How I Intend to Profit When CRE Gets Hit With Reality

The market has experienced a significant sector rotation in recent weeks as major fund flows have come out of Big Tech. Disappointing results from Alphabet, Inc. GOOGL and Tesla, Inc. (TSLA) after the bell on Tuesday triggered the biggest daily decline in the NASDAQ in trading on Wednesday since late in 2022. 

While the talking heads on CNBC remain focused on the carnage across the Magnificent Seven, let’s not take our eyes off of what is happening in the commercial real estate market. The continued deterioration here bodes ill for the financial markets, especially the regional banking system.

Office values continue to implode across many major cities across the United States. Yesterday’s disaster du jour was a 52-story office building in Los Angeles being sold off to a Chinese investor at the fire-sale price of $120 million, which translates into $117 per square foot. The lenders on this property took a major haircut, given that the previous owner defaulted on a $319 million loan against this once-prime office property.

The delinquency rate against commercial mortgage-backed securities (CMBS) against office collateral has breached the 7.5% threshold and would be much higher, except for all of the "extend and pretend" temporary deferment deals lenders have worked out for borrowers for the time being. Both multi-family and retail also saw large jumps in delinquency rates in June, according to Trepp. Fitch Ratings recently projected that delinquency rates for office properties will exceed those of the Great Financial Crisis in 2025. This is hardly surprising, given office vacancy rates are currently at all-time highs.

Increasing default rates and losses are starting to impact regional banks, who originate approximately 70% of CRE loans and hold some 30% of CRE’s overall liabilities on their loan books. New York Community Bancorp (NYCB) reported a much bigger than expected loss before the bell on Thursday, hardly a good harbinger for second quarter reporting season for the regional banks. After doing a more thorough review of its loan books, the bank found a much larger issue with its CRE loans. As a result, management upped its credit loss provisions to $390 million. This was far larger than the consensus of around $210 million. It also was a significant increase from the $315 million level of the first quarter. In the same period a year ago, NYCB had just under $50 million of credit loss provisions in way of comparison.

Not only is NYCB’s loan book deteriorating but the one it got when it took over most of the assets from the implosion at Signature Bank in the first half of 2023 also has become more problematic. Shares of NYCB lost 3% in trading on Thursday. The losses were quite possibly muted by the company also announcing it was selling off its mortgage servicing unit for $1.4 billion. This will provide a much-needed boost to the bank’s capital base.

However, despite the ominous developments in commercial real estate, most regional banks have moved up sharply in recent months on increasing hopes for rate cuts on the horizon. Unfortunately, 50 bps or even 100 bps of interest rate reductions are not going to more than marginally brighten the prospects for much of the commercial real estate sector. With the SPDR S&P Regional Banking ETF KRE trading at 52-week highs, I have increased the number of long dated, out of the money bear put spreads against this ETF this week. At some point, over the next few months or quarters, the current hopium in this sector is going to meet reality, and I intend to profit from that development.

At the time of publication, Jensen was short KRE.