CRE’s Game of Chicken Couldn’t Last Forever

By Joel Litman, chief investment strategist, Altimetry

Banks, investors, and borrowers have been playing a game of chicken…

And it’s about to end with a crash.

Since the pandemic began, commercial real estate (“CRE”) has been a massive question mark. Offices sat empty for months or even years. Occupancy rates are still only about half of what they were before COVID-19.

Yet despite the gloomy environment, there haven’t been too many prominent CRE bankruptcies. We haven’t even seen a lot of buildings sold at major losses.

So a lot of investors have been shoving their heads in the sand… determined to ignore the risks in this market.

As we’ll explain, the lack of blatant warning bells in CRE was by design. But it’s finally starting to change. We’re approaching a turning point in CRE… and it’s only a matter of time before investors realize how risky this sector has gotten.

Folks with skin in the real estate game hoped they could outlast the industry’s woes…

Whether it was banks offering CRE loans… real estate companies borrowing money… or investors speculating on office real estate… they all had their reasons not to sound the alarm.

And they didn’t have to. Until CRE loans start defaulting and buildings start going for steep discounts, none of these parties have to “mark” any losses on their books. That keeps all of their respective stakeholders calm.

It doesn’t change the fact that brokers are now selling debt backed by Blackstone-owned office buildings at half the price. At least one office tower in Los Angeles is being sold for nearly 45% less than it was 10 years ago.

Near the end of 2023, 37% of all office space in San Francisco was still available. Office buildings in the city are selling for a year-over-year discount of 40%.

And in Manhattan, CRE was discounted by 15%.

None of these stats paint a bright picture for CRE. But since key parties don’t have to mark them… it has been easy for investors to look the other way.

Until now.

Keep in mind, CRE owners take out loans just like you might take out a mortgage for a house…

They have to fork over between 10% and 30% as a down payment in order to fund the rest with loans. Since prices are dropping between 15% and 40%… that wipes out almost all of the equity in the transaction for office buildings that are heavily backed by debt.

And a lot of this CRE is at or near distressed levels… meaning they’re dealing with tenant problems, delinquent payments, defaults, or even bankruptcy.

As of the end of 2023, $86 billion of real estate is considered distressed. Of that number, $35 billion comes from office real estate. Another $55 billion of offices are considered “potentially distressed.”

That means we may see even more fire sales… which could be the beginning of the end for this CRE waiting game.

Banks were willing to keep extending these loans for a while, as long as property owners were willing not to sell.

For banks, this helps prevent investors and depositors from panicking… avoiding the kind of situation that led to last year’s bank runs. And real estate investors like private-equity firms were happy, too. They didn’t have to mark down the value of their investments.

Brace for panic as buildings start to sell for steep discounts…

Billionaire real estate investor Barry Sternlicht expects more than $1 trillion in losses from office real estate alone.

As investors start to fully grasp the problems in this industry, they’re going to head for the hills.

Keep a close eye on the office real estate market in the next few months. Any news about a major bankruptcy or a steep sale could be the tipping point for CRE.

Regards,

Joel Litman
March 5, 2024