The difficulties facing the office property market have (again) been brought into focus.
Just under a year ago, in a commentary on the problems facing the office-property market and the difficulties that those distressed properties would in turn cause the banking sector and elsewhere, I referred to the idea of the gray rhino, a concept developed by Michele Wucker:
A “gray rhino” is a highly probable, high impact yet all too often neglected threat: kin to both the elephant in the room and the improbable and unforeseeable black swan. Gray rhinos are not random surprises, but occur after a series of warnings and visible evidence.
The difficulties facing the office property market have (again) been brought into focus, this time by worries over a New York bank, New York Community Bancorp, because of its exposure to the commercial real-estate sector (which, of course, includes office buildings).
New York Community Bancorp’s decisions to slash its dividend and stockpile reserves sent its stock down a record 38% on Wednesday, with the fallout dragging the shares to a 23-year low on Thursday. The selling bled overnight into Europe and Asia, where Tokyo-based Aozora plunged more than 20% after warning of US commercial-property losses and Frankfurt’s Deutsche Bank AG more than quadrupled its US real estate loss provisions.
The concern reflects the ongoing slide in commercial property values coupled with the difficulty predicting which loans might unravel. Setting that stage is a pandemic-induced shift to remote work and a rapid run-up in interest rates, which have made it more expensive for strained borrowers to refinance. Billionaire investor Barry Sternlicht warned this week that the office market is headed for more than $1 trillion in losses.
$1 trillion!
While real estate troubles, particularly for offices, have been apparent in the nearly four years since the pandemic, the property market has in some ways been in limbo: Transactions have plunged because of uncertainty among both buyers and sellers over how much buildings are worth. Now, the need to address looming debt maturities — and the prospect of Federal Reserve interest-rate cuts — are expected to spark more deals that will bring clarity to just how much values have fallen.
Those declines could be stark. The Aon Center, the third-tallest office tower in Los Angeles, recently sold for $147.8 million, about 45% less than its previous purchase price in 2014.
Forty-five percent!
The New York Times (February 8):
Commercial real estate is a wide asset class that includes retail, multifamily housing and factories. The sector as a whole has had a tumultuous few years, with office buildings hit especially hard.
About 14 percent of all commercial real estate loans and 44 percent of office loans are underwater — which means that the properties are worth less than the debt behind them — according to a recent National Bureau of Economic Research paper by Erica Xuewei Jiang from the University of Southern California, Tomasz Piskorski from Columbia Business School and two of their colleagues. . . .
While huge lenders like JPMorgan Chase and Bank of America have begun setting aside money to cover expected losses, analysts said, many small and medium banks are downplaying the potential cost.
Some offices are still officially occupied even with few workers in them — what Mr. Hendry called “zombies” — thanks to yearslong lease terms. That allows them to appear viable when they are not.
In other cases, banks are using short-term extensions rather than taking over struggling buildings or renewing now-unworkable leases — hoping that interest rates will come down, which would help lift property values, and that workers will return.
“If they can extend that loan and keep it performing, they can put off the day of reckoning,” said Harold Bordwin, a principal at Keen-Summit Capital Partners, a distressed real estate brokerage…
But hopes for an office real estate turnaround are looking less realistic.
Return-to-office trends have stalled out. And while the Fed has signaled that it does not expect to raise interest rates above their current level of 5.25 to 5.5 percent, officials have been clear that they are in no hurry to cut them.
Mr. Hendry expects that delinquencies could nearly double from their current rate to touch between 10 and 12 percent by the end of this year. And as the reckoning grinds on, hundreds of small and medium banks could be at risk.
While I have certainly underestimated the extent to which working from home has continued (enabled partly by a remarkably strong jobs market), that’s only one problem in a market where much of the math (from property valuations onwards) was based on the ultra-low interest rates of the previous decade. Interest rates are still not particularly high, but when compared with rates a few years ago, they look usurious.
Fed chairman Powell has recognized (the Times reports) that there will be losses, but sees the problem as manageable, although some smaller banks would need to merge or close. The latter seems fair, as does his assessment that this will take “years” to resolve. How manageable the overall situation will prove to be is far from clear.
And even if the problem may be manageable for the banks, it is likely to be a major challenge for large cities where much of the economy revolves around the offices that fill their downtowns.
For New York City to be introducing a “congestion” charge on traffic coming into certain parts of downtown will only discourage workers from returning to the office, and is a helpful reminder that there are few problems that government cannot make worse.