Thread by @jameslavish

We're hearing more and more about how the CRE market could crumble soon, and take down some banks with it.

But what exactly is CRE, what's wrong with it, and why is it so important?

Time for a Credit 🧵👇

🤓 What is CRE?

First of all, what exactly is the Commercial Real Estate or CRE market, and what are its components?

To keep it simple, the CRE market can be divided into six main sectors:

Office, Retail, Industrial, Multi-Family Property, Hospitality, and Special Purpose.

To break it down further:

Offices = urban high-rises or suburban offices/campuses

Retail = shopping centers (strip or regional malls) + stand alone stores or big-boxes, like Home Depot or Krogers

Industrial = warehouses, manufacturing, and distribution centers 👇

Multi-family = high or mid rise apartments, apartment complexes, or senior facilities

Hospitality = hotels, motels, etc.

Special Purpose = healthcare and hospitals, college and university campuses, self-storage facilities, etc.

And who owns all this CRE?

As you may have guessed, anyone with deep pockets:

High net worth individuals, institutional investors (pension, private equity or hedge funds, or endowments), and REITs or Real Estate Investment Trusts, which are like mutual funds for real estate.

Also, many companies own the real estate they're using themselves

If you’ve read the story about Ray Kroc, you know one of the key aspects to McDonald’s financial success was owning the real estate the fast food restaurants sat on—estimated to be worth over $40 billion today.

After all, real estate is known to appreciate over time, even after recessions or major meltdowns (i.e., The 2008 Great Financial Crisis)

It always bounces back

So, what’s all the chatter about CRE being in trouble, then? Didn’t we fix the leverage and lending problems of 2008?

While this is generally true, the CRE market has some nuances that can affect its health, unlike the housing market

And because of this, we may have a little bit of a GFC echo ahead of us

Let’s dig a little further to see why.

👻 Occupancy problem

As we all know, ever since 2020 there has been a work from home or WFH craze. People who were banned from going to the office set up their own offices at home and parked it there for a year

Or two

Now three. And counting…

We won’t get into a debate about the effectiveness and efficiency of WFH, but suffice to say, many people spent a lot of money setting up their home offices to have access to and get as much done as they possibly could.

As a result, they’re reluctant to head back to the office full-time

I mean, why commute, spend money on gas, and waste time on the road, when you can take Zoom calls in pajama bottoms or shorts?

Amiright? 🙄

Even so, most companies are embracing a partial WFH policy

Why?

It makes employees happy, companies can save on office space—cutting back their cubicle footprint—and they don’t have to stock up quite as much on coffee and snacks in the office kitchen.

The result is called a hub-and-spoke office model:

The headquarters or hub is where employees gather and collaborate, and the spokes allow for people to work from anywhere they choose.

The impact to the Office portion of CRE?

The national vacancy rate for offices in Q1 2023 was 16.8%

And San Francisco's office vacancy rate just hit a record high of 29.4% (prior to 2020, San Francisco occupancy rate was basically 100%)

The resulting financial impact to all this non-occupancy across the nation?

A recent NYU and Columbia University study titled 'Work from Home and the Office Real Estate Apocalypse' projected the overall value destruction of the US office sector could reach over $500B by 2029

That’s half a trillion dollars.

The path we are on:

OK, so this pain seems focused on Offices and, perhaps soon, Retail

So, what does this mean for the investors, the owners of all this office space?

🧨 Regional banks…again?

As office building valuations fall, we must ask the question, how does that affect the owner of that building, the landlord?

It’s not like a house, where if the value falls, so be it. You just sit and wait for it to rise again. Live your life, as is.

First, many landlords use *floating-rate debt* to finance office buildings, and so, their borrowing costs have begun to skyrocket

(🙏 the Fed for 🚀 rates 5% in < 1yr)

And many fixed rate borrowers are facing maturity on that debt and will have to finance at much higher rates.

To recap:

WFH → lower occupancy rates → lower income for landlords → add higher interest rates → higher landlord costs → landlords face large losses

The answer for an increasing number of them?

Default

Just walk away from the property, eat the one-time loss, and move on.

And it’s not just San Francisco, where the owner of Hilton San Francisco Union Square and Parc 55 recently stopped mortgage payments on $725M of loans and simply walked away.

This is exactly what PIMCO Columbia Property Trust did on $1.7B of mortgages and Brookfield Corp did on $161M of properties a few weeks ago.

So, will this continue?

Considering over 4% of all commercial office loans are 30+ days delinquent, and the overall US CMBS delinquency rate jumped to 3.62% (a rise of > .5% in one month) this trend seems to be accelerating.

But if the landlords just walk away, then who is exposed to the pending losses? Who fares to lose the most?

Well, it’s like that old adage, if you owe the bank $1 million it’s your problem, but of you owe the bank $100 million it’s the bank’s problem.

So, who do these landlords owe? Who are they walking away from?

You got it

Regional banks.

As credit tightens, borrowing availability falls and rates rise, building values fall—some quite steeply, especially with much lower occupancy rates, all while the lower rate mortgages mature

A perfect 💩 storm, so to speak.

By Trepp’s estimates, $448 billion of CRE loans mature in 2023, of which $270 billion are from banks, and an eye-watering $2.56 trillion are maturing in the next 42 months

$1.4T of these loans are from banks

*Ouch*

And so, with already depleted reserves from poorly managed and underperforming reserve assets, i.e., US Treasuries, and now melting loan portfolios, The Reckoning Part 2 may be coming to a regional bank near you.

*Note: I’ve written all about the regional banking crisis and what's been happening there

If you have not read those posts or want to revisit them, they can be found here: jameslavish.substack.com/p/svb-the-fdic…

and here:

https://twitter.com/jameslavish/status/1654136968983478274?s=20

Bottom line, there’s an extremely high likelihood that a number of regional banks will feel the pending credit crunch

And this is not even considering a coming recession.

Remember the Retail part of CRE?

We could soon see retailers shutter stores, pull out of strip centers, and walk away from leases

And what happens to those loans? 😱

Then the real question becomes:

Just how severe does this credit crunch get, and will we see that other big bad C-word?

*Contagion*

Then all bets are off, and it will be up to the Treasury and Fed to come swooping back in to the rescue,

by firing up the money printer, monetizing debt, injecting liquidity into to the markets, and saving the oh-so-fragile financial system once again.

🧐 How can you protect yourself?

I’ve been saying it for months now, I would be extremely selective about where my money is deposited and just how much I have at any one bank.

As many of you know, I'm holding a large percentage of fully FDIC insured cash in my portfolio, as I expect the US economy to soon slip into a recession

And so, I want to be ready to take advantage of any resulting market weakness.

I also hold a large percentage of my personal portfolio in #Gold, #Silver, and #Bitcoin and have been adding to them opportunistically

Why?

I expect hard monies to perform quite well when the Fed has to ultimately step in and shore up the markets again with large amounts of QE.

But that’s me, and everyone’s situation is different

I encourage you to dig in carefully with your investment advisor and match your investments to your personal liquidity needs, appetite for risk, and long-term goals.

Because whether it’s a CRE-flavored 💩 storm, some other credit event, or just a plain vanilla deep recession, I want to be prepared

Don’t you?

This thread is a summary of a recent 🧠 Informationist Newsletter.

There's a free version that you can check out here: jameslavish.com