By Ambrose Evans-Pritchard
Emergency lending by the US federal authorities has bathed America’s struggling regional banks in short-term liquidity, disguising the slow-burn damage of the US commercial property slump.
A sobering analysis by four of the country’s leading finance experts says this comfort blanket has created a beguiling illusion of stability. The underlying crisis in the banking system continues to deepen as $US5 trillion ($7.4 trillion) of commercial real estate debt taken out during the zero-rate era comes due in tranches.
“It’s not a liquidity problem; it’s a solvency problem,” said Professor Tomasz Piskorski, a banking specialist at Columbia University, and one of the lead authors. “Temporary measures have calmed the market, but half of all US banks are running short of deposits with assets worth less than their liabilities, and we are talking about $US9 trillion,” he said.
“They are bleeding capital and could not survive if something triggers a sudden loss of confidence. It is a very fragile situation and the Federal Reserve is watching it closely”.
The Fed’s pre-Christmas pivot in monetary policy – along with a 100 point drop in 10-year US Treasury yields – mitigates the stress but comes too late, and is too tentative, to avert mounting insolvencies.
Property developers must refinance their debts into the most hostile lending market in living memory, while falling rents and soaring insurance costs are eroding their revenue streams. Almost $US1.5 trillion comes due by the end of next year.
“The entire commercial real estate space has to be reset. No one really knows where the values are,” said Scott Rechler, chairman of Long Island developer RXR and a board member of the New York Fed.
Rechler said lenders are only just starting to capitulate and mark down loans. “As an industry, we’re in the first innings of what’s going to be a long game,” he said.
Trophy buildings in prime spots are holding up, but he is purging “B” and “C” grade blocks from his portfolio. They are no longer viable in the post-COVID world of hybrid working. “It’s stuff that’s competitively obsolete: side-streets, dark buildings. You can’t give them away,” he said.
‘It’s a train wreck in slow motion.’Stijn Van Nieuwerburgh, Columbia University
He even defaulted recently on a $US240 million loan for a 33-storey office tower at New York’s 61 Broadway, handing the keys to a syndicate of banks. It is their headache now.
Rechler expects 500 to 1000 banks to disappear in a wave of consolidation. They have faced a relentless leakage of deposits to money market funds paying higher interest, compounding their property woes.
“You can’t raise rates this quickly and not expect a financial shock. We’re already working on transactions at 50 per cent on the dollar: the equity is wiped out and half of the loan is wiped out,” he said.
Piskorski’s paper says implicit office values have fallen by 50 per cent on average from their peak, and 45 per cent of all office loans are currently in negative equity. Most indexes register a smaller drop in prices, but they track prime sites, lag the market, and do not capture “junk” buildings.
The typical office loan carries a “legacy” interest rate of 3.97 per cent. The going rate today is 7.42 per cent – if you can borrow. Bank boards and regulators have forced lenders to cut exposure. Developers are shut out of the credit system once loan-to-value ratios rise above 80 per cent.
“Default rates could potentially reach levels comparable to or even surpassing those seen during the Great Recession,” said the paper, published by the National Bureau of Economic Research.
There has been no repeat of the lightning-fast bank runs that brought down Silicon Valley Bank, First Republic, and two smaller lenders last March, with contagion toppling Credit Suisse in Europe. But that is because liquidity support has allowed lenders to “extend and pretend”.
The NBER paper said banks have $US2.7 trillion of total exposure to commercial property. Almost 70 per cent is concentrated among small and mid-sized regional lenders. Most have burned through their safety buffers. Moody’s says exposure among regional banks with assets below $US250 billion is 180 per cent of their capital.
The full threat to the financial system is larger because some 2000 banks are already facing “negative capitalisation” due to the broader interest rate shock and paper losses on bonds. Any further stress in commercial property could push another tier of lenders over the edge.
The paper estimates that 300 banks risk “solvency runs”. The trouble may not stop there: contagion could trigger “a widespread run by uninsured depositors, unravelling a fragile equilibrium in the banking system.”
Officials at the Fed and the Treasury had assumed that employees would return to their offices gradually as COVID faded, stabilising rents at a manageable level. That has not happened. It is becoming ever clearer that hybrid work is here to stay.
Kastle’s 10-city “Back to Work Barometer” shows that the office occupancy has scarcely risen since mid-2022 and was still stuck at 51.1 per cent in December.
This is in stark contrast to Asia, where offices are almost 100 per cent full. On average, just 34.1 per cent of workers in the US are turning up on Fridays, or 28.2 per cent in Silicon Valley (San Jose) and 27.4 per cent in New York.
The US is a mosaic of different commercial property markets. Not all segments are in trouble. The disaster story is in second-tier office blocks, which are selling for discounts of 60 per cent to 70 per cent in San Francisco and New York.
Professor Stijn Van Nieuwerburgh, a property and finance expert at Columbia University, said renters are walking away as their leases come due, or are negotiating deals for less space. Only a third of these leases have expired so far. Most of the damage is still to come.
“It’s a train wreck in slow motion,” he said.
Some buildings can be converted to flats, but this requires a radical redesign, with new plumbing, windows that can open, and zoning permits. This is not commercially viable until prices have collapsed. Once banks foreclose on a property it is usually cheaper to tear the structure down.
Van Nieuwerburgh has co-authored and just republished a paper entitled Work From Home and the Office Real Estate Apocalypse, with revised figures estimating that the “value destruction” of New York office buildings could top $US650 billion, risking an urban doom-loop of shrivelling tax revenues and falling investment.
“Our paper is not a worst-case scenario; it’s the median scenario,” he said.
Rechler says this episode is not a repeat of the Lehman crisis. It resembles the savings and loan saga 30 years ago, which led to the failure of 747 “thrifts” and a taxpayer clean-up but never reached a systemic threshold. “This is very like the early 1990s, it’s not 2008,” he said.
The Fed may have pulled off an immaculate disinflation this time with no recession, but it is still too early for triumphalist celebration.
“People always talk about a soft landing when the Fed pivots. Everything looks perfect,” said Piskorski.
Monetary tightening hits with a long and variable lag, and this time the dosage has been huge.
The Telegraph, London
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