June through November is the Atlantic hurricane season. This is typically when most hurricanes form in the Atlantic Ocean or Caribbean Sea, and then often wreck terrible destruction on the continent and islands of North America. Meteorologists are constantly looking at formation of storms, ocean temperatures, winds, and other signs to spot these destructive storms as early as possible to give adequate warning to save lives and property.
As I look at the current temperatures of the commercial real estate market, look at the pressures surrounding it, consider the winds of change, and view the industry from an overall level, I must say that we are on the edge of a possible catastrophic storm in the CRE market. What we do not know is if this will be a small category 1 tropical storm or a major category 5 hurricane.
There are several signs to look at. The first is obviously the current interest rate and lending environment. In 2000, during the throes of COVID, Fed Funds rates were 0.25%. This rate was also where Fed Funds sat from 2009-2016. All institutions were overflowing with liquidity as people took government payments and help and stashed these with their local financial institution. Many of these credit unions and banks invested money into treasuries and agencies, locking rates of 10 years below 2%. On the CRE side, it was not uncommon to start out with rates below 4% for a period of 5 or even 7 years. Traditional margins we used in repricing loans were squeezed.
In February 2023, Lightbox reported that over $1 trillion of CRE loans will come due or be repriced in 2023 and 2024. 2025 has another estimated $425 billion of maturities coming up. When you consider a simple $1 million CRE loan on a 25-year amortized payment, the difference between an initial 5-year rate at 3.50% and a current rate at 7.00%, results is a payment increase of 34%. How many of these projects will be able to adequately service their mortgages with the new rate increases?
In some cases, the lender will require the owner to pay down the debt and the borrowers will have the ability and willingness to do so. Could these paydowns be used by the lenders for new debt? Probably not. Emerging Trends in Real Estate Survey reveals that 71% of the investors are reporting “more rigorous” debt underwriting standards in 2022 compared to only 18.6% seeing harder standards in 2021. Financial institutions (FIs) are more cautious considering new financing opportunities. Plus, the large amount of excess liquidity in 2020 and 2021 is gone from the banking system. Consider the Federal Reserve has been taking money out of the system with a $1 trillion reduction in the M2 Money Supply. Many of these repayments would be used to lower the FIs’ need to borrow to fund their balance sheet.
Lightbox tracks appraisal volume by county. This could be a leading indicator of new loan activity. In the first quarter of 2023, across 587 counties with at least 5 awarded CRE appraisals, 12% saw an average increase of 23% and 83% had an average decline of 47% of appraisal awards compared to the same quarter in the previous year. This should indicate that we will see lower CRE loan volume in the near future.
The next CRE weather sign to look at is a lack of experience among lenders and regulators. The last real recession (not including COVID) we experienced was in 2007-2008. This means that any lender who has been in the industry less than fifteen years, has not experienced the servicing problems associated with an economic downturn. I believe we sit on the edge of a downturn. The Federal Reserve’s tightening to manage inflation will continue until prices begin to stabilize. The higher interest rates, lower liquidity, inverted yield curve, and tougher lending standards, will all be factors in a tougher environment for borrowers to receive the loans they need to expand their business.
Consider all those in CRE lending with less than 15-year experience with the retirement of the experienced gray heads who have been through multiple recessions and economic cycles. This is a large mental drain on both the FIs and among the examiner ranks. Experience is often the best teacher. Lack of it could be very detrimental in navigating through the winds of problem loans.
Just like there is typically more damage in some areas where a hurricane strikes compared to others, we will see various impacts on CRE with the current storm. The impact will vary depending on asset classes and location. Office buildings face an uncertain future as companies have discovered they can reduce occupancy costs and increase employee satisfaction with work from home arrangements. I recently looked at a class A office building in California that has a 38% vacancy. If the leases that expire in the next two years do not renew, this would increase the vacancy to nearly 2/3 of the building. This level of empty space in a major metropolitan area of Southern California for a Class A building was unheard of prior to Covid. Some area of retail faces challenges with the continued popularity of on-line shopping. Multi-family should continue to be strong as we have not built enough housing stock over the past decade to meet the population increase and higher interest rates and construction costs will keep some people out of the housing market. Self-storage and warehousing should have strength.
The adage of location, location, location is so true when it comes to the impact on CRE. Lower regulation and tax states such as Florida, South Dakota, Tennessee, and Texas are attracting more population and strong economic growth. Of the ten fastest growing counties, by percentage population increase, in the US in 2022, five are in Texas, two in Georgia, and one each in Florida, North Carolina, and Washington. The area of Texas that I live in still has new construction coming out of the ground and land being cleared for new projects.
The negative impact of location is in areas with higher taxes, regulation, and crime. Annamarie Dicola, CEO of Trepp, estimates that $10 billion of CMBS office loans in New York City will mature and have no option to extend. As I write this, shopping center giant Westfield is turning over their $558 million loan on the San Francisco Centre Mall back to the lender. After 20 years of operation, they cite the challenging operating conditions in downtown San Francisco that lead to declines in sales, occupancy, and foot traffic. The final nail in the coffin may have been Nordstroms shutting down both its downtown San Francisco locations. This announcement comes a week after Park Hotels handed back two prominent hotels in downtown San Francisco back to the bank.
Kevin O’Leary, a “Shark Tank” entrepreneur, opened up a new fund to invest in North Dakota. When asked about the location he told CNN, “I don’t put companies here in New York anymore or in Massachusetts or New Jersey or California. Those states are uninvestable. The policy is insane; the taxes are too high.” We will see a disparate impact among different areas of the county and among different real estate types as the storm approaches.
What do you do if you have a CRE loan in your portfolio that is located in a high-tax, highly-regulated area, that is in an asset class which is challenged, and a loan which you wrote in a rate at 4% which barely made a 1.20 DSCR at the time you closed the loan in 2018? What happens when this loan reprices in 2023? You may be in a situation where the upcoming storm may hit you harder. The impact may be a cataphoric foreclosure and loss.
A colleague of mine who has decades of experience in the industry believes that we are in a summer lull where we are just beginning to hear of the upcoming CRE storm. He believes that nearly all CRE lending will stop other than high interest rate loans outside of traditional FIs. He cited a hotel acquisition he financed last week at a 14% rate. The borrower was just happy to be able to get the loan. He also believes that this will become one of the biggest stories in the mainstream media this fall.
Whether he is right or not will only be known by looking back after the hurricane passes. Only then we will know how much damage this present storm will inflict on your FI. Today we must keep an eye on the CRE weather and prepare.