Japanese, Canadian, and European banks started to acknowledge their losses. Over the past year, large losses have hit investors, rather than banks.
By Wolf Richter for WOLF STREET.
The mess in the commercial real estate (CRE) sector of the office industry is noteworthy due to the wide and global impact it has generated. Some estimates suggest that these losses, which could reach $1 trillion, have been distributed in diced and sliced form across the globe. This situation has turned out to be beneficial for US banks.
Some US banks have started to disclose the damage and warn about office CRE loans. However, foreign banks are also heavily involved in this issue, such as Canadian banks, Japanese banks, European banks, and various warnings have been issued. Nevertheless, a significant portion of the office CRE loans are held by investors rather than banks, leaving the latter at a disadvantage.
For over a year, we have been discussing this trend – the fact that the largest office CRE losses have impacted investors in Collateralized Loan Obligations (CLOs) and Commercial Mortgage-Backed Securities (CMBS), which are held by institutional investors globally, including bond funds, pension funds, and insurance companies, in addition to entities like REITs and mortgage REITs, whose investors are spread worldwide. This situation has led to the theory that US banks were able to offload their riskiest office property debt by securitizing or selling it to institutional investors around the world during the “office shortage” period when funding was abundant.
The delinquency rate of office mortgages securitized into CMBS surged to 6.3% by loan balance in January, more than tripling year-over-year (up from a delinquency rate of 1.9% in January 2023), according to Trepp, which tracks and analyzes CMBS. This represents a significant deterioration.
The losses in the office CRE sector are divided between lenders and landlords. Landlords lose their equity in the property, and even large landlords like private equity firm Blackstone and private equity firm Brookfield have relinquished their ownership of office properties.
Older office towers that are either empty or have been vacated are the most severely affected. Conversely, the latest and most advanced office towers benefit from a flight to quality, as companies abandon older towers.
Lenders have incurred losses ranging from a substantial portion to nearly all of their loan value when they sell the office tower they had seized through foreclosure or deed-in-lieu-of-foreclosure.
At the top end of losses was a 12-story, 50% vacant, old office tower at 300 W. Adams St., in Chicago, which recently sold for $4 million. This only represents the value of the building itself, excluding the land. Alliance HP had purchased the property for $51 million in 2012 and subsequently divided it into a leasehold interest in the building and a 99-year ground lease. Alliance defaulted on the loan on the leasehold interest, which had been securitized into CMBS. The special servicer representing the bondholders then seized the building via a deed-in-lieu-of-foreclosure and sold it for $4 million. However, Alliance HP still controls the ground lease and continues to collect rent on it.
At the high end of losses was also the vacant 46-story office tower, built in 1985, in downtown St. Louis, which sold for $4.1 million in an April 2022 foreclosure sale, leaving nothing for CMBS holders after fees and expenses, resulting in a 100% loss.
Now, it is the banks’ turn to reveal their losses.
When the three regional banks collapsed last year – Silicon Valley Bank, Signature Bank, and First Republic – it was not due to bad credit, but because of their unrealized losses on their Treasury securities and MBS, leading to a run on uninsured deposits. Unrealized losses among all banks have surged.
New York Community Bancorp [NYCB], which had acquired some of the Signature Bank assets from the FDIC, recently caused a stir when it disclosed various issues: a Q4 loss, declining interest income, the regulatory challenge of becoming a bank with over $100 billion in assets, and a net charge-off that rose to $185 million in Q4, mostly due to two defaulted loans, including an office loan from Q3. The bank has set aside $552 million in loan loss reserves, largely from its CRE portfolio, as it holds $3.4 billion in office loans.
Other US banks have, and will continue to disclose issues in their office loan portfolios.
Foreign banks heavily invested in US office loans. For example, Aozora Bank, a mid-sized Japanese bank, revealed that it had $1.9 billion in US office loans, primarily in major cities such as Chicago and Los Angeles, accounting for 6.6% of its total loans. These US office loans are expected to result in losses for its fiscal year ending in March.
The US CRE market was a significant investment for Japanese banks and other financial firms. With low yields in Japan due to the Bank of Japan’s prolonged interest-rate repression, Japanese firms pursued yield in the US CRE sector, and are now having to manage the consequences.
Major Canadian banks have been negatively impacted by their exposure to the US office sector and have set aside significant capital to address the anticipated losses. Canadian regulators have cautioned about this, assuring that while earnings will be impacted, banks have enough capital to endure the losses. Canada’s Imperial Bank of Commerce (CIBC) may have the most exposure to the US office sector, with approximately 1% of its assets tied up in loans backed by US office properties. According to Bloomberg News, the bank is attempting to offload some of its US office loans.
Similarly, European banks have made significant provisions for loan losses in the US CRE sector. Deutsche Bank AG more than quadrupled its loan loss provisions for US CRE to €123 million, up from €26 million a year ago. About 1.5% of its total loans are loans backed by office towers in various US cities.
Many of these CRE loans are coming up for maturity this year and next, requiring refinancing or extensions. However, with increased interest rates and the structural decrease in demand for office space, refinancing and extending these loans will be challenging, and banks will have to address potential losses.
The key takeaway is that these losses are dispersed globally, affecting institutional investors and banks worldwide. While the US banking system will bear some of these losses, they are not solely responsible for them. Consequently, these losses will impact earnings, dividends, share prices, and certain investors will incur significant losses. The situation is expected to worsen in the next few years, leading to further disclosures from various sources. Nonetheless, the US banking system will only bear a portion of these losses.
The underlying problem is structural and will not disappear with changing market conditions or declining interest rates.
For years, the real estate industry propagated the idea of an “office shortage,” prompting companies to secure unused office space for future use. Consequently, developers continued to build new office towers based on this supposed scarcity, while companies stockpiled office space that was ultimately unnecessary.
However, during the Covid pandemic, corporations realized that they did not require as much office space, prompting them to sublease their existing space and terminate other leases. This shift led to an oversupply of office space, exacerbated by the collapse of WeWork in many cities.
The availability rates for office space on the market for lease, either directly by the landlord or as a sublease, surged. For instance, in San Francisco, the availability rate increased from single digits in 2019, when it was the hottest office market in the US, to 36.7% in Q4 2023. Other cities such as Dallas, Atlanta, and Houston also experienced substantial availability rates.
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