Clickbait

• U.S. regional banks' CRE loans currently have an average LTV of 66%
• 30% decline in CRE prices during the GFC did not lead to widespread borrower distress
• European banks' median exposure to CRE is 6% and U.S. regional banks 36%
• Clickbaiters short 40% of shares in the iShares U.S. Real Estate ETF

As Oaktree Capital Management founder Howard Marks reminded us in his memo about bubbles "history doesn't repeat itself, it rhymes." This sentiment is particularly relevant in property, where cycles of boom and bust have played out time and time again. Marks believes that ‘first-level thinkers’ search for easy answers – ergo risk off attitudes to investment or lending – whereas ‘second-level thinkers’ know that success in investing lies in the antithesis of simple, and there’s value to be had from avoiding short-selling opportunism and the clickbait news cycle of doom.

The sheer size of the commercial real estate (CRE) market and its reliance on debt means that trouble in the CRE market can have significant implications for the wider financial system, and the recent sell-off of Deutche Bank shares raised fears that we may be holding a requiem for CRE once again. However, recent analysis suggests that the situation is not as catastrophic as some may fear. There are certainly circumscribed areas of concern, such as office markets, but this does not necessarily mean that a harsh correction is imminent.

Cap rate spreads could rise significantly and bring down property prices, but the bigger worry would be defaults, which have knock-on impacts on the wider financial system and feed through into further cap rate rises. Thankfully though, distress remains relatively absent. Unlike in the early 1990s, when LTV ratios were alarmingly high, U.S. regional banks CRE loans currently have an average LTV of around 66% according to MSCI Real Assets, and while vacancy rates in offices are soaring and the retail industry is exposed to recession, net operating income growth appears healthy, albeit somewhat boosted by inflation.

Cathy Marcus, the global chief operating officer at PGIM Real Estate remarked that the 30% decline in CRE prices during the Great Financial Crisis did not lead to widespread borrower distress. In an interview with Unhedged, Marcus notes that a similar discussion occurred during the GFC about a “maturity wall”, particularly in CMBS, with many anticipating significant distress but that this just never materialized. Marcus attributes this to the diversity of the market, with various lenders and different types of loans.

JPMorgan's credit research team conducted a stress test on U.S. regional banks to simulate the impact of a potential CRE crisis. The analysis assumes that banks will incur a 9% loss on their total office exposure and a 6% loss on retail, spread over three years. The results of the stress test reveal some significant losses at a few regional lenders. However, even in the worst-case scenario, the greatest losses were projected for Valley National Bank, a $5bn New Jersey lender. Even then, losses were only expected to reduce its tier 1 equity capital ratio from 9% to 8.7% - hardly likely to trigger a solvency crisis. Amundi concur, pronouncing the European banking system as robust and concluding that the concerns about credit crunches are exaggerated due to the solid liquidity profile and capital position of European banks.

BlackRock's also expect that, despite the turbulence, delinquency and distress in the U.S. will remain low on existing loans as property cash flow remains stable, particularly in the multifamily and industrial sectors. They expect that any distress is likely to be confined to properties with high LTV levels that need to refinance in today's market, creating attractive opportunities for investors with the appropriate risk profile. Nuveen Global Head of Strategic Insights Abigail Dean is also hoping the lack of finance will lead to an overcorrection, particularly in Europe which will then “provide a really attractive entry point towards the end of the year,” Dean said.

The short sellers are smelling blood though, and are actively ‘pinging’ office stocks in the search for pockets of distress which may lead to some isolated distress if they uncover any weakness in CRE positions. Bloomberg reported that almost 40% of shares in the iShares U.S. Real Estate ETF are being sold short, the highest proportion since June, according to S3 Partners data

After we conducted some analysis, we were comforted that the latest figures suggest that the major banks will be able to survive a sustained fall in real estate values. At HSBC, Stage 1 loans (not subject to a significant increase in credit risk) fell only 6.1%, Stage 2 loans (a significant increase in credit risk) rose 3.3% and Stage 3 loans (objective evidence of impairment) rose only 2.8%. NatWest reported an even better position at -3.6%, 3.7% and -0.1% respectively and AIB 7.6%, -4.7% and -2.9%. The size of exposure was also low, at Standard Chartered, CRE loans accounted for only 5% of total loans, a 32% fall on 2021. At Hamburg Commercial Bank, CRE loans also fell, down to €8.1bn from €12.5bn in 2019, with an LTV of only 59% (down on 2021), a DSCR of 235% and debt yield of 8.8%. At Secure Trust Bank, solely a UK lender, lending balances increased 1% on the year with an impairment charge of just ￡1.3m 2002 on a Real Estate Finance book of ￡1.12bn at an average LTV on of sub 60%. OakNorth commented that the company's real estate loan volumes remained stable, but with the impact of high inflation, high interest rates, and a recessionary economic outlook resulted in an increase of ￡10.8 million in the expected credit loss (ECL) charge in 2022, compared to a release of ￡3.7 million in 2021, although the company maintained a conservative average LTV across its loan book at 52%.

DWS is sanguine about European banks, stating that they are solidly capitalized, have higher returns and a lower exposure to commercial real estate compared to U.S. banks. European banks' median exposure to commercial real estate is around 6%, while U.S. regional banks have exposure at around 36%, and large U.S. banks at around 16%. DWS also notes that they have not observed huge deposit movements, and although credit conditions are getting tighter, European banks should be in a strong position to deal with upcoming challenges. On U.S. banks, they note that the Fed stress tests conducted in June 2022 found that all of the large U.S. banks, which represent 65% of total U.S. bank assets, could safely weather an adverse economic scenario like the Great Financial Crisis of 2007/08, which involves unemployment rising to 10% and CRE prices falling 40%.

Their concern is with small and regional U.S. banks which account for a disproportionate share of total bank commercial real estate lending, at around 70% despite only accounting for around 35% of total bank assets. This puts them at higher risk concerning CRE, which represents around 50% of their lending. However, the degree of contagion to these banks is still unclear, and although deposits at these institutions tend to be sticky, a higher share is already insured by the Federal Deposit Insurance Corporation (FDIC).

DWS believes that the squeeze on regional bank lending could hurt CRE prices in the near term. However, they expect this will create a disconnect relative to yields on U.S. Treasuries and investment grade, which they think will eventually be closed as capital comes in to fill the gap through other channels, including alternative lenders. The constraint on development and pullback of construction could set up for better fundamentals in 2024/2025. A significant tightening of regional bank lending would probably have a quality dispersion, disproportionately affecting higher-risk lending in smaller markets.

As Oaktree recently published in a market note, ultimately, real estate investors with a focus on risk control as well as significant expertise in debt and equity can potentially capitalize on the new opportunities created by this challenging macroeconomic environment while also properly managing their current portfolios. Paraphrasing Marks’s words in his book “The Most Important Thing”; for every person who gets a good buy in an inefficient market, someone else sells too cheap. One of the great sayings about poker is that “in every game there’s a fish. If you’ve played for 45 minutes and haven’t figured out who the fish is, then it’s you.” The same is certainly true of inefficient market investing. Why would the seller of the asset be willing to part with it at a price from which it will give you an excessive return? “Being too far ahead of your time is indistinguishable from being wrong.” Many of the best bargains at any point in time are found among the things other investors can’t or won’t do. The key turning point in Marks investment management career came when he concluded that because the notion of market efficiency has relevance, he should limit his efforts to relatively inefficient markets where hard work and skill would pay off best. The case for calm on CRE is that, excluding offices, fundamentals are strong, near-term risks are contained and pain has been realised gradually in past crises. So as this downswing unfolds there will be pricing opportunities for both lenders and investors.