The fallout from empty offices is coming. Here's where investors could see the pain

Published Fri, Apr 14 202310:06 AM EDT

Christina Cheddar Berk @in/christina-cheddar-berk-b864404/

As concerns about regional banks roiled markets, investors weighed another threat: commercial real estate. The theory goes something like this: Office property values are falling — with more to come. Workers have been slow to head back to the office , and companies may look to cut costs as the economy weakens by exiting office leases. If this happens, it would put further pressure on the value of office space, which has already been challenged by rising interest rates. Also, layered on top of the property value pressure, are the tightening credit conditions brought on by the recent turmoil in the banking sector. There is no doubt this scenario is a toxic mix for the capital-intensive real estate industry. Every year a large amount of debt needs to be refinanced. The Mortgage Bankers' Association said a quarter of office building mortgages will need to be refinanced this year alone. Funding also is needed to build or upgrade existing properties or to make new acquisitions. At the moment, many experts say the real estate market isn't causing trouble for banks, but fears about the financial system are likely worsening conditions in real estate because liquidity is being reduced. Delinquencies remain low, but have started to tick up in the office segment. A few fresh examples of landlords handing back the keys on properties include Brookfield's decision in February to walk away from two Los Angeles office towers. Around the same time, Pimco's Columbia Property Trust defaulted on about $1.7 billion of mortgage notes on seven buildings located in San Francisco, New York, Boston and Jersey City, New Jersey. More recently, Blackstone defaulted on a Nordic mortgage backed bond . Still, investors shouldn't jump and make comparisons with the global financial crisis or the savings and loan issues in 1980s and 1990s, according to Lotfi Karoui, the chief credit strategist at Goldman Sachs. In an interview, he said it's a different scenario that is playing out. "Most of the challenges that we're seeing in the office property space today are not symptomatic of years of loose underwriting standards," Karoui said. "In fact, it's been quite the opposite." In the wake of 2008 crisis, standards tightened considerably for debt service coverage ratios and loan to value has come down, he said. "From a credit quality standpoint, I think you're going into this in a position of relative strength," he said. Instead, the pain is being felt in the shift that was made to debt structures back in 2020 and 2021, when many borrowers moved into floating-rate loans when rates were low. Now, those borrowers are dealing with a "higher for longer" funding environment. "This is an asset class, that almost by design, is a lot more sensitive to the level of funding costs," he said. A closer look at loan concentration The concentration of CRE loans is smaller at the largest banks. Deutsche Bank recently estimated that office loans make up less than 5% of total loans at each of the larger banks it covers, and is less than 2% on average. However, as attention shifts beyond the largest banks, the sensitivity to the CRE market intensifies. CRE is the largest loan portfolio segment for half of all banks. But, in a recent report , Moody's Analytics stressed that the pool of CRE lenders is very diverse. "Overall, banks are the largest lender, accounting for 38.6% of lending. However, the 135 US regional banks (generally considered as those with about $10 billion to $160 billion in assets) hold just 13.8% of debt on income-producing properties," Moody's wrote. "The top 25 largest banks, which the Federal Reserve (Fed) considers 'large,' hold 12.1%. The 829 community banks (with $1 billion to $10 billion of assets) hold 9.6%, and the remaining 3.2% is spread among the 3,726 very small local banks with less than $1 billion in assets." Even CRE itself is a broad pool of assets, with the types of office structures most under pressure accounting for only a piece of the broader segment. Regulators consider a bank CRE-heavy when its construction and development loans top 100% of risk-based capital or if a CRE-to risk-based capital ratio tops 300% and 3-year CRE growth is more than 50%, Wall Street firm Janney said. Its analysts reviewed fourth-quarter data from the Federal Deposit Insurance Corp. to look at the concentration data for all publicly traded banks and compared the banks' exposure to these guidelines. Janney found 50 banks that had construction and development loans above the 100% threshold, including eight banks that topped 150%. Banks with more than $10 billion in assets were less likely to fall into this bucket, it said, with only nine banks at this asset level passing the 100% mark. However, more than half of all publicly traded banks exceeded the CRE concentration guideline. In some cases, the banks blew way past the mark. Janney identified 56 banks that had a CRE ratio above 500%, including 15 between 600% and 699%, and two that exceeded 700%. The table below details some of the banks in the last two categories. "Our data is meant to be a resource for investors when comparing Banks," wrote analyst Brian Martin in the report, published March 28. "Importantly, we note CRE concentration guidelines are just that: guidelines, and that Banks can operate above these thresholds so long as they have proper processes/procedures in place." But this does provide investors with a potential tool for identifying where risks may exist. Also important will be the upcoming earnings season, which kicks off on Friday. According to Refinitiv data, earnings estimates for many regional banks have fallen since March 10 — the day regulators shut down Silicon Valley Bank — as analysts look to assess the impact recent turmoil has had on their financial results. A multitude of factors are weighing on the sector's performance. Estimates have fallen nearly 40% at First Republic Bank, which saw many customers pull their deposits from the bank last month. But it's worth noting New York Community Bancorp , which has a high CRE concentration, has seen its estimates decline nearly 15% since early March. "We expect office loans will meaningfully contribute to credit losses over the next several years, but aren't too concerned at current valuations," Baird analyst David George said in a research note Thursday. "Given the rise in office vacancies from the hybrid work environment and expectation for ongoing lease roll-offs in major metro markets, investor-owned office properties are likely to come under pressure over the next several years." George anticipates the impact will be manageable for the banks he covers. "With the names trading at ~40% discounts to post-crisis P/E multiples, we are just less worried about < 5% downside EPS drivers," he said. Office REITS take a beating Even if the threat is contained for the regional banks, severe damage has already been done to real estate stocks. William Blair analyst Stephen Sheldon said that the real estate investment trusts he covers, which include outperform-rated CBRE Group , Jones Lang LaSalle , Cushman & Wakefield and Colliers International , are down 14% on average over the past three months. For comparison, the S & P 500 has risen more than 3% during that time. On average, this basket of stocks is about 35% off their 52-week highs, he said, noting that this equates to an average 2023 adjusted price-earnings multiple of about 10 times. CBRE 1Y mountain CBRE shares are holding up better than some real estate stocks. It's down about 9% since the start of the year. "While the next few quarters could be choppy, we believe that current valuations already reflect buy-side expectations for earnings to come in well below current sell-side consensus expectation, and we believe earnings could hold up better than feared," he wrote in a research note Thursday. Even if a company isn't refinancing, its costs have gone up dramatically if its debt had a floating rate. For those that are refinancing, they are unlikely to be able to cash out any value during that deal, which is something many REITs have come to rely on. The performance of each company will depend on the types of properties it owns, where the properties are located, when the debt matures and the types of decisions management makes about whether to stick it out during the down cycle. Morgan Stanley recently estimated that property values could fall about 40% from peak to trough. "Office is long tailed given leases are often 10 years," Deutsche Bank analyst Matt O'Connor wrote in a recent research note. "That said, we're into year four into the COVID-related correction. This implies losses may start to pop up a bit in 2023 and be more meaningful in 2024-26." Some types of CRE have been faring better, according to Manus Clancy, a senior managing director at data provider Trepp. He said property values have fallen about 15% to 20% for industrial and multifamily, which is less than the 30% to 35% decline in the value of shopping malls and offices. There are pockets of demand, such as for facilities for life sciences firms, he said. Offices in cities where remote work has been more entrenched are faring worse. Those cities include San Francisco, Seattle and downtown Chicago, among others, he said. The biggest concern is seeing how many other companies join Brookfield , Blackstone and Pimco in handing back the keys on office properties, Clancy said. The Trepp CMBS Delinquency Rate fell three basis points in March to 3.09% from the prior month, but the office segment continued to move higher. "We are in a moment now where banks are squirreling away their cash because they've seen what happened to Signature and SVB," Clancy said. "They saw the run on deposits and what they don't want to do is load up on illiquid assets that may be difficult to sell should a run come to their bank. And so banks have really shut down the artery, which is lending on commercial real estate for now. … The market is really struggling. It's not just empty rhetoric." Fallout for life insurers Another sector that also could be in the mix is life insurers. The long-term nature of commercial mortgages has made life insurers a key player in the real estate market. According to Moody's, life insurers hold about 14.7% the outstanding $4.5 trillion in CRE debt. However, Evercore ISI analyst Thomas Gallagher said the pressure on life insurance stocks, which peaked in late March, is "overdone." Gallagher said he anticipates it will take time for any situation in the group to play out and any losses would remain "pretty limited." MET 3M mountain Shares of insurance giant MetLife have come under pressure due to the company's exposure to commercial real estate. "We think the quality of maturing loans in [2023] are in good shape including office, which have sub 50% [loan to value] on average, which should mean that most life insurers re-fi much of the maturities themselves or do automatic loan extensions, with very few foreclosures," he said. Among the insurance stocks that have been under pressure are Equitable Holdings , Corebridge and MetLife . The trio is among the insurers most exposed to commercial mortgage loans, Gallagher said. The stocks all hit a 52-week low on March 24, but have since clawed back some of their lost value. Still, the group is down for the year. Equitable shares are have fallen more than 12% year to date, Corebridge is off more than 20%, while MetLife has shed 17%, as of Wednesday's close. —CNBC's Robert Hum and Michael Bloom contributed to this report.