Iin downtown Manhattan Reminders of the problems of commercial real estate are everywhere. On the west side, near Carnegie Hall, is 1740 Broadway, a 26-story building that Blackstone, an investment firm, bought for $605 million in 2014 but defaulted on its mortgage in 2022. Towering high above Grand Central Station is the iconic Helmsley station. building. The mortgage has recently been sent to a “special service” (the mortgage may be restructured or the owner may simply default). As the sun sets, the underlying problem becomes clear: working from home means fewer tenants. Floors bright with light, where workers mill about, are sandwiched between black strips.
This is not a new development. Many buildings have been vacant for four years since Covid-19 struck. Initially, the owners hoped to wait out the pandemic. But workers were slow to return, eventually forcing employers to cut back. Vacancy rates, especially in the poorer buildings, skyrocketed. Then interest rates rose. Most commercial buildings are financed through five- or ten-year loans. And many of these loans will soon be refinanced, while interest rates remain uncomfortably high. Within the next two years, approximately $1 trillion in U.S. commercial real estate loans will be rolled over, an amount representing one-fifth of total commercial building debt.
Recently, a number of office buildings in major cities have traded at less than half of pre-pandemic prices. These types of losses will wipe out the equity of many owners, leaving banks to swallow significant losses themselves. Three institutions have already been severely affected. In recent weeks New York Community Bank (NYCB), a medium-sized lender; Aozora Bank, a Japanese institution that raised U.S. commercial real estate loans; and Deutsche Pfandbrief, a German company with office exposure, all reported bad news on their loan portfolios and saw their shares plummet.
Meanwhile, the Chinese real estate crisis is becoming increasingly acute. With domestic portfolios struggling, some Chinese investors who have been buying properties around the world may have to raise money – and could start dumping foreign assets, putting pressure on property values. If consumers are severely impacted by rising interest rates on auto loans or credit cards, it is possible that more institutions will find themselves in a situation similar to that of nycb. It’s no surprise that people are starting to worry that the switch to working from home could ultimately cause financial disaster.
However, it is worth putting these problems in context. To start with the problems NYCB seem truly unique to the setting. Although the bank has exposure to offices in New York, it has essentially written down the value of its portfolio of loans on rent-stabilized “multifamily apartments” in the city. These fell in value after legislation in 2019 limited owners’ ability to increase rent if an apartment became vacant or if the landlord made capital improvements. The other lender that specialized in these types of loans was Signature Bank, which went bankrupt last year.
Moreover, there is a limit to the extent of the problem that offices can pose, even if the damage is serious. The total value of U.S. real estate (excluding farmland) reached $66 trillion at the end of 2022, according to data from Savills, a real estate brokerage firm. The majority of this consists of homes. Only a quarter is commercial. And commercial real estate is much more than just offices. It includes retail spaces, which are struggling, as well as warehouses, which are in high demand as data centers and distribution points, and multi-family housing. Offices, therefore, may be worth as much as $4 trillion, or about 6% of America’s total real estate value.
Between 2007 and 2009, residential real estate in America lost a third of its value. A similar shock today would wipe out $16 trillion in total real estate value. Even if every office building in America were to somehow lose its entire value, the losses would still be only a quarter of that size. In addition, lenders are better protected against losses in commercial real estate than against losses in residential real estate. While loans for the latter were often close to 100% of a building’s value, even the most ambitious commercial real estate loans only cover 75% of a building’s value.
Bloodshed
The wound inflicted by commercial property can best be compared to that caused by the slip of a kitchen knife: it is nasty, obvious and painful. Stitches may be required. But the victim is unlikely to be seriously injured.
The wound will also not continue to fester unnoticed. Because real estate problems are so visible, regulators are working on them everywhere. About half of commercial real estate debt consists of loans from banks (and mainly from smaller ones, as regulations discourage large institutions from making such loans). The rest are securities or loans from insurers. The Office of the Comptroller of the Coin, a regulator, reportedly advised NYCB to more aggressively write down the value of some of its loans, which they became apparent when it reported earnings on Jan. 31. On the other hand, the European Central Bank has asked banks to set aside additional reserves to cover credit losses on commercial real estate.
The US economy, which is still growing smartly, offers additional protection. Look up at the empty skyscrapers of New York and it’s easy to become alarmed. But return your gaze to street level and you can calm yourself down. The streets are busy. Shops are full. Restaurants are full. America is healthy and moving, even if it could use a bandage for that nasty cut. ■