The Office Real Estate Crunch!

Summary

Office mortgage default rates are rising globally, which could lead to problems for banks, insurers, and pension funds that lent money to real estate investors. Lower office occupancy rates, falling property values, and higher interest rates are making it difficult for owners to repay or refinance loans. Several recent distressed sales of iconic office buildings at large discounts highlight the extent of the issues. While expected losses are smaller than the 2007 mortgage crisis, there could still be billions in losses. Banks are using new strategies to offload risk, but profits fell 45% in Q4 2023, the biggest drop since 2020. Economists estimate office prices need to fall another 50% before converting empty offices to housing makes financial sense.

Takeaways

• 😟 Office property investors took out risky interest-only loans before the pandemic that are now coming due
• 😔 Falling office occupancy rates mean many buildings taken as loan collateral have dropped substantially in value
• 😣 Regional banks with exposure to commercial real estate loans are seeing profits fall and dividend cuts
• 😕 Delinquency rates on commercial real estate loans have spiked, but bank provisions for losses have fallen
• 👎 The FDIC will increase scrutiny on banks with large exposures to commercial real estate
• 😬 Distressed sales of iconic office buildings signal wider problems in the market
• 🤔 Banks are using new instruments to offload risky loans to investors
• 😐 Profits at US banks recently saw their steepest year-on-year decline since early 2020
• 🤨 Goldman Sachs estimates office prices would need to fall 50% further before conversion to housing makes economic sense
• 😌 Surfshark VPN helps protect your privacy and access geo-restricted content online

Q & A

Why are office mortgage default rates rising around the world?

Default rates are rising due to changes in how and where people work after the pandemic, leading to less demand for office space. Also, higher interest rates make it more expensive to finance office buildings.

How do commercial mortgages differ from residential mortgages?

Commercial mortgages are generally interest-only loans with a balloon payment at maturity, while residential mortgages amortize over time with monthly payments covering both interest and principal.

Why are office buildings more risky investments now?

The value of office buildings has declined due to lower demand, while interest rates on loans to finance them have nearly doubled, meaning many buildings are overleveraged or cash flow negative.

What signs of stress are emerging in regional banks?

Regional banks invested heavily in commercial real estate loans and some, like New York Community Bancorp, are seeing higher losses, dividend cuts, and regulatory scrutiny.

How have banks lowered their loss reserves on commercial real estate loans?

Despite a 50% rise in delinquencies, some banks like Bank of America have managed to lower their loss reserves through regulatory loopholes.

Can vacant office buildings be converted to residential housing?

Economists estimate office prices would need to fall an additional 50% for feasible conversion, so offices likely remain underutilized near-term.

How have changes in financial intermediation impacted bank regulation?

As lending moves away from banks, overall credit availability depends less on bank regulation, so raising capital requirements today has less economic impact.

What is significant risk transfer and how are banks using it?

It's a strategy to sell credit risk to investors via derivatives. Banks use it to reduce risk-weighted assets and capital requirements, but it lowers earnings.

Why did US bank profits fall sharply in Q4 2023?

Profits fell due to higher loan loss provisions, investment losses, restructuring charges, and a government assessment to recapitalize the deposit insurance fund.

How concentrated are US bank profits among the largest banks?

In Q4 2023, JPMorgan alone earned 22% of total US banking industry profits, showcasing the dominance of the largest banks.

Outlines

00:00

🏢 Office mortgage defaults pose risks for lenders and investors

Commercial mortgage default rates are rising globally, posing risks for banks, insurance companies, and pension funds that lent money to real estate investors. Commercial mortgages often use higher leverage and interest-only payments, leaving large balloon payments when they expire. This is now coinciding with lower office occupancy rates and property values, higher interest rates, and billions in upcoming loan expirations, raising the likelihood of losses.

05:01

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10:03

📉 Struggling office markets drive distressed sales and valuations

Office space usage in the US is only around half of pre-pandemic levels, with values for top-quality offices down 27% in the past year. Highly leveraged owners are being forced to sell prestigious buildings at deep discounts in cities like New York, Washington DC, and London as rents and valuations fall.

15:06

🚨 Regulators increase scrutiny of commercial real estate debt

US banking regulators will more closely examine banks with outsized commercial real estate loan exposure that has grown rapidly. Regional banks with heavy exposure are seeing their stocks punished as investors worry about losses and potential dividend cuts or forced recapitalization.

20:07

🏦 Banks trim risky debt and profitability suffers

As delinquencies rise, US banks have lowered their reserves and profitability has dropped 45% year-over-year. However, new structured products allow banks to offload risk to investors, reducing capital requirements at the cost of profits. Empty offices are still overvalued for conversion to residential use.

Keywords

💡commercial mortgages

Commercial mortgages are loans used to purchase or refinance commercial real estate like office buildings. They differ from residential mortgages in that they usually have interest-only payments and a large balloon payment when the loan matures. The video discusses how many commercial mortgages are coming due and may default given declining office property values.

💡negative equity

Negative equity refers to when the market value of a property falls below the outstanding balance on the mortgage loan tied to that property. With falling commercial property values, the video states that 44% of office loans may already be in negative equity, meaning property owners owe more than what their buildings are worth.

💡loan allowances

Loan allowances refer to the reserves or capital that banks set aside to cover potential future losses from loan defaults or delinquencies. The video discusses whether current allowances at major banks properly reflect the rising risks in commercial real estate lending.

💡significant risk transfer (SRT)

Significant risk transfer refers to strategies where banks offload the risk of loan defaults to other investors through credit-linked securities. This can reduce their capital requirements but also eats into bank profits. The video notes major US banks have started using SRT to hedge risks in commercial real estate loan books.

💡special assessment

Special assessment refers to an extra, emergency charge levied on banks to quickly restore depleted federal deposit insurance funds, usually due to major bank failures. The video cites a 2023 special assessment levied on US banks to replenish funds drained by regional bank collapses.

💡repossess

To repossess means to take back ownership of a property or asset when the owner fails to make loan payments. The video discusses 'distressed sales' occurring where lenders repossess office buildings from defaulting commercial property investors and sell at huge discounts.

💡insolvency

Insolvency refers to when liabilities exceed assets, income falls substantially short of expenses, or an entity cannot pay debts as they come due. The video discusses an insolvent Austrian property company being forced to sell its share of the iconic Chrysler Building office tower in New York City.

💡receivership

Receivership refers to a legal process where control of a property or business is handed to a designated receiver, usually because the owner defaulted on loans. The video cites London office buildings being sold after being put into receivership by lenders.

💡procyclical

A procyclical variable is one that rises and falls corresponding to fluctuations in the overall economy. If bank reserves moved procyclically, they would decline during economic booms and force recapitalization during busts. The video argues this should be avoided.

💡risk-weighted assets

Risk-weighted assets refer to a bank's assets that are adjusted based on risk to determine regulatory capital requirements. The video states that significant risk transfer deals allow banks to reduce risk-weighted assets and free up capital held against risky loans.

Highlights

Office mortgage default rates are rising around the world which could mean problems for the banks, insurance companies and pension funds who lent money to real estate investors.

Commercial mortgages differ from residential mortgages in that they are generally interest-only loans, meaning that the investors get to make small monthly payments but are then faced with a balloon payment of the initial loan amount on the date the mortgage comes due.

Commercial real estate investors – and in particular office real estate investors are struggling with changes to how and where people work in the wake of the pandemic, as workers have been reluctant to return to the office five days a week.

According to the Mortgage Bankers Association, many commercial mortgages that were set to mature last year were extended or otherwise modified and as a result, the amount of commercial mortgage debt maturing this year rose from $659 billion dollars as of the end of 2022 to $929 billion dollars as of the end of 2023.

Commercial mortgage rates have almost doubled since many of these loans were taken and the value of many of the underlying properties have fallen considerably, raising the prospect of billions of dollars of losses for real estate investors, and thus losses for those who lent money to them.

A recent paper on Commercial Real Estate and US Banks found that 44% of office loans are likely already in “negative equity” and that the majority of office loans are likely to encounter “substantial cash flow problems and refinancing challenges” in the coming years.

According to the FDIC delinquencies on bank loans backed by offices were at 1.5 percent at the end of the third quarter of 2023, which is quite low, but it is rising, while delinquencies on the equivalent – but riskier CMBS loans reached 6.3 percent in January, up from 1.9 percent from a year earlier, according to the real estate data firm Trepp.

Let’s discuss the distressed sales of office buildings that have been happening over the last few months, why New York Community Bancorp is down more that 65% year to date, what banking regulators are saying about loan portfolios at large US banks and how banks are hedging their loan books.

Three US regulators, The Federal Reserve, The FDIC and The Office of the Comptroller of the Currency — announced late last year that they would scrutinize banks whose commercial real estate loan portfolios are more than triple their capital. Within that group, they would focus on loan portfolios that had grown at least 50% in the past three years.

According to Bloomberg, under this standard, there are about two dozen banks in the United States that have portfolios of commercial real estate loans that would merit greater regulatory scrutiny.

The Banks chief risk officer had quit his job weeks before the big losses were announced. NYCB had appeared to be one of the big winners of the 2023 regional banking crisis that sank Signature Bank, Silicon Valley Bank and First Republic as they bought the operations of Signature Bank in a deal arranged by the FDIC.

The problems at NYCB have reawakened investor fears about regional banks, but investors are also beginning to worry about loan loss provisions at some of the largest US banks.

Some are arguing that banks should base their reserves on current levels of delinquencies, but the problem with doing that is that bank reserves would become pro cyclical where they decline during booms allowing banks to lever up even more and then increase in a slowdown requiring banks to recapitalize when investors are backing away from the sector.

According to FDIC filings, the average reserves at JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, Goldman Sachs and Morgan Stanley have fallen from $1.60 to 90 cents for every dollar of commercial real estate debt on which a borrower is at least 30 days late, meaning that bad property debt today exceeds reserves at the largest US banks.

Significant risk transfer (also known as SRT – but should not be confused with the cars tailgating you on the highway) is a balance-sheet strategy that has been approved under the European and UK banking framework and used for some time on a small scale to hedge credit risk at European banks.

Transcripts

Office mortgage default rates are rising around the world which could mean problems for the

banks, insurance companies and pension funds who lent money to real estate investors.

No one loves leverage more than real estate investors, who aim to amplify returns as much

as possible with borrowed money.

Commercial mortgages differ from residential mortgages in that they are generally interest-only

loans, meaning that the investors get to make small monthly payments but are then faced

with a balloon payment of the initial loan amount on the date the mortgage comes due.

This lump sum needs to either be repaid or refinanced when the mortgage expires.

With an interest only mortgage, the borrower gets to keep the property consistently leveraged,

and the risk to the lender does not get reduced over time because the principal is never paid

down until the mortgage expires.

Commercial real estate investors – and in particular office real estate investors are

struggling with changes to how and where people work in the wake of the pandemic, as workers

have been reluctant to return to the office five days a week.

This means that employers don’t need to rent as much office space – it also means

that shops and restaurants in business districts are closing down due to fewer customers.

On top of that, higher interest rates are making it more and more expensive to buy a

building with borrowed money or to refinance a mortgage.

According to the Mortgage Bankers Association, many commercial mortgages that were set to

mature last year were extended or otherwise modified and as a result, the amount of commercial

mortgage debt maturing this year rose from $659 billion dollars as of the end of 2022

to $929 billion dollars as of the end of 2023.

Many of those loans are on partially empty office buildings and were taken out in a low

interest rate environment which has now passed.

Commercial mortgage rates have almost doubled since many of these loans were taken and the

value of many of the underlying properties have fallen considerably, raising the prospect

of billions of dollars of losses for real estate investors, and thus losses for those

who lent money to them.

A recent paper on Commercial Real Estate and US Banks found that 44% of office loans are

likely already in “negative equity” and that the majority of office loans are likely

to encounter “substantial cash flow problems and refinancing challenges” in the coming

years.

About one third of the expiring office loans are funded with commercial mortgage-backed

securities, which are often held by insurance companies, pension funds and individual investors.

The remaining two thirds are held by banks, and these tend to be higher quality – lower

risk loans than the ones backed by commercial mortgage-backed securities.

According to the FDIC delinquencies on bank loans backed by offices were at 1.5 percent

at the end of the third quarter of 2023, which is quite low, but it is rising, while delinquencies

on the equivalent – but riskier CMBS loans reached 6.3 percent in January, up from 1.9

percent from a year earlier, according to the real estate data firm Trepp.

According to Moody’s Analytics, owners of 224 out of the 605 large buildings with mortgages

expiring this year will struggle to refinance, either because the properties are overleveraged

or because their rental performance is poor.

Let’s discuss the distressed sales of office buildings that have been happening over the

last few months, why New York Community Bancorp is down more that 65% year to date, what banking

regulators are saying about loan portfolios at large US banks and how banks are hedging

their loan books.

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OK, so while workers around the world have been reluctant to return to the office since

the pandemic, return-to-office rates have been much lower in the United States than

in Asia and Europe, and so the problem is more concentrated in big US cities than anywhere

else.

According to Commercial Edge, office space use is only around half of what it was before

the pandemic.

For this reason, values for institutional-quality offices are down 27% since this time last

year.

There are some big, distressed sales occurring on some iconic buildings.

Signa Holding, an Austrian property company, which fell into insolvency is selling its

50% share in the Chrysler Building in New York after being ordered to do so by an Austrian

court.

According to the insolvency administrator just 250 million euro of the 5.26 billion

euro debt owed by the property group had been secured against tangible assets, raising questions

about how much lenders to the group can expect to recoup in the bankruptcy.

In Washington, D.C., a 13-story building with ground-floor retail sold in December for $18.2

million dollars, down 70% from the price it last traded at in 2017.

In London, Five Churchill Place, a Canary Wharf office building was recently sold at

a 60 per cent discount to its last sale price, showing how much office real estate has fallen

in London.

This was one of largest distressed sales in London since rising interest rates started

rising.

It was owned by a Chinese real estate group and sold after being put into receivership

by its lenders.

Urban Land reports that most office buyers in this environment are private equity groups,

family offices, and ultra-high–net worth individuals who bring cash to the table or

can negotiate seller financing.

Three US regulators, The Federal Reserve, The FDIC and The Office of the Comptroller

of the Currency — announced late last year that they would scrutinize banks whose commercial

real estate loan portfolios are more than triple their capital.

Within that group, they would focus on loan portfolios that had grown at least 50% in

the past three years.

According to Bloomberg, under this standard, there are about two dozen banks in the United

States that have portfolios of commercial real estate loans that would merit greater

regulatory scrutiny.

A lot of the stress is showing up in regional banks.

The KBW regional banking index is down about 12% year to date and shares of the most leveraged

regional banks are down even more as investors worry both about losses associated with commercial-property

exposures, and the risk that regulators might force these banks to increase their reserves

or cut their dividends.

Shares of New York Community Bancorp are down 26% today alone on news that the regional

lender has replaced its CEO and disclosed that it has identified “material weaknesses”

in internal controls that guide how loans are reviewed.

The stock was already down more than 50% year to date, after reporting higher than expected

losses from real estate loans and a dividend cut which was needed to meet tougher regulatory

requirements.

The Banks chief risk officer had quit his job weeks before the big losses were announced.

NYCB had appeared to be one of the big winners of the 2023 regional banking crisis that sank

Signature Bank, Silicon Valley Bank and First Republic as they bought the operations of

Signature Bank in a deal arranged by the FDIC.

The problems at NYCB have reawakened investor fears about regional banks, but investors

are also beginning to worry about loan loss provisions at some of the largest US banks.

Loan allowances are the capital that banks set aside to cover future losses on delinquencies

and when a bank increases its loan allowances this reduces earnings, so banks try to avoid

doing this if at all possible.

Regulators set different loan loss allowances for different types of loans.

Higher allowances are set for risky unsecured loans, while loans with historically lower

default rates – like commercial real estate loans require significantly lower allowances.

The problem with using historical loss rates is that they are a backwards looking metric,

and the risk of losses on office real estate loans has increased significantly in recent

years due to falling property values and higher interest rates.

Some are arguing that banks should base their reserves on current levels of delinquencies,

but the problem with doing that is that bank reserves would become pro cyclical where they

decline during booms allowing banks to lever up even more and then increase in a slowdown

requiring banks to recapitalize when investors are backing away from the sector.

One way or another though, the reserves should relate to the riskiness of the loans on the

books, and these loans are a lot riskier today than they appeared to be five years ago.

According to FDIC filings, the average reserves at JPMorgan Chase, Bank of America, Wells

Fargo, Citigroup, Goldman Sachs and Morgan Stanley have fallen from $1.60 to 90 cents

for every dollar of commercial real estate debt on which a borrower is at least 30 days

late, meaning that bad property debt today exceeds reserves at the largest US banks.

This was driven by a spike in delinquent commercial real estate loans which more than doubled

last year.

Stephen Gandel at the FT pointed out in a recent article that while Bank of America’s

FDIC filings show that delinquencies on their loans tied to office, apartment and other

non-residential buildings have jumped 50 per cent in the final quarter of last year, the

bank cut its loss reserves for those loans by $50 million dollars to just under $1.3

billion dollars.

You just have to be impressed with whoever worked their way through that regulatory loophole

– fifty percent higher delinquencies leading to a lower reserve requirement.

That person really earned their bonus on that one.

When people say that AI will replace white collar workers – I just don’t think Chat

GPT will ever reach that level of creativity.

Well done!

Now, to be clear, the expected losses on commercial estate at this point are much smaller than

the losses that occurred during the 2007 mortgage crisis, but there could still be billions

of dollars of losses for developers, investors and lenders and we could see more forced sales

of office buildings.

A recent NBER paper called “The Secular Decline of Bank Balance Sheet Lending” which

analyzed trends in financial intermediation - estimates that the market share of US banks

in all private lending has almost halved since 1970 and that loans as a percentage of bank

assets have fallen from 70 per cent to 55 per cent over the same period.

The paper shows that private credit is increasingly intermediated through arms-length transactions

where a lender originates and then sells the resulting loan through debt securities.

The paper highlights that the share of household wealth held in deposit accounts at banks has

also fallen from 22 per cent in 1970 to 13 percent in 2023 as savers are increasingly

putting their savings in money market funds, Treasury securities and retirement accounts,

cutting out banks as middlemen.

The professors argue that most of the decline in bank lending and household savings being

held at banks happened in the 1990’s and was not significantly impacted by the global

financial crisis – despite all of the additional regulation that came in its wake.

They go on to analyze how the changes in the nature of credit intermediation have impacted

the financial sector’s sensitivity to regulation and capital requirements.

Their analysis shows that the impact of raising bank capital requirements would have had twice

the economic impact in 1963 than it would have today.

Now, in their stress test they find that raising bank capital requirements to 25% would cause

bank balance sheets to contract dramatically, but the effect on overall lending in the economy

would be much more muted today because of an offsetting increase in lending through

shadow banks that substitute for bank balance sheet lending.

Essentially, they show that as lending has moved away from banks and into private and

public markets, the availability of loans is less sensitive to changes in bank regulation.

This possibly explains why the overall share of bank lending didn’t change much after

the introduction of all of the new regulations that came in the wake of the global financial

crisis.

Banks are making the same amount of loans today, but they are less risky loans, and

risky lending is being done by less regulated lenders.

It might be reasonable – based on this research to expect that any increase in banking reserve

requirements brought about by delinquencies in commercial real estate loans would have

less of an impact on the overall economy today than it would have had in the past.

Significant risk transfer (also known as SRT – but should not be confused with the cars

tailgating you on the highway) is a balance-sheet strategy that has been approved under the

European and UK banking framework and used for some time on a small scale to hedge credit

risk at European banks.

The Federal Reserve clarified its rules on the use of this strategy last September which

involves the sale of credit-linked notes that carry the risk of losses on bank loan portfolios

to investors.

Canadian banks have started using this strategy too.

In Europe and the UK, each SRT transaction is examined by regulators to ensure that a

real transfer of risks is occurring and getting this regulatory approval transaction by transaction

can be slow.

SRT’s allow banks to reduce their risk weighted assets and free up capital held against these

assets (which are mostly loans) on their balance sheets.

US banks like JP Morgan have already started using these deals to cut their exposure to

risky loans.

Shedding risk this way does cost banks money, but it does reduce their risks – and thus

their capital requirements.

These products are usually bought by specialist investors with expertise in credit risk, who

feel they are being adequately compensated for the risk they are taking.

US Banks can, and likely will use these structures to reduce their exposure to risky loans, but

doing so will lower their earnings.

Profits in the US banking sector fell almost 45 per cent year on year in the final quarter

of 2023.

This was the biggest year-on-year drop in quarterly profits since the second quarter

of 2020.

Some of this was driven by the government-imposed “special assessment”, which replenished

a deposit insurance fund depleted by the regional bank failures earlier in the year.

Increased bad loan provisions, losses on securities and higher costs due to redundancy payments

to laid off staff also cut into profitability.

While profits also fell at the biggest banks, they did better than their smaller peers.

In the final quarter of 2023, JPMorgan earned 22 per cent of the entire industry’s profits.

It will be some time until the problems in commercial real estate are worked out.

While there is an excess of office real estate there is a shortage of residential housing

in the United States.

This imbalance has led commentators to question whether empty office buildings can be rezoned

and repurposed as housing.

Economists at Goldman Sachs built a model showing that current prices for struggling

office buildings are still too high for conversion to residential use to make sense.

They estimate that office prices would need to fall an additional 50% for conversion to

housing to be financially feasible, meaning that offices will likely remain underutilized

in the near term.

If you enjoyed today’s video, you should watch this video on the brewing trade wars

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