By Pascal vander Straeten September 11, 2023
From a systemic banking risk perspective, the U.S. office sector is most at risk, given widespread shift to working from home arising from the pandemic. And that has impacted demand and thus affected pricing/valuation + debt servicing.
Research shows that a 35% plunge in office values is forecasted by end-2025 and a recovery is unlikely before 2040. Basically, it means that office values probably won’t regain their pre-pandemic peaks in the next 17 years.
Additionally, the U.S. CRE sector is facing a wave of loan maturities ahead – amid stricter lending standards with impacts on delinquencies and property value declines.
– The CMBS market saw in June 2023 a noticeable uptick in delinquencies – highest in 15 months – to 4.41%, driven mostly by office delinquencies.
– As a comparison delinquencies neared 9% in 2009.
More than $1 trillion (out of $5.9 trillion) in U.S. CRE loans will need to be refinanced in next 24 months with new lending rates up by 300-500 bps vs. pre-pandemic levels.
This could potentially result in a peak-to-trough CRE price decline of as much as 40%, worse than in the GFC.
The ‘better’ news is that:
– The Fed will likely not increase rates much further with the U.S. economy cooling down a bit while avoiding a recession.
– Remote work seems to be less in demand and thus vacancy rates for office buildings are bound to improve somewhat.
– Most of these maturing loans wont’t (really) face a refinancing risk as ‘tactics’ such as extensions and loan modifications are available to borrowers.
And even if some of these loans will need to be restructured, the scale of the concern pales in comparison to the >$2 trillion of bank equity capital. Office exposure for banks represents <5% of total loans and only 1.9% on average for large banks.
However, what is more at stake, in the scope of securitization, is the phenomenon of ‘liar loans’, ie. loans underwritten based on lies:
– Before 2008 it affected the RMBS industry with lies about the borrowers’ credit.
– Nowadays it affects the CMBS market with potential inflated cash flows (CF). Many CRE loans might have been underwritten – not based on actual CF but projected CF.
By inflating CF of some ‘underperforming’ properties that may constitute the CMBS collateral pool, 3x benefits emerge for the lenders:
1. They show a less volatile CF profile of the underlying asset; less volatility means a higher credit quality, and thus higher credit rating.
2. Thet get the loan securitized, that is an otherwise unsalable loan.
3. They can leverage more debt, because when CF increases, it also increases the value.
While it is difficult to forecast the outcome, there is a saying by Warren Buffett: “When the tide goes out, you find out who’s been swimming naked”. That is what happened in 2007-2008.