deposits. This obliges lenders to demand repayment, which aggravates the slowdown in the sector and further damages the financial situation of banks. This triggers more deposit outflows in a “vicious circle”.

Customers line up outside the headquarters of Silicon Valley Bank in Santa Clara, California on March 13, 2023. The U.S. lender’s bankruptcy has raised concerns about other weak links in the banking system.

That’s not the central expectation right now. Since the 2008 financial crisis, banks have tightened lending standards and diversified their customer base. Loans on behalf of offices for less than 5% of US banks” total, according to UBS. And JLL’s Ulbrich said that while the rate at which borrowing costs have risen has put significant pressure on the commercial real estate sector, it has lived with rates at this level for “most of its history. “.

“There’s always a risk of self-fulfilling prophecies here, but I’d still be pretty optimistic that things will turn out in a digestible way,” Ulbrich said.

The most likely outcome is thought to be increased defaults and reduced access to finance for the commercial real estate sector. The banks, it is predicted, will resist the storm, even if their income may take a hit.

That doesn’t mean, however, that there won’t be any fallout.

“Historically, distress like this hasn’t just hurt homeowners and the bankers who lend to them,” Lisa Shalett, chief investment officer at Morgan Stanley Wealth Management, said in a note to clients this month. Non-bank lenders, related businesses and investors could also be affected, she said.