Office CRE Confronts the Rise of Hybrid Work

Summary

• The recent New York Community Bank (NYCB) blowup has brought renewed focus on bank exposure to commercial real estate (CRE). It is a potential problem – banks hold about 50% of CRE debt.
• Fortunately, the risk is distributed across some 5,000+ mostly small banks that serve local markets. More bank failures and mergers are likely – but it is an idiosyncratic rather than systemic issue.
• CRE defaults (especially in the office sector) are inevitable. That will be painful for CRE equity investors, but far less so for CRE lenders.
• Office CRE has been a chronic problem area since the thrift industry-funded building spree of the 1980s. Today’s problems are more an ongoing adjustment to the emergence of hybrid work in the post-pandemic economy than something new – but one that will take time to resolve.

Market Implications

• While the economy avoids recession, office CRE will be primarily a headline risk issue. Expect it to flare up if recession risks rise.
• On balance, we expect the office market will ride out the storm.

NYCB Reawakens CRE Concerns

It has been a rough year for most banks since the Silicon Valley Bank implosion in March 2023. The major bank equity indices sold off more than 20% then and have struggled to recover since, even with lower rates and receding recession concerns (Chart 1).

Then the NYCB bombshell hit on 30 January^[1]. Bank-related ETFs KBWB, KRE and QABA have since fallen 2%, 8% and 6%, respectively^[2].

Various concerns have dogged banks this past year, mostly related to sharply rising interest rates since the Federal Reserve (Fed) started tightening in early 2022. Among them are mismatched assets and liabilities, underwater securities, potentially hidden exposures to crypto, deposit flight, narrowing net interest margins, and lastly, concerns about CRE and the office market in an era of hybrid work.

The NYCB shock reignited concerns about CRE.

Here we review the CRE situation from 10,000 feet to better understand the structure of the CRE market, how it is financed, and who the major players are. We then discuss the implications for banks and the broader economy.

Some CRE Facts and Figures

CRE is financed through a combination of debt and equity. Typically, at origination the loan-to-value (LTV) ratio of CRE debt is 50- 60%, meaning at least 40% is financed through equity. We estimate the market value of all CRE is $12-15tn. Total CRE debt financing is about $5.8tn, so the overall LTV is about 40-50%. For debt holders to lose money, the borrower must default and the value of CRE must fall 40-50% or more.

We now focus on CRE debt financing.

CRE Is Diverse

The two major CRE segments are multifamily housing, and other CRE^[3]. The CRE debt market is about 35% multifamily, with the balance in other CRE, including construction-related loans (Chart 1, Table A-1).

Other commercial real estate is diverse, with major segments including office, industrial, retail, hospitality, and healthcare. Much recent attention has focused on the office market, but it accounts for only 17% of total CRE (and about one-third of other CRE).

Known-Knowns and Known-Unknowns

The big issue for the office sector has been a rising vacancy rate. The media recently trumpeted the latest survey data from Moody’s Analytics that showed office vacancies (unleased empty space) at 19.6% – the highest rate since the 1980s (Chart 2).

Lost in translation is that the office market has been troubled for decades. During the 1980s, the thrift industry went on a lending spree that pushed the vacancy rate from the mid-single digit level in the late 1970s to nearly 20% and left a legacy of overbuilt office space lingering since. The market gradually recovered during the 1990s, but since the dot-com crash in 2000 and ensuing recession, the office vacancy rate has been mostly well above 15%. In the decade before the pandemic, it averaged about 17%.

Vacant office space might better be thought of as a known known.

Leased but unoccupied – The office market’s problem today is not the vacancy rate but rather the ‘unoccupied space’ rate. This is leased, unused space. Security firm Kastle Systems reports that occupied space in buildings that it services is about 55% of pre-pandemic levels based on pass swipe data. Granted, this is a subset of all office space and is oriented toward downtowns in larger cities. But it illustrates that work-from-home persists.

The question is whether and to what extent corporate tenants keep leased space as leases approach renewal.

Think of this as the known unknown about the office market.

Other points about the office market:

• The notable divide between top tier class A properties, where demand remains good, and class B/C properties, where demand is soft.
• Downtown office space usually have higher vacancy rates than suburban buildings.
• It may be a cliché, but the real estate market is largely local. Suffice to say, many of the problems with the office market are concentrated in certain cities and regions, while many other markets are in good shape.

Other CRE Sectors Are Stable

Currently, other sectors of the CRE market appear stable, benefiting from low unemployment and a firm economy.

The past few years have seen considerable construction across the US multifamily sector, with concerns about how quickly it can be absorbed. Given the general housing shortage in the US, we expect that vacancies will not be a significant issue. Our primary concern is that landlords may be unable to increase rents as quickly as thought a couple of years ago.

Retail has also been a difficult market since the global financial crisis, but it has stabilized and is showing signs of improvement as shoppers return to brick-and-mortar shopping after the pandemic.

Who Holds CRE Debt?

Banks hold about $3tn of CRE debt, or about 50% of the total (Chart 4, Table A-2). Roughly 20% is multifamily and another 18% is construction-related loans, with the balance in other CRE. Note that only banks are involved in farm and construction lending.

The next largest category is life insurance companies, which hold about 12% of all CRE. That amounts to a about 7% of life insurance assets.

Government-sponsored enterprises (GSE) finance or guarantee about half of all multifamily debt (and 18% of total CRE debt).

Small Banks Are the Big Players in CRE

Let’s delve further into how CRE debt is distributed across banks (Table 3).

The largest 100 banks in the US hold nearly 60% of total bank assets, but only 30% of bank-held CRE debt. Most of the balance is distributed across some 5,000+ smaller banks. Furthermore, CRE is only 7% of large bank assets, but 30% of small bank assets. Note also that smaller banks account for virtually all farm-related lending and 70% of construction lending. CRE would be a very different market without small banks.

This is mostly good news. It is unlikely that CRE problems will inflict major losses on the larger banks that pose potential systemic risks, although we have not reviewed individual bank holdings. Smaller banks have concentration risk but pose little systemic risk. Further, many or even most of those smaller banks serve communities where hybrid work is not a major issue. We believe it will take a significant economic downturn for CRE to cause a wave of small bank failures.

That said, there are surely weakened small and community banks out there, and more than a few will fail over the next year or so. Regulators generally do not have difficulty resolving small bank failures. Typically, they are closed, merged with a neighbouring institution, and soon reopened for business.

We do not have data on bank holdings of CRE by property type; for now we assume it is roughly proportional to the distribution of property types across the CRE market. Individual banks may be concentrated in one or two CRE property types.

Delinquencies Still Low – For all the talk about CRE risks, it has yet to appear in banking statistics. Fed data on delinquencies in banks’ commercial lending portfolios remain near all-time lows (Chart 5). These statistics may reflect lingering forbearance from the pandemic years and are backward rather than forward looking. They also reflect delinquencies across all property types. That may speak to the overall soundness of the broad CRE market even if delinquencies in the office market might be rising.

Office Market Faces Three Looming Cliffs

The office market has survived decades in a weak but steady state. Whether that continues, improves, or worsens may depend on whether it avoids three potential cliff events in coming years.

First is lease renewals. As discussed, the unoccupied rate for office space is much higher than the vacancy rate. Tenants may pay rent on that leased space, but as leases approach renewal, they could reduce the amount of space they lease, keeping pressure on the vacancy rate.

Second is mortgage refinancing. CRE mortgages typically have five- to ten-year terms, with little or no amortization of the principal amount, so it must be refinanced when the loan matures. If property values have declined, lenders may only be willing to refinance a portion of the loan. The mortgagor then must put more equity into the property or default on the loan and give the property to the lender.

Third is a contingency – that the economy sinks into recession. If so, hitting either or both previous cliffs become inevitable. Many tenants will opt to renew less rather than more space; and property values will drop, leaving many CRE landlords facing default.

Until now, there have been relatively few office defaults and transactions, making it difficult to put values on properties. In coming years, some 10-20% of properties face leases or mortgages maturing annually, guaranteeing that the office sector could remain stressed for the remainder of this decade. If the economy avoids recession, we think the office sector overall can outrun these problems, although some defaults and increases in vacancies are inevitable.

What Do We Think?

Base Case – Our base case is a). most of the CRE market is in good or OK shape, b) risk exposures are idiosyncratic rather than systemic, clustered in specific cities and regions; c). we remain confident that the Fed will err on the side of trying to avoid recession, and d). if it is successful, the office sector can outrun the first two cliff events (lease renewals and mortgage refinancings).

That said, rising defaults in the office sector are inevitable. These will be costly for equity investors, but less so for lenders due to mostly relatively low LTV ratios.

Banks Have Cushion – It is problematic that banks hold half of all CRE debt, especially in a recession scenario. But given that two-thirds of it is distributed across 5,000+ smaller banks, the risk is widely distributed. And many of those banks presumably serve healthy CRE markets. Relief is available if banks experience more difficulties:

• The Fed will likely ease policy to avoid a broader banking crisis.
• If many smaller communities face losing a local bank, Congress could provide support, especially given the outsized role small banks play in the CRE market and local communities.

We go further, suggesting that the problems most banks face are related to higher interest rates rather than CRE specifically. These include mismatched assets and liabilities, underwater securities portfolios, narrowing interest margins, and deposit flight. Many of these problems will ease as interest rates decline.

Beware Headline Risk – Even if our base case holds and the office sector avoids escalating into crisis, headline risk is inevitable. Media may play up rising vacancies and defaults and bank failures as though local problems are national and systemic problems. Again, we are talking idiosyncratic risk, not systemic risk.

End of a Long Road? In coming years, we may see a wholesale structuring of the B/C class office market that is no longer desirable or cannot be upgraded to meet the needs of new office tenants. Some of that space may be converted to residential or other uses but, whether due to cost or structural constraints, that is not an option for most office buildings. Instead, they will be torn down and replaced.

Over the next decade, we could achieve a healthy office market and finally bury this remaining legacy of the thrift industry collapse.

Appendix

Notes

1. NYCB cut its dividend and boosted loss reserves some 10 times more than expected to cover multifamily exposures in the New York City rent-controlled multifamily market. These moves were attributed to tougher regulatory guidelines because NYCB total assets breached the $100bn level after acquiring assets from the failed Signature Bank last year. It remains unclear how much of these moves were due to rising credit risk or simply ‘stroke of the pen’ pro-forma regulatory requirements due to becoming a larger bank. ↑
2. These are bank-related ETFs – KBWB covers large banks, KRE covers regional banks, and QABA covers community banks. ↑
3. We generally use the term commercial real estate (CRE) to refer to all CRE, including multifamily. We refer to CRE ex multifamily with either ‘CRE ex multifamily’ or ‘other CRE.’ Other CRE includes construction loans. ↑

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)