Wall Street’s main artery for financing commercial real estate has sputtered this year as higher interest rates and sagging property values darken the outlook for borrowers with an estimated $2 trillion of debt coming due through 2024.
Issuance of commercial mortgage-backed securities, or bonds sold by Wall Street banks to finance commercial buildings, has fallen by about 83% so far this year to $9 billion, according to Deutsche Bank research.
While these bonds finance only roughly a 11% slice of the estimated $20.7 trillion commercial property market, the sector has long served as a visible gauge of the financial health of hotels, office buildings, apartment buildings, shopping malls and other income-producing real estate.
“Frankly, the machine is shut down,” said Gabe Rivera, co-head of securitized products at PGIM Fixed Income. “It’s not a great environment.”
Since landlords finance the bulk of U.S. real estate with debt, interest rates
TMUBMUSD10Y,
3.749%
play a major role in dictating market conditions. Terms were looser, and borrowers could take equity out of buildings based on record valuations, when financing was cheap and abundant in recent years, but the reverse has gripped properties in need of funding since the Federal Reserve began to rapidly increase rates by 500 percentage points in the past year.
Fed officials pulled the trigger on another hike of 25 basis points on Wednesday, bringing the policy rate to a range of 5%-5.25%, the highest level since 2007. Fed Chairman Jerome Powell also reiterated that rate cuts are unlikely soon.
“That puts pressure on valuations everywhere,” Rivera said. “There’s a whole face-off going on between borrowers and lenders, which is causing the machine to stop here.”
Office building price may drop up to 50%
In addition to office properties left half-empty by remote work, stress at regional banks loaded up with commercial real-estate exposure also has been a source of angst since the failure of Silicon Valley Bank in March.
U.S. stocks
SPX,
-0.73%
DJIA,
-0.77%
were higher Friday, looking to rebound from a four-day losing streak after First Republic Bank’s failure and takeover by JPMorgan Chase & Co failed to calm market jitters in the past week.
“I don’t think the market is upset about the 25-basis-point-hike,” said Brett Ewing, chief market strategist of First Franklin Financial Services. “I think it’s just the refusal by the Federal Reserve to acknowledge the regional banking crisis is actually accelerating, not decelerating.”
Shares of the SPDR S&P Regional Banking ETF
KRE,
-1.79%
were down about 35% on the year through Friday, according to FactSet.
Ewing thinks the majority of big banks remain sound and resilient, but worries about continued fallout at regional banks, especially without regulators approving some form of a temporary and limited government backstop for deposits on accounts used by businesses to cover payroll and for working capital.
Still, Ewing also isn’t lumping the entire commercial property market in the same bucket, particularly over the long-run.
“Yes, there is a lot of carnage coming if you look at San Francisco’s office market,” Ewing said. “But we do think that if you aren’t throwing the baby out with the bathwater that there’s a lot of value out there.”
PGIM expects property prices to drop in a range of 7.5%-50% in this cycle (see chart), with office properties likely facing the most downside risk.
PGIM Fixed Income expects office buildings to drop in price by as much to 50% in this cycle
RCA Analytics, PGIM Fixed Income
Rivera also sees value in higher-quality commercial mortgage bonds, but expects price discovery to be a long a protracted process, particularly when banks and thrifts, which financed about half of the $5.5 trillion in outstanding U.S. commercial real-estate loans, can work out problems out of the public eye.
That’s not an option in the bond market, where investors can quickly see when big-name borrowers like Brookfield Asset Management or Pimco hand lenders back the keys to struggling properties, rather than continuing to make monthly debt service payments in an uncertain backdrop, since bond investors get monthly reports on progress at the property level.
“Right now, we are in the eye of the storm,” Rivera said.
