Office property woes could be tip of iceberg if credit freezes up as $1 trillion bill comes due

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Creditors eager to avoid steep losses on half-empty office buildings in the wake of the pandemic have been sending chills through the rest of the roughly $5.5 trillion commercial real-estate debt market.

A year later, old and outdated office towers remain a key source of dread, but lenders now also must navigate stress in the banking system, tighter credit conditions, and a Federal Reserve that appears committed to keeping interest rates restrictive, despite cracks in the banking system emerging a year into its interest rate-hiking campaign.

“It couldn’t be more tone deaf,” said Jason Callan, head of Columbia Threadneedle’s structured assets team, of the Fed’s decision to raise rates in March after the collapse of Silicon Valley Bank and Signature Bank.

“Those issues are present at other banks as well,” Callan said. “It’s clearly a concern.”

Callan, a longtime investor in the roughly $700 billion commercial mortgage-backed securities (CMBS) market, said volatility was running high before concerns about “old-school, asset-liability management problems” surfaced at U.S. banks.

“CMBS seems to be at the epicenter of it,” he said, pointing to a blowout in credit spreads on bonds tied to skyscrapers, hotels, shopping centers and other property types. “It’s up and down the capital structure. It’s everywhere.”

See: ‘Some losses’ in commercial real estate and Treasurys may still need to work ‘through the banking sector,’ says Fed’s Kashkari

Blowout like 2008

The CMBS market isn’t the biggest lender to U.S. commercial properties, but it matters as a key funding source for landlords, and as the closest thing to a real-time snapshot of credit conditions in the property landscape.

The mantra of the CMBS sector for decades has been that it helps diversify risks for real-estate debt investors, regionally and by property type. In theory, when a sector like aging shopping malls falls on hard times, a boom in office space to highflying technology companies could help mitigate the damage.

The problem is tech and office buildings are now concerns too, with Pinterest Inc.
on Monday being the latest to shed San Francisco office space.

CMBS credit spreads in March reflect high anxiety from investors about commercial real estate and default risks. Top AAA-rated bonds from older “conduit” deals that have exposure to different properties nationally, gapped out by almost 45 basis points in March, according to BofA Global, pushing spreads to about 155 basis points above the risk-free Treasury rate.

Higher risk bonds with BBB- ratings were pegged at 950 basis points above the
risk-free benchmark, or a yield of about 13%.

“We might have seen it briefly gap out like this during the depths of COVID,” said David Petrosinelli, senior trader at InspereX. “But you really have to go back to 2008.”

‘Difficult’ out there

A deal with regulators on Monday to sell the deposits and loans of Silicon Valley Bridge Bank out of receivership to First Citizens Bankshares Inc.
helped bolster market tone and to briefly firm up stocks. The S&P 500 index
was lower Tuesday.

Even so, a tough backdrop still lies ahead for landlords, particularly if credit tightens further as roughly $900 billion of commercial property loans mature through 2024 (see chart).

Almost $1 trillion of commercial real estate debt is coming due through 2024

Real Capital Analytics, BofA Global

It took years for commercial property lending to revive after the global financial crisis. What followed next was a decade of low rates that may soon backfire, not only for landlords with debt coming due, but for lenders who let borrowers take out billions in cash in the process.

San Francisco has been touting tax breaks and revival plans for its reeling financial district, while New York City wants rules eased to convert commercial buildings to housing.

Still, rows of eerily vacant 1960-era office buildings filling big-city skylines have become almost a no-go zone for many lenders, while a smaller share of newer trophy buildings have attracted tenants.

Some Wall Street strategists think property prices could fall 30%, while an estimate from Fitch Ratings in 2021 warned that office values could plunge by 54% if companies and workers were to adopt a work-from-home strategy of three days a week.

“Look, there is going to be a lot of pain, but I think people slowly are going to be coming back to the office,” said Daniel Lisser, vice president capital markets, Marcus & Millichap Capital Corp, an arranger of debt and equity financing for commercial real estate. “But right now, it is difficult out there.”

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