Real Estate in the US: Systemic Risks

by bitkogan

Fresh data on commercial real estate has been released, and frankly, it’s no laughing matter. The proportion of unoccupied space recently hit a 5-year low.

This comes after recently discussing the risks associated with this sector.

What else can we expect?

🔺 US commercial property prices are falling amid rising interest rates. This has particularly affected office buildings: not everyone has returned to the office after COVID, and the vacancy rate in rented spaces hasn’t returned to pre-pandemic levels.

🔺 Prices for some properties have dropped by 25-30% or more. Recent data shows that commercial real estate in Californian cities such as Santa Ana and San Francisco is up for sale at discounted prices compared to just three years ago—30-60% off, depending on the age of the buildings.

🔺 The main issue is that most commercial real estate has been purchased on credit. In the next two years, according to some estimates, around $1 trillion in mortgage loans will require refinancing.

There are serious concerns that banks will be very reluctant or even unable to refinance troubled borrowers.

Why? First, banks have their own full plate of problems.

🔹 US commercial banks hold $4.2 trillion in Treasury bonds and other government securities. For large banks, these assets make up nearly 24% of their portfolios on average, while for smaller banks, it’s 15%.

🔹 Additionally, banks hold a significant portion of their assets in commercial bonds. This is largely to meet liquidity coverage ratio requirements.

🔹 The decline in the market value of these assets due to raised interest rates has seriously reduced banks’ ability to return funds in the event of a run on deposits.

🔹 Small and regional banks were the largest source of credit for the industry last year. Following the recent bankruptcies of SVB and Signature, depositors withdrew some of their funds, and these banks will be less willing to provide financing.

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❗️ Now, the most important part – providing credit for office real estate, for example, is extremely risky today. The collateral consists of the very square footage that is dropping in price. Moreover, in some cases, the value of the collateral is already significantly lower than the volume of loans issued against it.

If, or more accurately, when some borrowers fail to meet their obligations, banks may start going bankrupt. This wave of bankruptcies appears INEVITABLE. Similarly, as will be the case for developers.

The FDIC won’t have enough money to save all banks, and in the worst-case scenario, they will focus on systemically important ones.

Commercial mortgage-backed securities (CMBS) that won’t receive payments will plummet. This, in turn, will spread panic among CMBS holders and increase the likelihood of bankruptcies for issuing banks. Of the aforementioned $1 trillion needing refinancing, ~30% is backed by CMBS.

The stock market will slump, and spreads will rise to levels exceeding those during the COVID era.

Do you think everything described here is just a theoretical picture? Let’s talk about it in a year.

Nevertheless, I believe that a major systemic crisis comparable to 2008 will likely be avoided. There is both experience and a difference in scale. However, the recession that is currently only being threatened is inevitable and will drag on for a long time. And the real estate sector could very well be one of the most problematic in this situation.

It’s hard to predict what the Federal Reserve will do in such a situation. Interest rates may need to be lowered, but any compromise between growth, unemployment, and inflation will be less favorable than the situation during the COVID era.

Global markets will also feel the impact.

✔️ Initially, due to a slowdown in lending rates and a general reduction in the money supply,

✔️ Later, when the recession starts to gain momentum and energy resource prices fall, the impact may intensify.

And you ask – why do I see a very real possibility of the S&P dropping to the 3200 level? There is a chance. The question is only a matter of timing. Although it is unlikely to happen quickly and all at once.


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