On Valentine’s Day this week, an article from Bloomberg struck me as a high probability risk that a black swan moment may be approaching us. I have been observing this sector for the last few weeks as many banks around the world have been adding loss provisions and reserves to their property portfolio, particularly for commercial buildings like office space.
I have been watching this story unfolding since the Fed did multiple aggressive interest rate hikes of more than 500 basis points (5%) from late 2021 into 2022. I was wondering when the dam will break for highly leveraged investors as borrowing costs skyrocket at least 5x, especially for property-related plays.
Before that, Covid had hit us in full force by Mar 2020 and global demand collapsed due to country shutdowns as supply chains stopped functioning. When we saw light at the end of the tunnel in late 2021 as the vaccines were introduced, it was inevitable that the inflation monster would have happened, based on hindsight. Because of a lower base of demand caused by the pandemic, a small increase and turnaround in demand would have easily set off inflation red flags.
This in turn triggered the Fed to act accordingly. The low-interest rate environment caused by the 2008 GFC could not be sustained after 14 years. The Fed had to stay ahead of the inflation curve and hike very fast to tame the beast – a textbook move.
Before the rate hikes from 2008 to 2022, traders and investors have been taking advantage of the low-interest rates to make leveraged bets on all asset classes as a sure win and profitable move. Buying any dips was the main strategy and leverage provided a winning combination of maximizing profits.
But the bets began to unravel into 2023 as borrowing costs skyrocketed by a factor of 5 to 8 times. A 1% loan to buy a property on leverage had become 8%. Most of the trades are not sustainable as interest costs began to outweigh revenues.
Coupled with hybrid work that continued into the endemic, companies have started to reduce office space too. In the era of Zoom meetings and hot desks, demand for commercial rental fell off the cliff. It was a disaster waiting to happen for the highly leveraged big players of real estate around the world.
Some real estate funds began to walk away from their loan obligations in 2023, forcing the banks to repossess the buildings and begin loss provisions for non-performing loans. Several banks have recently announced setting aside big reserves for these loans. We are seeing a wave of them lining up to update the shareholders on these new potential liabilities and losses.
It is a global phenomenon as real estate plays are beginning to crack under the pressure of higher interest costs and collapsing rental demand – a double whammy.
“The shakeout in the $20 trillion US commercial real estate market has long been delayed for a simple reason: No one could figure out just how much properties were worth. And, more crucially, few wanted to.”
The Bloomberg article cited a Blackstone-owned office building in Manhattan that was offering a 50% discount. Many other buildings were also being sold at fire sale prices. With $1 Trillion of commercial real estate loans set to mature by 2025, there is more urgency for companies to unload.
The same picture is being played out all over the world from Europe to Japan. Investors have to write down their properties or walk away from their loan obligations when left with no options. Banks that backstop the original loans will be forced to sell into an already weak market while provisions surge.
Even as the stock markets are reaching new highs thanks to the AI boom, the commercial property sector could trigger a reassessment of the rosy situation. Hopefully, the global contagion effect from this sector will not turn into a tsunami that puts the brakes on the party.
Expectations of rate cuts had been dampened by sticky inflation numbers. We are never returning to the good old days of low to zero rates again. It is more likely that we will return to the historical levels of where the long-term rates should be, which will be between 3 to 5% range.
As of today, the outstanding commercial loans could be a ticking time bomb that is waiting to explode as maturities come due in the next 12-24 months. Opportunistic real estate fund managers now wait on the sideline to buy over these highly discounted buildings. Hopefully, the purge would be happening in a controlled manner, rather than as an avalanche of selling. That tsunami may tip the stock markets and cause the economy to turn bearish.
But in the overall scheme of things, this asset class alone may not tip the boat over. There have been so many assets that were inflated because of the low-interest rate environment for so long and it will need a number of them crashing at the same time to trigger a major down move.
Leave a Reply