When markets are in a “seek and destroy” mode, like the last dragon in Game of Thrones, it’s fruitless to guess where they might attack next in search of weaklings. But their next focus, alongside the impact of fast-rising interest rates on bond portfolios, may be commercial property and commercial real estate loans.
Concerns about a commercial office space crash have followed the collapse of Silicon Valley Bank, Signature Bank, and the regional banking crisis that began in early March. Federal Reserve officials have stressed that the collapse of these two banks had nothing to do with commercial real estate.
So often used for investment purposes, higher interest rates are making the commercial office property sector far less enticing. Fast increases in the Federal Reserve Bank’s benchmark interest rate have led to significant shifts in customer behavior. Institutional investors are shunning real estate for higher yields at lower risk on government bonds.
Fragility in parts of the banking system has not stopped the Federal Reserve from pushing up interest rates to subdue stubbornly high inflation. The Fed recently voted to raise the benchmark borrowing rate by a quarter of a percentage point, the ninth increase over the past year. That brought the fed funds rate to a target range of 4.75-5 percent, its highest level since late 2007. Another part of the motivation to raise rates might be to show—rather than simply tell—that the central bank has faith in the banking sector.
As property deals become more expensive to finance, the appetite for them wanes, which means fewer projects being built. Across, the sector, the Green Street Commercial Property Price Index is down 15 percent in a year, with the biggest drops in urban office real estate, where space stands empty as working from home takes permanent hold and people predict the death of the office.
U.S. office occupancy rates are between 40 and 60 percent of pre-COVID levels, according to the real estate firm JLL. Further, almost a quarter of the mortgages on office building must be refinanced in 2023, according to Mortgage Bankers’ Association data, which will bring higher interest rates.
COVID changed everything when employees were forced to work from home. While some companies have pushed for a return to the office, others have adapted to the change and are allowing their workers to stay remote. That is a bad sign for office owners. As leases come up for renewal, many companies that have embraced work from home as the new normal will opt to terminate the leases. That leaves some banks, especially regional ones, facing losses on real estate loans.
Consider that commercial real estate is a highly leveraged asset. When mortgages on these properties mature and owners have to refinance, interest costs increase and adversely impact cash flow. Higher interest rates and more vacancies also decrease the value of some office buildings. Indeed, some bank commercial office real estate loans may be threatened.
This is especially concerning for smaller banks, due to larger exposure as a percentage of their assets. For example, before its collapse, Signature Bank had the 10th-largest commercial real estate book in the United States. Another bank in the news, First Republic, had the ninth-largest loan portfolio in the same market.
According to Fitch Ratings “the office sector faces asset quality deterioration, putting smaller banks at risk.” It may turn out that the pretense that Silicon Valley Bank was a one-off is finished.
In 1992, Warren Buffet coined the phrase: “It’s only when the tide goes out that you learn who’s been swimming naked.” Now that the flood of cheap money has drained away and interest rates are on the rise, there may be more unpleasant revelations.
It’s unclear what the market dragon’s breath may scorch next. But the next banking calamity may be commercial office real estate