Chart of the Month - March 2023

Are bad loans to Commercial Real Estate (CRE) the next stage of the US banking crisis?

The inflation-recession dichotomy has been busted by a US and Swiss banking crisis. Duration risk and an old fashioned bank run led to the collapse of Silicon Valley Bank. This then spilled over to Signature Bank and Credit Suisse. Regulators and big players have stepped in to provide stability and settle nerves. However, could we be sailing into a perfect storm where banks’ exposure to Commercial Real Estate (CRE) has left it vulnerable to the coming economic recession?

Increasing US Bank exposure to Commercial Real Estate (CRE)

US bank’s exposure to CRE is now USD 5.21 trillion and has never been greater in absolute size - see chart below. CRE now represents 24 percent of total loans - the most since the 2008 financial crisis.

Around 80% of these loans by value are held by small and medium sized banks. For small banks with assets between USD 1 and 30 billion, CRE represents around 33% of total loans. Like SVB, these banks face lighter regulation than systemically important banks. 

After the shock of the 2008 financial crisis, it took until 2014 for total CRE loan value to increase again. However, because of the role of mortgage-backed securities (MBS) in the 2008 crisis, investors have less of an appetite for CRE MBS. As a result, commercial banks have been forced to keep more CRE on their books than they otherwise would have, which has increased their exposure to CRE.

COVID-19 and deteriorating CRE loan quality

The pandemic continues to have a negative impact on the quality of office loans, which are a key subset of CRE. CBDs from New York to San Francisco emptied out with the COVID-19 lockdowns. While some workers have returned, many have not, because of the rise of hybrid and work-from-home policies. This has now been added to with layoffs in the tech and other sectors. Between Q4 2018 and Q3 2022, the US office vacancy rate increased by +510 bps to 18.2 percent. As leases expire and are not renewed, the vacancy rate is expected to grow in the short and medium term.

The situation is even worse for older and lower quality buildings. Those companies who have decided to keep offices downtown are now expecting 5-star amenities and better environmental ratings. Changing rooms are being exchanged for fully-equipped gyms. This has created a gap in the vacancy rate between 4 and 5-star office buildings and is putting even greater stress on the owners and loan-holders of 4-star office buildings - see chart below.

Tightening financial conditions and recession

Unfortunately, financial conditions have tightened since the collapse of Silicon Valley Bank and the market is expecting at least another 25 bps hike in the Federal Funds rate. Further, many economists now believe that the financial tightening has made a recession and even a “hard-landing” inevitable. Bloomberg now has the probability of recession at 100% - see chart below.

Together, tighter financial conditions and a recession will ramp up the pressure on office and other commercial loans. This is on top of the mounting pressure from unrealised losses in securities held by banks - see chart below. If conditions tighten further as is expected, many small and medium US banks may need to turn to the FDIC.

Can a CRE financial crisis be avoided?

Banks and the Federal Reserve need to work hard to ensure confidence in the banking system. Only confidence can stop a bank run. This includes ensuring there is adequate liquidity. The Federal Reserve recently introduced the Bank Term Funding Program to provide additional liquidity for up to a year to banks. However, a lot will come down to how the market and depositors react when delinquencies in CRE’s increase and how bad they get. Of course, a milder recession can stop delinquencies getting too high. 

What does this mean for Private Debt in Australia?

The Australian banks have seen a similar increase in CRE loans since the 2008 crisis. However, Australian CBDs have recovered from COVID-19 much better than their US counterparts. In January, Australia’s CBD office vacancy was 12.5%, which is more than 500 bps lower than the rate in the US. Further, in the industrial and logistics real estate segments there is a lack of supply which should keep prices up and vacancies low.

Since last year, Australia’s major banks have been moving their loan books away from office, construction and apartment loans to the industrial sector. This has provided increased opportunities for private debt companies in those sectors. Some Australian companies are also looking to diversify their debt away from the majors. 

As the economy slows, some CRE loans will become distressed but this will be from very low starting levels. Further, the Australian financial sector enjoys among the best prudential standards in the world. Australian banks came through the 2008 GFC with few scars and are perhaps better prepared than most banks in the world for the potential difficulties of 2023.

Private debt funds also have the advantage of applying a more granular filter than the banks and the ability to tailor loans to the individual risks of borrowers through the use of covenants and different levels of seniority. In Australia private debt funds can also have priority over cash flows. 

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