Commercial real estate (CRE) has tumbled into a downturn as property values are sliding. This situation worsens because small and regional banks are the biggest source of credit to CRE owners. Over the past three months, these banks have been the epicenter of financial turmoil, a concern we presented to readers when the regional bank domino began falling in early March in a note titled “Nowhere To Hide In CMBS”: CRE Nuke Goes Off With Small Banks Accounting For 70% Of Commercial Real Estate Loans.
Bloomberg cited the latest data from Moody’s Analytics that showed first-quarter CRE prices fell for the first time in over a decade. An ominous sign as the regional bank crisis developed late in the quarter and has since sparked credit tightening in the second quarter.
Moody’s said courthouse records of transactions revealed CRE market dropped about 1% in the quarter, led by multi-family residences and office buildings.
Moody’s Analytics chief Mark Zandi warned: “Lots more price declines are coming.”
Just how deep will the CRE correction be?
According to Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management, she believes “peak-to-trough CRE price decline of as much as 40%, worse than in the Great Financial Crisis.”
“More than 50% of the $2.9 trillion in commercial mortgages will need to be renegotiated in the next 24 months when new lending rates are likely to be up by 350 to 450 basis points.”
Although we do not discount the possibility of such a drastic plunge in CRE values, it’s important to note that the Federal Reserve will likely cut interest rates should such a decline happen.
Complicating the matter is a JPMorgan analysis showing small banks have accounted for the lion’s share of CRE lending relative to larger banks. As shown below, as of February 2023, small banks account for a staggering 70% of total CRE loans, excluding multi-family, farmland, and construction loans.
Last week, the Federal Reserve’s semi-annual Financial Stability Report said, “The magnitude of a correction in property values could be sizable and therefore could lead to credit losses.”
On Tuesday, Fed Vice Chair for Supervision Michael Barr told lawmakers that he’s watching for “commercial real estate risks.”
The price declines come as the regional bank fiasco has led to the sharp tightening of lending standards. This means a massive slowdown in bank credit extended, making it more difficult for CRE clients to refinance. And what’s worse is a multi-trillion-dollar CRE debt maturity wall over the next five years.
A “doom loop” is developing, explained Paul Ashworth, chief North American economist for Capital Economics. He said the reduction in lending by banks would depress CRE prices, prompting even further credit cuts.
“Delinquencies and defaults will rise, but I don’t think we’ll see a lot of forced sales,” Zandi said, adding his price forecast is for a 10% drop.
Here are other notes we’ve highlighted about the CRE downturn:
Blackstone, of course, is waiting with dry powder for the “largest ever” real estate drawdown.