US banks on alert over falling commercial real estate valuations

U.S. banks are increasingly concerned about falling commercial property valuations and the risk they pose to lenders’ balance sheets, senior executives said this week.

Office valuations, in particular, have been dented by rising interest rates and many employees’ preference for working from home since the coronavirus pandemic.

However, financial executives sought to reassure investors that they did not anticipate significant systemic risk as assets are widely spread among banks and other institutions.

“What’s going on with commercial real estate, especially office space” was State Street’s top concern, U.S. custodian bank chief executive Ron O’Hanley said this week. Not all properties have been affected equally, he added: “Class A is holding up. Rents may be down but they are not in trouble. Classes B and C absolutely are.

“The question we’re all asking is whether the contagion will spread from the office sector,” said Bryan McDonnell, head of PGIM’s real estate debt business, which manages $122 billion. “If you have a trust issue, all of a sudden people could put all commercial real estate in the same bucket.”

There are signs of mounting stress in bank earnings in the first quarter. Last week, Wells Fargo announced that its non-performing commercial real estate loans had jumped nearly 50% since December to $1.5 billion. Morgan Stanley cited commercial real estate and a deteriorating economic outlook as reasons for a sharp increase in its provisioning from a year ago.

“In my opinion, we are not in a banking crisis, but we have had, and may still have, a crisis among some banks,” chief executive James Gorman told analysts on a call.

Commercial real estate loans make up about 40 percent of total lending from smaller banks, compared to about 13 percent of the books from larger lenders.

Bank OZK, headquartered in Arkansas, which is heavily exposed to the sector, said Friday it had increased loan provisions by 10% in the first quarter. At $36 million, that was up tenfold from levels a year ago.

Line chart of price movements (%) from the March 10 Silicon Valley Bank collapse showing concerns persist over smaller banks

Nearly a third of the $4.5 billion in commercial real estate debt matures before the end of 2025, according to analysts at Morgan Stanley, who called it “preloaded.”

This week, Christopher Ailman, chief investment officer of California’s $306 billion state teachers’ retirement system, told the Financial Times that he believes office values ​​have fallen by around 20% and that he was bracing for steep losses on the fund’s $52 billion real estate portfolio. .

Investor jitters are growing, with nearly half of those polled this month by Bank of America identifying commercial real estate as the most likely source of a systemic credit event.

The sector is raising similar concerns beyond the United States, with a senior IMF official this month describing commercial real estate as “a point of interest”.

The multilateral lender’s latest financial stability report has warned that a toxic combination of falling property values, tighter financial conditions and illiquid markets could cause borrowers to struggle to refinance an ever-growing stock of loans coming to maturity. maturity, resulting in significantly higher default rates.

Brookfield real estate group added to a growing number of high-profile defaults this week by forgoing $161 million in loans tied to a cluster of mostly suburban office buildings near Washington. In February, he returned the keys to two prime office towers in Los Angeles.

Blackstone and Pimco have also shed some of their office investments in recent months rather than continue their loss-making bets.

“If you have debt maturing, you can’t bear the burden of the existing debt, and you’re not ready to invest more money, then that’s a foreclosure,” said Tony Natsis, head of the real estate group of the law firm Allen Matkins.

He added, however, that lenders would prefer to modify existing loans: “They’re like, ‘Do I really want to take this over in a bad market?'”

In the first three months of this year, office-related transactions fell to their lowest level in more than a decade, according to data from MSCI Real Assets.

Real estate experts have been at pains to point out that commercial real estate is a slow, lumpy market and investors shouldn’t expect quick resolutions to difficult situations – or that those difficulties quickly accumulate. as lenders and borrowers attempt to work through potential solutions.

“The silver lining here is that large parts of commercial real estate are still doing quite well, such as logistics, hotels, rental housing and data centers,” Jonathan Gray, chairman of Blackstone, the country’s largest real estate investor. world with $332 billion in real estate assets, says this week.

Gray made a name for himself through the real estate arm of Blackstone and underscored how tightly held real estate investments were.

“Commercial real estate is broadly split between big banks, smaller banks, insurance companies, government agencies, securitizations and mortgage funds,” he added. “I don’t think it’s the kind of systemic problem people say it is.”

Reporting by Jennifer Hughes, Brooke Masters, Harriet Clarfelt, Madison Darbyshire, Antoine Gara and Stephen Gandel in New York and Colby Smith in Washington

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