Big Short Investor Explains the Commercial Real Estate Crisis

I mean, do I think commercial real estate, well, not commercial real estate; office real estate is going to be a problem? Yeah, we do! But there is Steve Eisman, the senior portfolio manager for the Eisman Group at Neuberger Berman. Like Michael Burry, Steve was one of the few investors that saw the 2008 housing crisis coming. You probably know him as Steve Carell's character in The Big Short.

There's no doubt when it comes to spotting a property-fueled economic crisis, Steve has a pretty good track record, which is why everybody's ears perked up when he recently admitted that he does see a problem forming in U.S. commercial real estate, but also anticipates that this will likely impact the economy for quite some time. You know, the way these things unfold, it takes a long time; it really depends on each company when their debt rolls over because when their debt rolls over, that's when it's crunch time.

So, what's the big problem and how will it impact the economy over the next few years? It starts back at the pandemic. It's no secret that the pandemic forced a huge change in the way people worked. People around the world were, in a lot of cases, required to work from home and this meant a lot of companies had no choice but to adapt. But ever since the lockdowns, many companies have now seen the benefits of working from home, the most obvious being they don't really need to pay for office space.

Take San Francisco for example; leased office space has fallen by approximately two-thirds since before the pandemic. But what this means is the owners of the commercial real estate aren't earning anywhere near what they were in rental income. Bloomberg notes that in San Francisco, in one of the city's few office deals, Wells Fargo recently sold a 13-floor tower at 550 California Street for about $200 per square foot, down from the 2019 market peak of more than a thousand, according to Numark Group.

So, unfortunately for the owners of these properties, because the rental yield is so much lower than before the pandemic, the value of their properties is falling fast. But because of this dynamic, it also means that the owners of commercial real estate aren't really looking to sell. In a perfect world, they simply hold on to the property until the values recover. But that's where the other big problem comes in.

The owners of these buildings have very fat, chunky loans that are coming due and will need to be refinanced, aka the old loan needs to be renegotiated and replaced with a new one. That's the big problem right now—the refinancing—and it's a problem for two reasons: owners needing to fork out more cash during the refinancing process and then the interest rates on new loans being much more expensive.

Steve sees both of these being big issues, specifically when you're looking at offices. There's about $175 billion of office debt coming due this year and about $150 billion of office debt coming due next year. If you took out a loan, let's say three, four years ago to buy something and the LTV was 60 percent, today it's probably 100. So, I mean, the issue is the refinancing and I think it's going to be tough.

So, because commercial property holders are now looking at rather dire valuations, that makes refinancing quite hard. They took on the loan at really high valuations but now face a situation where the value has fallen well below the actual loan amount. But because banks will only lend up to a certain percentage of the total value of the property, this means the owners may have to fork out the extra cash themselves to even be able to refinance their loan.

This is happening at a time where their cash flows are next to nothing. But beyond that, the other problem is that because interest rates are so much higher now, interest payments on these new loans are going to be a lot more painful than what they locked in on the old loan. You know, if somebody bought that building two years ago with, you know, with long-term debt at three percent, right? And let's say it's a five-year paper and in five years it's going to roll over and it's going to be seven percent—that's not good!

And as Bloomberg notes, a tipping point is coming. In the U.S. alone, about $1.4 trillion of commercial real estate loans are due this year and next, according to the Mortgage Bankers Association. That's not good! And what it's already causing is owners facing large debts to simply default instead of borrowing again at higher rates. For example, in the once fashionable Union Square District of San Francisco, the owners of the city's largest mall, Westfield San Francisco Center, in June essentially handed the keys over to the holders of a $558 million mortgage.

Instead of refinancing, they just walked away. They note major institutional owners like Blackstone, Brookfield, and Pimco have in some cases already chosen to stop payments on some buildings because, quite simply, they have better uses for their cash and resources. They're literally giving up these assets because they know they won't be able to pay the new loans. You bought something when rates were nothing and you paid a three percent debt and your cap rate was, let's say, three or four percent and now if you wanted to borrow, you're going to pay seven or eight—the value of your real estate went down, period.

So, that's the second big part of this crisis: current interest rates making a lot of real estate unprofitable. And if interest rates stay really high, well, you have $1.4 trillion worth of commercial real estate loans coming due by the end of next year. Granted, not all of that will be a problem, but some of it will need refinancing on pretty punishing terms. But the other thing is if rates would have come down, there's a chance that this could all be avoided.

And that's what a lot of people are even discussing right now—that the Federal Reserve may look to lower interest rates as inflation has been rapidly cooling down. This is something Steve discussed too, but unfortunately, he does not see that situation playing out in reality. In terms of people have lived with low rates for so long that it is unimaginable to them that the Fed's going to keep rates high. They just can't imagine it. You know, they were like, "Oh, the Fed will cut rates in the second half of this year."

That was never my position, but that obviously was the position of the market, and that now seems to be going away. But like I said, you know, people, I like to say, you don't think about your paradigm; you inhabit it. And one of the paradigms is that we're all entitled to live in a zero-rate world; that's gone! Just, everybody hasn't woken up to that fact.

And once, Dave says it's very true; we've all become accustomed to very low interest rates. In fact, the last time interest rates were as high as they are now was in 2007. That's a long time ago! But what's even more interesting is that the longer you zoom out, the more you realize that rates aren't actually that high right now versus historical data. In fact, they're pretty normal—they just feel extra high because we are so used to them being so low.

And as people and investors have slowly fallen deeper into that false promise of a new normal for interest rates, the leverage increased! Everybody overextended and now we find ourselves in positions like this where even the likes of Brookfield and Blackstone are walking away from properties. And as Steve is about to note, if they're both handing back keys, well, how on Earth is everyone else holding up?

I mean, I'm sure some of you have seen, you know, Blackstone and Brookfield. I mean, these are not small companies that have given back the keys for some of their pretty good buildings because, you know, they know that that's going to come due in a few years. They know what the cash flow is going to be, and they can't support the cash flow, so they're giving the keys back.

So, if Blackstone and Brookfield are giving back buildings, you know, how's everybody else going to be? So, no doubt, there's a big issue. There's a lot of owners of commercial real estate that are really going to hurt over the next few years—next to no rental income—and if they can't handle it, they'll need to sell it at a massive loss or simply default.

But that actually isn't the worst issue because, at the end of the day, we have to ask who actually owns the real estate? Well, it's whoever provided the owner with the loan, aka the banks own these properties. Commercial banks continue to hold the largest share of commercial or multi-family mortgage debt at 39 percent, and with banks already suffering, there's a lot of concern that this massive problem in commercial real estate could really punish them.

JP Morgan notes that we should be particularly wary of the small banks. They say, compared to big banks, small banks hold 4.4 times more exposure to U.S. commercial real estate loans than their larger peers. Within that cohort of small bank CRE loans make up 28.7 percent of assets compared to only 6.5 percent at big banks. A little further down in the article, JP Morgan also shows a graph of all the U.S. banks and their dependence on commercial real estate.

As you can see, many of the banks have very high ratios of commercial real estate loans to CET1 capital, which at any value over 100, JP Morgan deems risky. Of these banks, there are two that stand out: Cinemas Financial at over 200 and Valley National at a whopping 400 percent. So, there are no doubt some issues, but to be fair, even though this all sounds very problematic, there are also arguments that this might not be such a big crisis at all.

Firstly, office buildings only represent 14 percent of total commercial real estate assets in the U.S. As JP Morgan notes, the market capitalization of Apple is at $2.6 trillion, larger than the entire capitalization of the U.S. office sector valued at just over $2 trillion. Another thing to consider is that banks may very well negotiate with commercial real estate owners and work out a way that the owners don't have to default.

That same article explains in the short run, borrowers will likely take advantage of loan extension options. But on top of that, given current market conditions, we believe lenders are unlikely to repossess commercial properties that they would have to either manage or sell, especially at stress valuations. Instead of foreclosing, lenders may offer borrowers short-term forbearance or even modify their loans.

I mean, do I think commercial real estate—well, not commercial real estate; office real estate—is going to be a problem? Yeah, we do! But you know, the way these things unfold, it takes a long time. And if some of these rollovers can be postponed through loan extensions or even smoothed out through debt restructuring, then there may be a world where this doesn't turn into such a big crisis. JP Morgan sums it up like this: we feel confident that the office sector isn't likely in isolation to be a significant source of GDP weakness.

But broader and legitimate concerns about confidence in the banking system are relevant, especially questions about smaller banks and the credit they provide to the broader economy. Our view is constructive; we see stronger fundamentals outside of office buildings and vintage malls and we expect few losses beyond these two vulnerable CRA segments.

So hopefully that gives you a bit of an overview as to what's currently happening in commercial real estate and Steve Eisman's take on the whole situation. But please let me know what you think. Do you think this has the potential to blow into another bank crisis or do you feel the office sector simply isn't large enough to make a meaningful difference? So let me know that down in the comments, and please leave a like on the video if you did enjoy it. Also, check out this video if you're interested in more on Steve Eisman's view of the banks right now with all that's going on. But with that said, guys, I'll see you all in the next video.