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Commercial real estate is the next shoe to drop for regional banks and the stock market

Empty storefrontA person wears a protective face mask near an empty store in the NYC Flatiron District.

Photo by Noam Galai/Getty Images

  • Commercial real estate is probably the next pain point for regional banks and the stock market, according to BofA.
  • The bank noted that US regional banks account for 68% of all commercial real estate loans.
  • A combination of low occupancy and a wave of refinancing at higher interest rates could spell trouble for banks, stocks, and the broader economy.

The next domino to fall in the ongoing banking crisis could be commercial real estate loans, according to a Friday note from Bank of America.

A potential credit crunch in the sector, sparked by a wave of upcoming refinancings of commercial real estate loans at much higher interest rates than in the past, could send stocks spiraling and the economy into a recession.

“Commercial real estate [is] widely seen as next shoe to drop as lending standards for CRE loans to tighten further,” Bank of America’s Michael Hartnett said.

What’s not helping is the fact that occupancy rates in offices across the country are still far from their pre-pandemic levels. According to Hartnett, office occupancy rates are still less than 50% as work-from-home trends persists.

At the same time, growth in national rent levels peaked over a year ago and has been steadily falling according to data from Zillow, which means of the office buildings that are collecting rent, it’s likely less than what it was in the past.

The weakness in commercial real estate is evidenced in current market prices for stocks and debt tied to the sector.

The iShares CMBS ETF, which tracks a portfolio of bonds backed by commercial mortgages, is trading well below the lows seen at the height of the COVID-19 pandemic in March 2020, and is just 6% above its lowest levels since the inception of the fund in 2012. 

Meanwhile, shares of office REITs are trading at multi-year lows, with Boston Properties Group trading at its lowest level since 2009, down about 68% from its record high reached right before the pandemic began.

This is a perfect storm for regional banks because they have so much exposure to commercial real estate loans. According to Bank of America, US regional banks account for 68% of commercial real estate loans, much more than their mega-cap banking peers.

There’s nearly $450 billion in commercial real estate loans that are maturing in 2023, and about 60% of them are held by banks, according to a recent note from JPMorgan that cited data from Trepp. 

“We expect about 21% of commercial mortgage backed securities outstanding office loans to default eventually, with a loss severity assumption of 41% and forward cumulative losses of 8.6%… Applying the 8.6% loss rate to office exposure, it would imply about $38 billion in losses for the banking sector,” JPMorgan said.

And the losses in commercial real estate could be worse this time around than it was during the Great Financial Crisis because the latter was driven by a relatively short-lived recession, while today’s dynamics are being driven by work-from-home trends that show no signs of letting up.

“Furthermore, regional banks are a lot more stressed which reduces their ability to amend and consent to loan modifications given the pressure on the liability side of the balance sheet,” JPMorgan said. 

To stem a potential crisis, Scott Rechler, CEO of NYC-based real estate company RXR Realty, thinks regulators need to take emergency actions now.

“There is $1.5 trillion in commercial real estate debt maturing in the next 3 years. The bulk of this debt was financed when base interest rates were near zero. This debt needs to be refinanced in an environment where rates are higher, values are lower, & in a market with less liquidity,” Rechler said in a tweet this week.

“I have joined @TheRERoundtable in calling for a program that provides lenders the leeway and the flexibility from regulators to work with borrowers to develop responsible, constructive refinancing plans… If we fail to act, we risk a systemic crisis with our banking system & particularly the regional banks,” Rechler said.

All in, the weakening outlook for commercial real estate, combined with a mounting wall of debt due to mature soon, could lead to a wave of defaults that stings bank stocks and add to a “coming toxic recession,” Bank of America said.

Read the original article on Business Insider
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