'Higher for Longer' Is Hurting CRE and These Banks Will Feel the Pain
Even the 'safest' sectors of commercial real estate are deteriorating and regional banks should brace for harsh impacts.
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The yield on the 10-Year Treasury crossed over the 4.6% level earlier this week and the "higher for longer" narrative around interest rates is starting to cause increasing harm to the real estate markets.
Thursday, pending home sales for April came in far worse than anticipated and hit their lowest levels since April 2020, when the country was in COVID-19 lockdown mode. Average home prices are still rising slightly, making housing affordability even worse. However, this is primarily due to the lack of inventory as tens of millions of homeowners have "golden handcuffs" thanks to the low and no-longer-available rates on their current mortgages.
This situation in commercial real estate, or CRE, is much worse. Let me highlight a few news items this week to bring focus to the deteriorating condition of this sector.
This week, it was disclosed that the appraised value of the 1.4 million-square-foot office building known as the Gas Company Tower in Downtown Los Angeles dropped 21% on a year-over-year basis to $215 million. And there are a couple of major issues with the new appraisal, at least for the owner and its lenders. First, the building had an appraised value of $632 million coming off the pandemic. More importantly, the debt against the building includes $350 million in commercial mortgage-backed securities (CMBS) loans and more than $100 million in mezzanine financing.
Los Angeles is hardly alone in dealing with an office sector that is in deep distress. In Chicago, the office vacancy rate has moved up to 16.3% from 11.9% prior to the pandemic. The "availability" rate is much higher. This includes businesses that have already moved out of at least some of their office footprint even as their current leases are still active. Only five large office buildings were sold in Chicago during 2023, with haircuts of between 50% to 90%, it should be noted. Most alarmingly, recent data from KBRA Analytics show that three-fourths of the mortgages backed by Chicago office properties are either in default or are at risk of default.
The good news is that the major banks like Bank of America BAC and JPMorgan Chase & Co. JPM have done a commendable job managing their CRE exposure. Most have allocations of between the mid-single digits to low teens of their loan books allocated to this struggling part of the economy. Unfortunately, regional and community have more like a third of their loan books on average in CRE loans.
Some regional banks went harder into the CRE sector after the pandemic, even as major banks were pulling back. Some like Bank OZK OZK grew their CRE exposure to over 60% by the end of 2023. Now, some of those chickens are coming home to roost. Early this week, Wells Fargo WFC reissued its "sell" rating on this regional bank due to its large exposure to commercial construction lending. The next day, Citigroup C issued a double downgrade around OZK. The analyst there also chopped his price target from $57 a share to $37 a share and reduced his FY2025 EPS estimates by 8%. He took this action because of two large life sciences building loans that make up nearly 4% of the bank’s loan book and that the analyst sees as potentially troubled.
The stock fell some 14% on Wednesday in response to the downgrade. The worrisome part to me is that life sciences is believed to be one of "safest" subsectors of CRE. That makes me wonder what other "cockroaches" are out there, not only for Bank OZK but other regional banks. And what impacts will they have on lending and the economy? If interest rates continue to stay "higher for longer," I have a feeling we are going to find out together in the quarters ahead.
At the time of publication, jensen was short OZK via long date, out of the money bear put spreads.
