Property Values and the Banking System

As you know, the stock market is in ecstasy mode. It may or may not be terminal, but euphoric states are usually not a good sign. And, lest we forget, the price of Bitcoin has exceeded $20,000, apparently a hedge against the declining value of the dollar. This too is not a very good sign. For most wizzened finance veterans, none of it is encouraging.

And yet, our experts tell us that nothing can go wrong. 

Time will tell.

And then there is the question of commercial real estate. You might guess that this field is not exactly my bailiwick. And yet, this is no reason to ignore the issue. It means that I will take a back seat to financial adviser Brian Graham who surveyed the field for the Wall Street Journal. 

For now, Graham suggests, the collapse in commercial real estate has not threatened too many banks. Those that are threatened are community banks, not large financial institutions.

Perhaps the vaccine will solve all of our problems, but one is slightly skeptical of anything that pretends to be a panacea.

So Graham surveys the landscape and sees an economy that is reeling:

Neiman Marcus and at least 28 other major retailers have filed for bankruptcy. Hotel occupancy is down 32%. The Journal reported last month that world-wide airline capacity in October was down 58% from 2019. Apartment rent levels have collapsed 15% to 25% in large cities including New York, San Francisco, Boston and Seattle. Suburban shopping malls have been devastated.

A recent Citigroup report on 400 properties in the retail and hotel sectors found an average decline in value of 27%. The stock prices of real-estate investment trusts, companies that own equity in commercial properties, are down 42% for retail properties since the most recent valuation prior to the pandemic onset in March. Office-property REITs are down 36% and lodging property REITs are down 50%—all despite the recent stock-market rally on vaccine news.

Those are crash numbers, though we all believe that the Federal Reserve has the situation in hand and that nothing can go wrong.

Of course, by the laws of contrary opinion, when everyone believes that nothing can go wrong, everything goes wrong.

Graham continues to say that many companies are not just leaving New York and other major cities. They are reassessing their real estate needs and concluding that they do not need as much office space or even retail space. What will happen to New York commercial real estate if banks conclude that they need fewer branches. Keep in mind, in New York City there’s a bank branch or two or three on every block. And that does not count the restaurants and shops that are being destroyed by local politicians.

The decadeslong shift to online retail went to warp speed this year, with severe implications for traditional retail properties. Many companies are looking hard at their office space and concluding they need much less of it. Similarly, banks are reducing their branch networks as the pandemic sweeps away their customers’ concerns about mobile banking. “What’s clear is consumer behavior has changed, and my belief is, in a lot of ways, it’s changed permanently with this adoption to digital,” said William S. Demchak, chairman and CEO of PNC Financial Services. “We’ll have to adjust the way we serve our clients, and it is likely that will mean less physical space.”

At what point do property owners become insolvent? At what point do they owe more than they own?

For properties financed with typical debt levels of 75% to 80%, even a 30% drop in value—if sustained—is more than enough to push the property underwater. Receding temporary factors may improve this picture, but the emerging long-term factors will make it worse for many properties. If the downdrafts for a specific piece of real estate are entirely temporary in nature and the property owners have the resources to stay afloat (or get them through future government aid), perhaps even underwater properties won’t become total losses. But how many retail, office and lodging properties will be so well-positioned in the end?

Good questions. We do not know the future-- as of yet-- but the level of risk seems to be substantial.

Today, banks are in good shape and their large commercial real-estate exposure is not yet a problem. Hopefully that continues, but the available facts suggest a challenging few years lay ahead. Many, including community banks, will weather this storm in solid shape due to some combination of loan diversification, careful underwriting and good fortune. Unfortunately, not all will be so lucky.