The Commercial Real Estate Problem Just Got Worse.

There will be losses by some banks. It isn't really the big banks; it's really medium and small-sized banks that have these higher concentrations. It's going to be with us. It's a problem we'll be working through, I think, for several years. Commercial real estate is a very hot topic right now in America. As you've seen, a plethora of faces: Jerome Powell, Janet Yellen, Steve Eisman, Ray Dallio, Warren Buffett, Jamie Dimon—they are all chiming in to raise the alarm, with some even the Fed chair himself now thinking this could trigger another wave of bank failures.

And the response hasn't been pretty. Regional banks with high exposure to commercial real estate have been crunched. New York Community Bank Corp has fallen 67% year to date, as investors continue to fear a full-blown commercial real estate crisis across the next 12 months. I mean, this is what some of the world's most informed people have been saying. Yes, I do have a concern about commercial real estate; they're getting properties handed back to them now, and so you have non-recourse mortgages, and they're going to walk away, and the bank's going to get stuck with losses.

When interest rates go up to 300 basis points, whatever you own with their cash flow is worth 30% less. That's part of banking. Do I think commercial real estate, well not commercial real estate, office real estate, is going to be a problem? Yeah, we do. There may be some institutions that are quite stressed by this problem.

So what on Earth is going on? Why are Jerome Powell and the Fed so concerned about commercial real estate, and what is likely going to happen next? Well, first, indulge me with a bit of story time. COVID strikes—a big bummer, major bummer. Everyone works from home; there's economic hardship. Damn, this sucks! The Fed then tries to help out; interest rates get moved to zero, a lot of money gets printed, and it gets handed out to people.

Now, money printing and a variety of other factors cause inflation to skyrocket from 0 to 9%, and the Federal Reserve hikes interest rates from 0 to 5.25% to try and cool it down. That's important a little bit later. Now the problem for office real estate, though, is businesses kind of like this new work-from-home vibe, and they realize they can save money by dishing their offices and having a more remote workforce.

Vacancy rates of office buildings skyrocket to a 40-year high of 19.6%, and the increase in Q4 of 2023 was the steepest rise since Q1 of 2021, suggesting conditions are actually worsening. You can have a look at a place like San Francisco, for example, where the amount of vacant office space has reached the highest level ever recorded in the city's history. So vacancy rates are rising, and what this means is less rental income, and thus the valuations of these office buildings start to decline.

Owners of these office buildings simply aren't making as much money from them now as they were before the pandemic, and that quite simply makes them worth less. One example I spoke about last year was this tower in San Francisco that sold for $200 per square foot—a massive decline from the 2019 market peak of over $1,000. More recently, a prime office tower in Los Angeles sold in December for about 45% less than its purchase price a decade ago. When deals on office real estate do go through, they're all at massive discounts.

What does this mean? Well, it means that if you're the proud owner of one of these beautiful office buildings, chances are you don't want to sell your asset in this kind of environment. You'd much prefer to just hold on and just wait this out if you can. But then we get to the second problem, which is the rise in interest rates. You see, when it comes to office buildings, these mortgages are not like your typical family-home style mortgage. When we buy a home, we have to make principal and interest payments, right?

Well, for the buyers of office buildings, they can often elect to pay no principal and just pay the interest. Then, when the debt comes due, they simply refinance. The old loan expires, so they create a brand-new loan to continue on with. The idea here is that as long as the rental income exceeds the interest payments, then you're making money.

Now, like what we saw in the early 2000s, refinancing is always easy when property prices are rising and interest rates stay stable. But as 2008 showed, needing to refinance in a down market is very painful. That's the big problem in commercial real estate right now—it's a refinancing crisis.

Interest rates are a lot higher now versus 5 years ago, so owners of commercial real estate are now facing a world where not only are they generating less rental income, but the costs to service their commercial real estate loans are also much higher. And the stats are concerning: nearly $150 billion of mortgages on U.S. office buildings are maturing by the end of 2024, and just over $300 billion of loans will mature by the end of 2026.

According to a review of commercial real estate databases as of October 2023, the review of more than 880,000 office properties in the U.S. with $920 billion of mortgage debt found that 16.1% of loans by dollar volume will mature by the end of 2024, and 32.7% will mature by the end of 2026. So this is what people are so concerned about—there's a lot of office real estate loans that need to be refinanced over the next few years in conditions that are pretty punishing.

Listen to Steve Eisman explain this problem in simple terms: "It really depends on each company when their debt rolls over. You know, if somebody bought that building two years ago with long-term debt at 3% and let's say it's 5-year paper, and in five years it's going to roll over and it's going to be 7%, that's not good. But it really depends on each building and each company how much debt they have rolling over."

But there's one more layer to this story. So far, we've spoken about how hard it is for those that own commercial real estate. In fact, in some cases, companies like Brookfield are simply walking away from some of their office lines. You know, Blackstone and Brookfield—I mean, these are not small companies—have given back the keys for some of their pretty good buildings because they know the debt's going to come due in a few years. They know what the cash flow's 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, how's everybody else going to be? Now, that's sad for their business and everything, but think about this: if you default on your mortgage in a down market, who ends up with your house? It's the bank, right? Well, in the case of commercial real estate loans, it's the exact same thing. Brookfield is walking away from their buildings, and they're leaving it with the bank that gave them the loan.

So that's why people are so concerned about this situation because all these bad loans have the potential to really stress the banks, and this is already being shown. Take New York Community Bank, for example, where they have $84.6 billion of property loans on their balance sheet, of which commercial real estate makes up 12%. They shocked shareholders by slashing their dividend, and a few weeks ago, did a $1 billion capital raise to start bolstering reserves for their troubled loans.

In late February, the lender said it found "material weaknesses" in how it tracks loan risks, and as you can imagine, the investor response has not been pretty. Year-to-date, the stock is down 67%, signaling just how worried the broader market is around this property crunch. And the fear at the moment is that as time goes on and more of these loans come up for renewal, more and more banks will face a similar problem to what New York Community Bank Corp is facing right now, just like what we saw last year from Silicon Valley Bank, Silvergate, First Republic, and Signature.

But is it really going to develop into a full-blown crisis, as many investors are fearing? Is commercial real estate really going to be at the epicenter of the next great American real estate crisis? Well, of course, nobody knows for sure, but there are some factors out there that seem to suggest that maybe this is being dramatized a little bit more than it should.

For example, commercial real estate loans seem to be more concentrated at regional banks, and the general consensus at the current time is that while some regional banks like New York Community Bank will likely suffer, the big banks in America should hold up okay. JP Morgan noted last year that compared to big banks, small banks hold 4.4 times more exposure to U.S. commercial real estate loans than their large peers.

Within that cohort of small banks, commercial real estate loans make up 28.7% of assets, compared with only 6.5% at big banks. So yes, it seems like commercial real estate loans may very well topple some unprepared regional banks, but the consensus is that it's less likely to topple America's banking sector.

This is essentially what JP Morgan CEO Jamie Dimon said on the topic in a CNBC interview last week. "I want to ask you about commercial real estate. We've got nearly a trillion dollars of commercial multi-family real estate debt that will mature this year, but half of that is owned by banks, mostly regional banks. The rest is either securitized or due to non-bank lenders. We've seen higher levels of defaults in certain pockets of the market and a slump in property prices recently. Do you think that stress in commercial real estate will ultimately be the source of the next credit event?"

"You know," he continued, "first of all, put commercial in perspective with consumer. The consumer markets are far bigger. So what happened in '07 or '08? This isn't that kind of thing, and a lot of these owners of this can handle what you call stress. So in the banking system, I'm just going to focus this on office for a second, because there's warehouses, there's data centers, there's hospitals, and some of that stuff is actually well done. But if you take just offices, first of all, they're worth less because when interest rates go up to 300 basis points, whatever you own with their cash flow is worth 30% less.

So people—that's not a crisis; that's kind of a known thing. And then there's the, you know, if you have a recession, yes, it'll get worse; if we don't have a recession, I think most people will be able to muddle through this, you know, refinance, put more equity in, and of course, you talk about default being higher—part of that's just a normalization process; they were so low for so long. So all of credit, you're watching these things go up, but they're not at a crisis level; they're just kind of going to normal.

So yes, if rates go up and we have a recession, there will be real estate problems, and some banks will have a much bigger real estate problem than others. So you think, you know, as you kind of assess the landscape and regional banks, there'll be more of a whack-a-mole than a kind of domino effect. As long as the economy stays like this, there'll be more of a whack-a-mole; there should be no domino effect. The problems you've seen were kind of idiosyncratic problems with Silicon Valley, First Republic, and New York Community Bank; it'll be pockets."

So in that clip, Jamie pretty much reiterates exactly what we were just talking about. When the interest rates go up, there's a lot more stress on office real estate as the loans need refinancing. But in his opinion, office real estate is a small pocket of loans. It's nothing like having a residential real estate crisis like what we saw in 2008. And if there are big issues in office real estate, then it's likely going to trouble a few regional banks here and there.

As he said, he predicts it'll be more of a whack-a-mole situation rather than a domino effect. And funnily enough, that's pretty much exactly what Jerome Powell said on the matter, too, in a testimony before the House Financial Services Committee. In a 60 Minutes interview a few weeks ago, he characterized distress in the commercial real estate market as sizable but manageable. "Do you still feel like that risk is manageable? Do you feel like you've got the visibility and the transparency and the tools to address it?"

"It makes me nervous, because this has echoes of 2008, 2009 when vacancy rates come were declined relatively rapidly. We're not seeing that right now. So how do you feel? Does that risk continue to be manageable, and do you have the tools to manage it?"

"I would say yes to that. I think it is manageable, and we've been, you know, working hard to manage it for some time now really. And you know, what it really is, it's a lot of downtown real estate where there's too much office supply because of work from home, and also, you know, the kind of downtown retail that is no longer as profitable and things like that are really at the heart of it.

So what we've done is we've looked at banks that have significant concentrations, and we've been in touch with them to make sure that they have a plan to deal with that. There will be losses by some banks. It isn't really the big banks. It's really medium and small-sized banks that have these higher concentrations. It's going to be with us; it's a problem we'll be working through, I think, for several years. The idea is you've got to have enough capital, enough liquidity, and a plan to, you know, take the losses that you're probably going to take."

So at the end of the day, Jerome Powell and the Federal Reserve are acutely aware of this situation. They do think it's manageable, and they are actively working with at-risk banks to help them restructure in order to handle potential losses. He notes like Dimon that there will be some banks that for sure will come under pressure but also reiterates that this will likely be localized to a few smaller regional banks as opposed to the big banks, which were at the heart of the U.S. financial system.

But then, of course, the other thing he notes is that this is likely going to be a slow-moving problem that will take many years to fully unfold. So I made a video around the middle of last year talking about this issue. Things seem to be about the same now. So I guess we'll just have to come back a little bit further down the line, maybe later this year, for another update.

But with that said, please let me know what you think. Do you see systemic risk from commercial real estate? Let me know down in the comments. Also, as always, if you're interested in learning about how I go about picking stocks the Warren Buffett way, and you want to learn three full valuation techniques, you can check out Introduction to Stock Analysis over on New Money Education, and that also supports the channel.

Also, story time— I was in Melbourne a few months ago with my girlfriend Tash, and we were at a bar having dinner. Anyway, we got recognized at the bar by a guy called Jimmy who it turns out was there checking in on the sales of his tequila, which was called Tromba. But long story short, Jimmy actually said that he would want to send me a bottle, and that bottle actually arrived.

So thank you very much, Jimmy. I appreciate the present, and I'm excited to place this one somewhere in the background of my videos. So thank you very much. But guys, with that said, thank you very much for watching, and I'll see you guys in the next video.