# The Problems In The Commercial Real Estate Market

An episode of [Patrick Boyle On Finance](https://invisiblenetwork.ai/podcast/1547740313), 20 May 2023, 14 min.

Audio: https://anchor.fm/s/fc0914e0/podcast/play/92761862/https%3A%2F%2Fd3ctxlq1ktw2nl.cloudfront.net%2Fstaging%2F2024-9-8%2F387759615-44100-1-986cb7ae38a14ea3.mp3

Send us a textThe next big potential risk to the U.S. economy may be lurking in office buildings across the country's downtown districts. With so many people still working from home, companies are cutting back on office space which threatens to unleash even more headwinds for the U.S. economy. What is going wrong in the commercial real estate market, and how might we be affected?Patrick's Books:Statistics For The Trading Floor: https://amzn.to/3eerLA0Derivatives For The Trading Fl...

## Transcript

[0:00] Hello and welcome, you are listening to Patrick boil on
[0:03] finance a podcast, exploring ideas, from quantitative Finance
[0:08] examining events occurring in markets right now and financial
[0:11] history to see what lessons can be taken away including
[0:15] interviews with some of the most interesting people in the world
[0:18] of Finance to learn more about the podcast visit on finance
[0:22] dot-org. Nearly 20% of office spaces are
[0:30] currently empty across the United States.
[0:33] This is higher than the vacancy rate during the 2008, Global
[0:37] financial crisis and it's worse in places like San Francisco and
[0:41] downtown Los Angeles where more than a quarter of offices are
[0:45] empty Rising interest rates, falling prices and the trend of
[0:49] hybrid working. In the wake of the pandemic
[0:52] reduce demand for office space straining.
[0:55] The commercial property market and These troubles have only
[0:59] gotten worse as the recent bank failures raised fears about
[1:03] other Regional banks. That account for the bulk of
[1:07] commercial, real estate loans running into trouble economic
[1:11] concerns and the regional banking crisis have led us Banks
[1:15] to tighten their lending standards for all categories of
[1:19] commercial real estate loans, according to the latest senior
[1:22] loan officer survey published by the Federal Reserve, a majority
[1:27] of U.s. Banks said they tightened credit
[1:30] standards for loan secured by non Residential Properties in
[1:34] the first quarter. While none said that they eased
[1:38] standards. Some lenders, are even,
[1:40] requiring personal guarantees from property owners in which
[1:44] borrowers, pledged their personal assets to secure a
[1:47] mortgage, the extent to which these more restrictive.
[1:51] Lending practices, prevent existing borrowers from
[1:54] refinancing commercial real estate loans still, Remains to
[1:58] be seen if companies continue to give up their leases.
[2:02] And if demand for office space remains as slow as it has been
[2:07] office. Landlords will struggle to
[2:09] collect enough friend to keep up with mortgage payments to pay
[2:13] off commercial loans. A lot of these loans are coming
[2:16] due in the next year, and many building owners need to
[2:21] refinance their debt. At a time when low occupancy has
[2:25] eroded building values, Straights have gone up and banks
[2:29] have become significantly more reluctant to land.
[2:33] This is not just an issue in the United States while workers in
[2:37] Europe and the UK have been quicker to return to the office
[2:41] and in the u.s. vacant office space in the UK is still at its
[2:46] highest level. In nine years, the amount of
[2:49] empty office space having climbed steadily.
[2:52] Since the start of the pandemic in March 2020, Swedish office.
[2:57] At Castle. Mm.
[2:58] Had to issue additional shares and has divested.
[3:02] Some of its properties to reduce its loan-to-value ratio, from 44
[3:07] percent, to 38 %. SB be one of Sweden's biggest,
[3:11] landlords abandoned and Equity Capital raised, canceled, its
[3:16] dividend and is now selling off assets to reduce its
[3:20] loan-to-value ratio from 47%, German residential landlords are
[3:25] expected to make their own cash. Also in the near future earlier
[3:30] this month in the UK st. James's Place property fund
[3:35] sold, 141 wardour Street, an aging Art Deco Block in London
[3:41] Soho 439 million pounds which is 30% below what they pay to buy
[3:47] the property back in 2018 British Land, one of the UK's
[3:52] largest landlords announced on Wednesday that property values
[3:57] had fallen. In twelve point three percent in
[3:59] the first quarter of 2023 valuations for offices and
[4:04] factories have fallen almost as much over the last year as the
[4:09] 20-month price decline. That began in September 2007.
[4:14] So overall things are not great for landlords.
[4:18] KK or is suing Twitter for unpaid rent as Elon Musk has
[4:23] reportedly stopped paying office, rent in California,
[4:26] Boston and Lon. Since he bought Twitter last
[4:30] year, this is likely a negotiation tactic for lower
[4:34] rent, but legal experts, argued that it's unlikely to work and
[4:38] will cost Twitter more in the long run than a good faith.
[4:42] Negotiation Ward. Now, while things are not going
[4:46] well for a Commercial Real Estate Investors increase
[4:49] defaults and foreclosures, could cause problems for banks, that
[4:53] make commercial real estate loans to the majority of the
[4:57] Point two trillion dollars in US office space.
[5:00] Debt is owed to Regional Banks who have been more aggressive in
[5:04] this style of Landing than large.
[5:06] Too-big-to-fail banks, have been due to the lower regulation that
[5:10] they have faced. Since the credit crunch, if
[5:14] office landlords can't make their debt payments, these Banks
[5:18] would end up owning the commercial properties and would
[5:21] need to sell them which would be difficult in such an
[5:24] environment. The problems in commercial real
[5:27] estate. State have drawn the attention
[5:29] of the Federal Reserve who published a report last week
[5:33] saying that they've increased monitoring of the performance of
[5:37] commercial real estate loans and expanded examination procedures
[5:42] for banks with significant commercial, real estate
[5:45] concentration risk. When trying to understand the
[5:49] extent of the problem, it's becoming more and more difficult
[5:52] to even calculate the actual value of Office Buildings in the
[5:57] current Market environment investors are looking at things
[6:00] like office, badge swipes and cell phone usage, in business
[6:04] districts, to get a better understanding of how much office
[6:08] buildings are being used and what the demand for office.
[6:12] Space will be going forward. Academics, Arun, Romani and
[6:17] Nicholas Bloom wrote a paper last year called the doughnut
[6:21] effect that use data from the US Postal Service and Zillow to
[6:26] understand the migration. Turns and changes that have been
[6:29] happening in real estate markets in American cities, they found
[6:34] that in large US cities, real estate demand shifted from
[6:38] Central Business, districts to lower density suburbs and exurbs
[6:43] which gave them their paper titled, the donut effect, which
[6:47] reflects the hollowing out of city, centres and the growth of
[6:51] suburban outer Rings which appears to be happening, they
[6:56] found sizable. In large cities smaller Donuts,
[7:00] in mid-sized, cities and no real changes in small cities.
[7:04] On average, interestingly the opposite appears to be happening
[7:09] in the United Kingdom where in London's West End.
[7:12] Vacancy rates are as low as 3% would even less space being
[7:17] available in high-end modern buildings, further out of town
[7:21] locations and older buildings on the other hand are struggling
[7:26] and this may relate to the Public transportation system in
[7:29] the UK and how it differs between European cities and
[7:33] American cities. The rising office.
[7:36] Vacancies in big, American cities are already changing the
[7:40] ecosystems of Downtown City, Center's stores restaurants, dry
[7:45] cleaners, and convenience stores that depend on heavy
[7:48] five-day-a-week foot, traffic are struggling to survive for
[7:53] public transportation systems in, do not affect cities fewer.
[7:57] Commuters are leading to budget deficits and massive projected.
[8:02] Shortfalls for local governments, High office,
[8:05] vacancies will mean a drop in property tax revenues which will
[8:09] burn a hole in City finances. So, it's not just Real Estate
[8:13] Investors that are taking a hit. So should we expect to see
[8:18] Financial contagion, where the problems in commercial real
[8:21] estate lead to problems at Banks which then lead to another
[8:26] credit crunch will maybe Not according to Barclays.
[8:30] The economics team at Barclays argued in a note last month that
[8:34] the worst fears of economic contagion from a collapse in
[8:38] office, property valuations might be overdone.
[8:42] They point out that office, real estate where the problems are
[8:45] most concentrated makes up around 25% of the US commercial
[8:50] real estate market. So the problem for banks is
[8:54] maybe not as big as many people think.
[8:57] They additionally highlight that offers loans and office leases
[9:02] are long-term contracts. So there's a long chain of
[9:06] events that has to occur before the popularity of working from
[9:10] home causes. Widespread default on office
[9:14] loans that then hits Banks. The team at Barclays point out
[9:19] that office availability a statistic that measures how much
[9:23] space is vacant combined with how much space will open up.
[9:27] Coming months, hasn't climbed to dramatically.
[9:31] This is partially because there was a Slowdown in the
[9:35] construction of new Office Buildings once the pandemic
[9:38] began looking at this statistic things don't look as bad as they
[9:43] look. When just considering vacancies,
[9:46] the Barclays note points out that office landlords run into
[9:50] problems when a large percentage of their leases roll over and
[9:55] the tenants don't renew or when an office loan is maturing and
[10:00] is either not being extended by the Lander or is being extended
[10:04] at a much higher interest rate. The worst situation is when both
[10:08] happening at once a drop in property prices while bad for
[10:13] landlords and quite worrying for lenders isn't really enough to
[10:17] spark a loan. Default commercial real estate.
[10:20] Borrowers will usually hold onto a property that continues to
[10:24] bring in enough rent to cover the loan payment.
[10:27] Even if the property value has declined significantly, this
[10:31] makes sense, as there's upside optionality, even if all Equity
[10:36] has eroded, as long as the cash flow is positive or break, even
[10:41] the landlord will hang on with the hope that there's a recovery
[10:45] on the way, finally. And most importantly, Barclays
[10:50] point out that if we're going to worry about a return of the
[10:53] global financial crisis, we have to keep in mind that since Since
[10:58] the financial crisis banks have much more Capital.
[11:01] Leverages much lower and policymakers are acutely aware
[11:05] of not allowing counterparty risk to go on rained, they say
[11:10] that the potential losses just aren't large enough to make a
[11:14] dent in aggregate Bank Capital, Charlie, Munger Warren Buffett,
[11:19] sidekick warned last month of a brewing storm.
[11:22] In the US commercial property Market with American Banks, full
[11:27] of What he said were bad loans as property prices fall, it's
[11:32] not nearly as bad as it was in 2008.
[11:35] Monger said in an interview but trouble happens to banking just
[11:39] like trouble happens. Everywhere else in the good
[11:42] times. They get into bad habits.
[11:44] When bad times, come, they lose too much Bank of America's
[11:50] monthly fund manager. Survey shows.
[11:52] That overall fund managers have already cut their allocations to
[11:57] Or real estate. Their allocations to the sector
[12:00] are at the lowest level since the 2008 financial crisis,
[12:05] almost half of the fund, managers in the survey said that
[12:09] they viewed commercial real estate.
[12:11] As the most likely cause of a systemic event compared with
[12:16] just eight percent, who viewed a downgrade of US debt due to the
[12:20] dispute in Washington, over the debt ceiling as the main risk.
[12:25] Interestingly the same survey April of last year showed that
[12:30] fund managers had reached their highest allocations to
[12:33] commercial real estate in 16 years.
[12:36] At that point, showing how quickly sentiment towards the
[12:39] sector changed? When interest rates started
[12:42] going up? Thanks for tuning in to the
[12:45] podcast and a special. Thanks to my supporters on
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