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The exodus of renters and workers from cities during the pandemic is having dramatic impacts on commercial real estate values in many markets that could put strain on regional lenders who are also crucial suppliers of jumbo mortgages and funding for new home construction.
But in her first interview since the resolution of the debt ceiling crisis, Treasury Secretary Janet Yellen said that while she expects that “there will be some pain” and even consolidation in the banking sector, stress tests of the nation’s largest banks show they’re adequately capitalized to weather the storm.
“I do think that there will be issues with respect to commercial real estate,” Yellen told CNBC Squawk Box co-anchor Andrew Ross Sorkin Wednesday. “Certainly the demand for office space, since we’ve seen such a big change in attitudes and behavior toward remote work, that has changed. And especially in an environment of higher interest rates, I think banks are broadly preparing for some restructuring and difficulties going ahead.”
In a May 15 update to a report they published last year, “Work From Home and the Office Real Estate Apocalypse” researchers Arpit Gupta, Vrinda Mittal and Stijn Van Nieuwerburgh concluded that the trend toward remote work has destroyed an estimated $506 billion in commercial real estate value.
The largest dollar losses have been seen in New York City ($69.6 billion), San Francisco ($32.7 billion), Los Angeles ($24.8 billion), San Jose ($24.3 billion) and Boston ($22.2 billion).
The researchers found that there’s been a “flight to quality” to newer buildings in prime locations, while lower quality office space “appears to be a more substantially stranded asset, given lower demand, raising questions about whether such assets will ultimately need to be repurposed towards other uses.”
Commercial real estate ‘doom loop’
Gupta and his fellow researchers identified the potential for a commercial real estate “doom loop,” if falling real estate values gut local tax revenue and government services, generating even more outmigration from cities.
Repricing of commercial real estate
In another recent analysis, PGIM Fixed Income researchers Gabe Rivera, Gary Horbacz and Jason Pan concluded that while office properties could lose up to 50 percent of their pre-pandemic peak values, multifamily, retail, and industrial properties could also be facing double-digit declines in value.
While loan-to-value ratios for commercial real estate are generally in the range of 60 percent to 70 percent, even senior lenders could experience principal losses, “particularly on loans collateralized by office assets,” PGIM Fixed Income analysts warned.
Regional banks, which are already struggling to convince their customers not to withdraw their deposits in the wake of recent bank failures, are among the most exposed to a commercial real estate doom loop.
Commercial mortgage debt, by investor
“Banks, currently responsible for approximately 50 percent of all CRE loans outstanding ($5.5 trillion), play a critical role in commercial real estate funding,” PGIM Fixed Income analysts noted. “Over the past decade, banks have steadily increased their market share in CRE lending, with regional banks accounting for the lion’s share.”
Fannie Mae economists warned in March that ongoing banking instability “may affect the availability of jumbo mortgages and residential construction loans due to the high concentration of those originations stemming from small and midsized banks.”
The prospect that falling commercial real estate values will ripple through the banking system and cause more widespread harm has become a subject of popular discussion, fueled by high profile figures including Barbara Corcoran, Twitter owner Elon Musk and Big Short investor Dave Burt.
Yellen said stress tests of the largest banks “show that they have adequate capital to deal with it, and I know supervisors will be looking closely at a wide range of banks to make sure that they are adequately prepared to deal with it. But my overall read is that the level of capital and liquidity in the banking system is strong, and that while there will be some pain associated with this, that banks should be able to handle the strain.”
Asked if regulators will allow more consolidation in the banking business, Yellen suggested that while there’s a desire to preserve “a diverse set of financial institutions capable of satisfying different needs across our economy,” regulators are unlikely to stand in the way of every deal.
“We do have a diverse banking system with strong community banks, regional banks, larger banks that are involved in global business, and I wouldn’t want to see that threatened,” Yellen said. “But certainly in this environment, some banks are experiencing pressure on earnings, and there is a motivation to see some consolidation and it wouldn’t surprise me to see some of that going forward.”
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