International Finance
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Banking concerns for US property market

IFM_ US property market
One of the largest commercial real estate lenders in the New York metropolitan area before its bankruptcy was Signature

The markets have not wholly recovered from the COVID fallouts. As a result, some are concerned that another economic slowdown would increase worries about a recession.

The recent financial crisis, sparked by the failure of three prominent American regional banks, has resulted in a slowdown in commercial real estate as borrowers worry that these lenders will reduce their capital supplies. Analysts and real estate professionals warned this could slow the sector’s further growth.

In the same week, both Silicon Valley Bank and Signature Bank failed. First Republic Bank followed the same direction soon. Large lenders to developers and owners of office buildings, rental apartments, shopping centres, and other commercial properties had accounts at Signature and First Republic.

Small banks own 4.4 times more exposure to US CRE loans than their larger counterparts as compared to big banks. CRE loans account for 28.7% of assets at those small banks, compared to only 6.5% at big banks. A sizable portion of those loans will need to be refinanced, further compounding problems for borrowers in the context of rising interest rates.

The office sector has a unique set of difficulties. Stronger fundamentals exist in several other CRE industries. Additionally, we don’t think prospective losses in the office sector will jeopardize the stability of nearby banks. The office sector is a minor portion of the economy in terms of GDP and wealth.

Nevertheless, the small bank lending channel more broadly does provide a macro risk, as tighter lending requirements and issues with profitability in the banking industry might limit the amount of financing available and drive up the cost for small and medium-sized firms. However, it is challenging to estimate this risk properly and there is a lot of uncertainty regarding potential offsets.

The struggling office sector is under increasing strain due to rising rates. Early on in the COVID phase, vacancies surged, and they have continued to rise ever since. The office vacancy rate, 12.5% as of 2023, is comparable to 2010, one year after the global financial crisis. The volume of office sales is currently getting close to its post-GFC lows.

The increase in remote work is the main cause of these difficulties. Even though more workers started returning to their workplaces in 2022, the overall amount of remote work is still seven times more than before the COVID period. Moreover, it’s not difficult to imagine the pain in the office sector getting worse given the Federal Reserve’s historically quick pace of interest rate increases over the past year, as well as the acceleration of layoffs in professional and business services and the obsolescence of older office buildings.

However, investors must keep in mind that there are two parts to the office market. Geographically specific challenges are arising and differently affecting property vintages, with Chicago and San Francisco facing far greater challenges than Miami, Raleigh, and Columbus. Newer office construction especially that completed after 2010 is experiencing significantly higher net absorption rates than earlier construction.

Increasing rates and limiting credit availability will inevitably cause problems for some borrowers. Although the sector’s current liquidation rate is low, we anticipate that over the next ten years, the total number of commercial mortgage-backed securities (CMBS) liquidations for the office sector will climb to about 20% (with total losses anticipated to be about 8.5%).

The figure below shows that this level of hardship is comparable to the sector’s levels in the years following the GFC, but, more importantly, it will likely take many years to manifest. Borrowers will probably make use of loan extension options shortly. Looking further out, it is anticipated that in 2025–2027, CMBS loan maturities will become increasingly difficult.

According to Trepp, a commercial real estate data company, First Republic had the ninth-largest loan portfolio in that market in the United States. Similarly, Signature had the tenth-largest loan portfolio before it failed.

In addition to offering most commercial real estate loans to businesses, midsize and regional banks are also part of a much larger market. Typically, banks package their loans into intricate financial products and sell them to investors to acquire additional funds to make new loans.

This implies that a reduction in lending may change how investors behave. An industry body estimates that commercial real estate made $2.3 trillion in economic contributions to the United States in 2022. However, analysts worry about a new recession because the industry hasn’t fully recovered from the pandemic’s damage.

“It’s a perfect storm right now,” declared Varuna Bhattacharyya, a real estate attorney with Bryan Cave Leighton Paisner in New York who primarily represents banks.

“We were already in a place with a much lower rate of originations,” Varuna Bhattacharyya said about the new loan applications that banks handle. So it’s challenging to avoid experiencing some worry and panic.

According to Varuna Bhattacharyya, lenders will be even more careful when approving loans for brand-new building projects other than the most high-profile “trophy deals.”

Borrowers now worry that banks will become more cautious about making loans. Even though the panic has generally subsided for now, regional banks may still be plagued for months by the possibility of another operational failure.

When new loan applications nearly reached a standstill in the fourth quarter of 2020, commercial real estate lending had started to recover from the depths of the COVID lockdowns for much of the previous year. In contrast, according to Trepp, the annual rate of commercial real estate loan origination by dollar volume increased by 18% in the fourth quarter of 2022.

Lending to the commercial real estate sector started to slow in January 2023, even before the Federal Deposit Insurance Corporation intervened to take over Silicon Valley and Signature.

According to Matthew Anderson, a managing director at Trepp, the commercial real estate loan growth rate in 2023 has already decreased by 50% compared to 2022 on an annual basis. He claimed that the Federal Reserve’s interest rate increases, which were beginning to impact the commercial real estate market, were partially to blame for the downturn. Moreover, since Silicon Valley and Signature’s failures, lending has likely decreased even further, according to Matthew Anderson. However, he added that the impact’s duration and depth are still uncertain.

Commercial real estate encompasses mortgages, building loans, and loans designed expressly for operating apartment complexes with multiple dwelling units. Commercial mortgage-backed securities, a market worth over $72 billion in 2022, are the so-called securitized products that include bank loans. It’s a different situation in 2023, though, as issuance of such bonds has decreased by 78% from 2022.

Daniel Klein, the president of Klein Enterprises, a Maryland-based company that manages commercial real estate, had recently discussed a construction loan for a new project with several banks. He claimed that one of the banks abruptly withdrew a term sheet for a loan after the banks failed.

Daniel Klein, whose family-owned company oversees around 60 office, retail, and apartment buildings, claimed that the bank had yet to justify its choice and was unsure whether the recent troubles in the banking industry had played a role. In the coming months, he predicted, as midsize banks become wary following the failures of Silicon Valley Bank and the Signature, loan terms from lenders will become more onerous.

“Banks are generally being more conservative than they were six or nine months ago. However, we’ve had good fortune. We have a lot of established local banking links.” he said.

According to Michael E. Lefkowitz, a real estate attorney with Rosenberg & Estis in New York, regional banks are an essential component of the commercial real estate ecosystem because their bankers spend a lot of time building connections with real estate developers and managers. However, large banks typically do not offer such “high-level service” to middle-market real estate companies.

When the FDIC revealed that it had sold virtually all of the remaining deposits at Signature Bank to a subsidiary of a peer, New York Community Bancorp, which is also a significant commercial real estate lender, some of the worries of real estate lenders eased a little bit. Following money withdrawals from the bank by corporate clients, including real estate companies and cryptocurrency investors, the banking authority took control of Signature on March 12, 2023.

One of the largest commercial real estate lenders in the New York metropolitan area before its bankruptcy was Signature.

A sign of precisely how many customers fled the bank before authorities intervened on March 12 to stop the flow was the $34 billion in client deposits that New York Community Bancorp acquired upon purchasing some of Signature’s assets, down from the $88 billion that Signature held before the bank ran.

There are concerns about whether other banks will step forward to fill the hole created by the demise of Signature, even with the selling of banking deposits to New York Community Bancorp.

According to the FDIC, New York Community Bancorp purchased loans totalling around $12.9 billion from Signature, most of which were business loans to healthcare organizations and wasn’t a part of Signature’s sizable commercial real estate portfolio. Therefore, the FDIC must still find a buyer for Signature’s primary portfolio of commercial real estate loans.

The FDIC official stated that the company “has not characterised the types of loans left behind” and that they will be “disposed of at a later date.”

Matthew Anderson of Trepp said, “I believe this indicates that Signature’s commercial real estate portfolio is still in limbo.”

First Republic’s home base in San Francisco, where Trepp utilizes an indicator to gauge the likelihood of default on bank-owned office complex loans, had the most trouble.

In anticipation of more Federal Reserve interest rate hikes and renewed calls for regulators to become more rigorous in monitoring bank risk-taking, banks are likely to reduce lending to retain capital and improve their balance sheets. Any reduction in new credit could delay the beginning of commercial construction and bring the economy closer to a recession.

Bank regulators will need to monitor banks keeping too many commercial real estate loans in their portfolios as they attempt to stabilize the financial system. This can lead to its own set of issues in a slowing economy.

The credit rating firm Moody’s Investors Service reported in 2022 that 27 regional banks already have significant concentrations of these loans on their balance sheets. According to the paper, the problem might become severe for banks if the economy enters a recession.

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