A Reckoning Looms for Commercial Real Estate—and Its Lenders

Commercial space will be available for rent in New York on July 13th.


Photo:

Lev Radin / Zuma Press

Even if Covid-19 cases increase globally, the arrival of viable vaccines promises to return to something resembling normal by the middle of next year. But the commercial real estate sector may never return to normal, and that could mean trouble for banks.

Many banks focus on and are dependent on commercial real estate loans. Banks hold half of all commercial real estate loans. The roughly 5,000 US community banks, with roughly a third of total assets, focus two to three times as much on commercial real estate loans as the roughly 30 larger banks.

Commercial real estate problems can hurt banks in two ways. Losses on existing loans can directly damage earnings, and a correction can reduce future loan volumes and adversely affect a key earnings driver. From what we now know, things are not looking good.

Neiman Marcus and at least 28 other major retailers have filed for bankruptcy. Hotel occupancy has fallen by 32%. The Journal reported last month that global airline capacity was down 58% in October from 2019. In major cities like New York, San Francisco, Boston, and Seattle, apartment rental rates have dropped 15% to 25%. Suburban shopping malls were destroyed.

A recent Citigroup report on 400 properties in the retail and hotel sectors found an average depreciation of 27%. The stock prices of real estate mutual funds, companies that own stakes in commercial real estate, have fallen 42% in retail real estate since the last valuation before the pandemic broke out in March. Office REITs are down 36% and residential REITs are down 50% – all despite the recent stock market rally on vaccine news.

Some of the pressure on commercial real estate is undoubtedly temporary. Leisure and business travel should gradually recover and support the travel industry. The youngest college graduates who have lived and worked in their parents’ homes will move out at some point, fueling the rebound in rental housing markets. If a vaccine is distributed, customers will likely flock back to restaurants and bars.

However, some more permanent changes in the commercial real estate market are only emerging, due to the acceleration of pre-existing trends. The decade-long shift to online retail has grown rapidly this year, which is having a serious impact on traditional retail real estate. Many companies take a close look at their office space and conclude that they need much less of it. Similarly, banks are reducing their branch networks as the pandemic removes their customers’ concerns about mobile banking. “What is clear is that consumer behavior has changed, and I believe that in many ways it has changed permanently with this introduction to digital,” said William S. Demchak, chairman and CEO of PNC Financial Services. “We need to adapt the way we serve our customers and it is likely that this will mean less physical space.”

It’s not all bad news. Companies like Amazon are successful and have increased the demand for storage and distribution space. Stock prices for data center REITs are up 23% and industrial REITs 9% this year. But these types of properties fetch much lower rents than office and retail properties. A strong performance from a property type is a modest comfort for a lender suffering losses on a retail, office, or vacation rental property.

For properties that are financed with a typical debt of 75% to 80%, a loss of value of 30% – if it persists – is more than sufficient to drive the property under water. Declining temporary factors can improve this picture, but emerging long-term factors will make it worse for many properties. If the downdrafts for a given property are temporary and owners have the resources to stay afloat (or maintain them through future state aid), even underwater properties may not become total losses. But how many retail, office, and residential properties will end up being so well positioned?

Banks are in good shape today and their large exposure to commercial real estate is not yet a problem. Hopefully this will continue, but the facts available suggest that there are several challenging years to come. Many, including community banks, will weather this storm in solid shape due to a combination of credit diversification, careful drawing, and luck. Unfortunately, not everyone will be so lucky.

Mr. Graham is a partner and co-founder of the Klaros Group.

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Published in the print edition on December 15, 2020.