Experts, including investor Charlie Munger, are raising red flags about a potential commercial real estate crash.
Currently, U.S. banks seem to have a lot of bad loans on the books that will be especially vulnerable as property prices go down and the likelihood of a recession in the economy looks more likely.
Munger recently told the Financial Times that he doesn’t believe it’s nearly as bad as 2008 was but went on to say that if there’s banking trouble, it’s going to be felt in other sectors as well.
According to Munger, there’s a lot of problematic commercial real estate right now, including office buildings, shopping centers, and other similar property types.
Major cities like San Francisco, New York and Los Angeles are especially dealing with the effects of an oversupply of office space. That started with COVID-19, as people started working from home en masse. There are other trends affecting it, too, like the quiet quitting trend.
There’s also the issue of credit and debt, both of which are needed in a healthy economy for it to function as it should. This is especially relevant in real estate because of leverage. If credit and debt shrink, so too does the economy.
Many mortgages throughout the country are issued not by large, big-name Wall Street banks but by smaller, regional banks. The relationships these banks build with their clients are much more personally driven than the AI algorithms used by Wall Street and big banks.
When the Fed raises rates, as it’s been doing for months, banks have assets devalued in their books because the older long-term treasures and mortgage-backed securities aren’t as marketable as the higher-interest bonds. Banks holding older assets can see their asset values drop, which is what happened with the Silicon Valley Bank collapse.
While a real estate crash could technically happen sector-wide, most analysts and experts believe that it will likely affect specific areas significantly—namely, commercial real estate. There will be fewer buyers in commercial real estate because they won’t be able to access cheap mortgages anymore or development loans.
This is paired with what was mentioned above—many office space vacancies are growing, especially in big cities. According to a report from CommercialEdge released recently, occupancy rates of commercial real estate in many of the nation’s big cities are incredibly low. This adds to the banks’ problems—they have to foreclose on office spaces if not enough tenants are signing leases.
With people likely to continue working from home now, the office spaces might currently have paid leases, but when those end, tenants may end their leases or move to smaller spaces, and we haven’t even started to feel the effects of that yet.
Commercial retail is in a similar position. The pandemic further accelerated the e-Commerce trend leaving many open retail spots.
If developers have variable loans, they might have just had a higher rate become effective, and their lease payments might not be enough to cover what’s due on their loan, or maybe it’s just enough with no profitability.
Developers might decide to walk away from the project and let it go into foreclosure.
There are some efforts to convert open office spaces into residential properties, but that requires a lot of changes, including in zoning. It may not make sense financially for most developers to try and do that.
Of course, there could be pockets of the country where commercial real estate is in high demand. It may not follow uniform trends throughout the country even if there is a crash.
Only time will tell, but there are some major cities where the commercial real estate market is looking incredibly bleak, with little relief on the horizon.
