Greater Hidden Risk to Market After SVB

The onset of a financial crisis is like finding rotting food in your fridge. Something starts to smell and you think you know what’s rotting, but when you search, you find something far worse in the back of the fridge that you haven’t thought of for weeks. This may just be my fridge, but you get the analogy. Commercial real estate loans sitting in mid-sized banks in the US is the hidden problem we’re all starting to remember.

According to the Louis Fed, commercial real estate loans in the US are approaching $2.9 trillion, with a large proportion held by regional banks. In the years following the Global Financial Crisis, regional banks turned to commercial real estate loans. It was a capital deployment that did not require significant technology investment or large teams, and for loans on assets in their region, they could claim to have greater underwriting expertise and to compete on cost. This part of the economy is under significant pressure right now, as the same banks are struggling even more around deposit levels.

The two main sources of weakness in the commercial real estate sector are offices and retail. Retail as an area of ​​weakness won’t surprise anyone, but this problem comes at the worst possible time. The post-COVID switch to online spending and higher interest rates has accelerated the closure of many retail names. The latest alarm was in January when Bed, Bath and Beyond said they could no longer pay their debts. This physical retail collapse is happening as office space suffers its own weakness due to remote work and artificial intelligence. Owners with variable-rate debt will struggle to refinance, even in the dynamics of the status quo.

CommercialEdge expects 2023 office transaction volumes to be at their lowest level since the years following the Great Financial Crisis. The national vacancy rate currently sits at approx. 17% Teleworking and tech-driven layoffs already sit above 18% in some centers like Denver, Seattle and San Francisco. This is before any other effects enter the system, such as fallout from SVB and rapid deployment of AI. AI is a wild card that I wish I had the equipment to predict but wasn’t. All I will say is that in a few short months, many white collar jobs have been increased to the point where smaller teams are likely to be warranted. At some point, this will flow into the office sector, which is already under pressure.

The problem with commercial real estate loans is that it’s not an easy fix as even lower rates may not change some of these trends and there is no further negative impact. Remote work will remain somehow, artificial intelligence is out-of-the-box and COVID accelerated online retail.

Given the interconnected effects on the system we’re all involved in, chances are you’ll see a concerted effort to support this asset class. Amazon
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and Disney have announced their back-to-work schedules over the past few weeks. House Republicans even announced a bill that would abolish remote work for some government employees. Some North American municipalities, such as Calgary, are taking more proactive approaches and providing dollars to convert commercial buildings to residential buildings. How quickly this can consume unused commercial space remains to be seen, but programs like this have been very well received so far. If you can get everyone back to the city centre, it will be an unexpected boost for this asset class and even energy demand. As a result, the fundamental trends are peaking while rates are drastically increasing. This is a cascading dynamic that causes massive asset class disruption, often to the point where it can create a crisis.