Erin F. writes: Hi Mitch, I’ve been hearing a lot about a potential crisis with commercial real estate in the next 12 months and was wondering your take on the situation? Thanks.
Mitch’s Response:
Thank you for emailing in your question, Erin. Allow me to frame the issue in your question for other readers before offering my take.
In referencing a potential crisis in commercial real estate, Erin is referring to a few forces that are currently at work. The first force is one that many readers are familiar with – the structural shift to remote and ‘hybrid’ work, which has significantly reduced demand for commercial office space. This structural shift is a legacy of the pandemic, of course, but that period also accelerated a shift to shopping online – which has dented demand for mall and other brick-and-mortar commercial real estate.1
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The end result is that the U.S. looks a bit saturated when it comes to big office buildings and commercial real estate spaces that companies don’t want or need.
For property owners, this has meant falling rents and hearing from tenants that they don’t want to renew leases. Falling rents mean less revenue for property owners, which means less cash flow available to service the debt on the properties. For loans that are up for refinancing, it’s easy to see how this situation can be hugely problematic. Interest rates have moved sharply higher over the past two years, which will make these properties even less profitable and affordable.
This setup in the markets has led property owners to write down the value of buildings, and it also may signal defaults are likely in the months and perhaps years ahead. We’ve also seen some major banks like JPMorgan, Goldman Sachs, and M&T Bank trying to sell off some of their commercial real estate debt holdings, though for now, they don’t appear willing to accept fire sale prices.
To answer Erin’s question about the next twelve months and what it could mean in the commercial real estate industry, I think it would be fair to assume that we’ll see more property write-downs and likely some defaults. There is approximately $1.5 trillion in commercial real estate debt due to be refinanced in the next three years, some of which are likely to encounter trouble with higher rates and lower property values. I expect banks to take some losses, and I would argue that this is another reason to avoid regional banks in particular in the current environment.
From a broader market perspective, I’m less worried. The issues surrounding commercial real estate are widely known, and analysts have a clear idea of the size of bank exposure and possible haircuts that may be in the offing. Much of that worry is likely already priced into bank stocks, in my view.
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