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Greater hidden risk for the post-SVB market

by SuperiorInvest

The beginning of a financial crisis is like finding rotting food in the fridge. Something starts to smell and you think you know what’s rotting, but when you investigate, you find something far worse in the very back of the fridge that you hadn’t thought of in weeks. It might just be my fridge, but you get the analogy. Commercial real estate loans sitting at mid-sized banks across the US is a hidden problem that we are all starting to remember.

U.S. commercial real estate loans are approaching $2.9 trillion, according to St. Louis Fed and regional banks are over-inflated. In the years following the global financial crisis, regional banks turned to commercial real estate lending. It was a place to deploy capital that didn’t require significant technology investment or massive teams, and they could claim more underwriting expertise and compete on price in asset lending in their region. This part of the economy is now under considerable pressure, while the same banks are waging a larger battle over deposit levels.

The two main sources of weakness in the commercial real estate sector are office and retail. Retail is no surprise as a weak area, but this problem comes at the worst possible time. The post-COVID shift to online spending and higher interest rates has accelerated the closure of many retail names. The latest alarm came from Bed, Bath and Beyond in January, which said it could no longer pay its debts. This physical collapse of retail is happening while the office space is experiencing its own weakness due to remote work and artificial intelligence. Owners with variable rate debt will have difficulty refinancing even under status quo dynamics.

CommercialEdge already expects office transaction volumes in 2023 to be at their lowest level since the Great Financial Crisis. The national vacancy rate is currently approx. 17%. Telecommuting and tech-focused layoffs have some hubs like Denver, Seattle, and San Francisco already at more than 18%. That’s before the system breaks through other impacts like SVB fallout and AI rapid deployment. AI is a wild card that I wish I could predict, but I’m not. All I will say is that in a few short months many white collar jobs have already been expanded to the point where smaller teams are probably justified. At some point, this will trickle down to the already stressed office sector.

The problem with commercial real estate loans is that there is no easy fix, as even lower rates may not reverse some of these trends without further negative effects. Remote work will remain in some form, artificial intelligence is out of the box, and online sales are accelerated by COVID.

Given the interconnected impacts on the system we all participate in, there is a chance you could see a concerted effort to support this asset class. Amazon
and Disney have announced back-to-work programs in the past few weeks. House Republicans even announced a bill to eliminate telecommuting for some government employees. Some North American municipalities, such as Calgary, are taking a more proactive approach, providing dollars to convert commercial buildings to residential. How quickly this can overwhelm unused commercial space remains to be seen, but programs like this have been very well received so far. If you can get everyone back downtown, that would be a windfall for the asset class and even energy demand. But the bottom line is that key trends are coming to a head while rates have increased massively. This is a cascading dynamic that typically causes significant asset class depreciation to the point of causing a crisis.

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