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Will Commercial Real Estate Cause The Next Financial Crisis?

There is a lot of chatter lately regarding commercial real estate and whether or not a significant crisis is on the horizon. Let's dive in.

What's happening?

Commercial real estate has done well over the past decade. The economy was humming along, interest rates were low, and developers were able to leverage those low rates. Occupancy was great, until COVID hit.

Work from office schedules turned to work from home. The economy bounced back with vengeance but the employees never returned to the office. With the economy being hot, the Federal Reserve raised interest rates which put further strain on commercial properties. Valuations were turned upside down and occupancies fell to record lows to make matters worse.

Prices have continued to fall, especially for large office buildings in busy cities. Other areas like apartments and industrial have held up admirably.

Prices are down 20% which is similar to the commercial crisis in the 1990's but it's been difficult to gauge just how bad the damage has been. There haven't been a lot of transactions because of the depressed valuations, making it difficult to determine how long this cycle will drag on.

So where's the risk?

Borrowers could be on their way to defaulting. A lot of commercial loans are coming due in the next two years and they will need to put new loans in place. The problem is interest rates are two or three times higher than their last loan. Borrowers will need to figure this issue out by using more cash, finding alternate sources for loans, or face defaulting on their loan.

The second, and perhaps larger issue, is lenders are facing a serious rise in defaults. Banks, particularly small ones, are extremely exposed to commercial real estate loans. Some small banks have almost half of their loan exposure in commercial real estate. A lot of these smaller banks are starting to stockpile reserves which tends to be a sign they expect trouble coming down the pike.

How big of an issue is this?

The big names in charge are aware of how nasty this problem could be. Jerome Powell, Federal Reserve Chairman, discussed it in a recent 60 minutes interview. It's comforting to know we won't be completely blindsided. But this is also a similar storyline to subprime mortgage crisis in 2008. It wasn't supposed to break the system, but it did.

Small banks make up a large part of our economy. If they falter it could really stress the rest of the system. It's a vicious cycle where bank stress leads to conservatism, which leads to restricted lending, which hurts businesses, which hurts employees, which hurts household spending, etc.

And sometimes it doesn't even have to be fundamentally bad. If investor psychology turns sour, money could rush for the exit. Look at what happened with Silicon Valley Bank.

The last and most important item relies on interest rates. A hot economy means interest rates will remain high - which will undoubtedly put more pressure on commercial real estate. On the other hand, if interest rates come down it could be a sign that a recession has already started.

It's a delicate balancing act. And I have to give credit where credit is due - I thought the house of cards would have already come crashing down. Jerome Powell has seemingly pulled off the impossible, but we're not totally out of the woods yet.


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