Fears about the state of commercial real estate (CRE) in the United States have recently resurfaced, rekindled by the unexpected quarterly loss recorded by New York Community Bancorp. The significant provisions made by one of the largest regional banks for potential bad debts linked to the commercial real estate segment, followed by the regulator's inquiries of other institutions, have sent shockwaves through the sector, extending from the office to the multifamily market.
What is the state of the US commercial real estate market? To what extent will this shockwave spread to other US financial entities as well as European banks? What does it mean for other €-denominated credit markets such as REITs, bank debt and notably covered bonds? In a webinar and a special report, Natixis CIB experts take stock on the situation.
Fed set to pivot in May to easier policy
The tailwinds that had propelled growth in 2023 are set to fade. Consumer spending, in particular, is likely to lose momentum as inflation and high interest rates begin to erode the purchasing power of households that have depleted their savings.
As economic sluggishness becomes increasingly evident (2% growth expected for 2024) and inflation continues to ease in 2024, we expect the Fed to pivot towards accommodation, likely at in Q2-24.
This could alleviate the pressure on real estate valuations which have suffered heavily from rising interest rates since 2022. Indeed, transactions in CRE halved from 2022 to 2023 on both sides of the Atlantic while US CRE prices fell by 11% on average.
Multifamily: high available supply weights on rent growth
Existing home sales activity has moderated due to interest rate increase, leading to more and more renters-by-necessity. Meanwhile, construction activity created an oversupply, which is gradually resorbing with slowing completions and still rising demand to rent. Housing supply is therefore high currently. This should be temporary and the market should absorb the new apartment supply over the next 18 to 24 months.
Our experts see a short-term downward pressure on rental growth. They estimate rental growth to remain flat for the next 18 months before bouncing back to +2% or more from end-2025 onwards. Yield shift and accelerating rental growth should therefore support medium to long-term valuations for multifamily properties.
Offices: the remote work storm
The office segment was also in a construction spree until the Fed raised rates, leading to oversupply. Coupled with reduced demand for office space due to the rise of remote working, offices are under particular stress with vacancy rate at record level, around 20% on average, and up to 24% including available spaces from sublease.
Thus, demand / supply balance is very favorable to tenants and buyers, leading to a sharp price decline, especially in office dense district. Central business distric office prices have fallen by an average of -39% from mid-2022 to end-2023 and should continue their downward trend in 2024.
Similarly to the multifamily market, disparities are observed depending on cities and locations. For instance, the return to office policies from financial companies appears to support the New York market, while Sunbelt markets appear better positioned than Seattle, Chicago, San Francisco or Washington DC for instance.
Are US regional banks out of trouble?
US regional banks are the first lender of CRE loans with 50% of market share. The smallest ones are particularly exposed, as CRE loans represent as much as 68% of their total outstanding, compared to 32% for large US banks. More than one-third of regional banks have CRE loans representing more than twice their CET1.
Delinquencies on US bank loans in the commercial real estate market remain generally low, at around 1%. However, CRE delinquencies have increased for the third consecutive quarter. As a result, regional banks have massively increased their provisions, by 90% YoY in Q4-23. This will put pressure on their profitability, at least, especially as the profitability of some small and regional banks will not be sufficient to absorb higher provisions.
Our experts expect this trend to continue in 2024, with an expected further $10bn in provisions for our sample of 25 big regional banks compared to circa $30bn profitability, which means that banks could actually lose 1/3 of their current profitability.
What risk of contagion to European credits?
With €56bn, European banks have relatively little direct exposure to developments in the US market. Most European countries are mainly exposed to domestic commercial real estate market, except for Germany and Ireland.
However, the US and European commercial real estate markets are highly correlated, and developments in the US market could spill over into Europe, as CRE exposures now represent around 8% of European Banks’ total loan books.
Certain German and Nordic banks show much higher exposure. German specialists have the highest exposure in terms of commercial real estate compared to the CET1. For Swedish banks, CRE represents more than 13% of the total loan book.
The European Central Bank might potentially increase the capital requirement for some banks highly exposed to commercial real estate market.
The risk for covered bonds remains limited
German Pfandbriefe have one of the highest exposure to commercial real estate. However, the risk for covered bondholders remains very limited as they benefit from several protection mechanisms.
First, covered bonds are excluded from bail-in. In addition, bondholders have a dual recourse on both the issuer and the cover pool, which is actively managed. Cover assets, notably in Germany, are governed by conservative valuation requirements. Finally, their high overcollateralisation provides good protection against fluctuations and defaults.
Credit conclusions
Although a stress has clearly been seen on some specialized lenders’ debts, our experts hardly believe this could turn into a systemic risk. However, under an adverse scenario, a US CRE crisis could lead to a few weeks of credit volatility as seen after SVB and Credit Suisse failures last year.
If we compare the spread-tightening potential under our base-case scenario (around 10bp for Corp IG spreads vs swap) with the spread-widening risk under that adverse scenario, we conclude that Corporate IG and Covered Bonds currently offer the best risk reward in the credit universe, followed by AT1 bank debt where extension risk is still too much priced in according to our econometric models as well as REIT credits which display too much risk of rating downgrades.
Conversely, our experts recommend being underweight in T2 bank debt as well as HY non-financials given their lower risk/reward versus other credit segments.
