‘Zombie Offices’ Spell Trouble for Some Banks

‘Zombie Offices’ Spell Trouble for Some Banks

Graceful Art Deco buildings towering over Chicago’s main business district have an occupancy rate of just 17 percent.

A series of gleaming Denver office towers that were full of tenants and valued at $176 million in 2013 now sit mostly empty and were last valued at just $82 million, according to data from Trepp, a research firm that tracks real estate loans tracked. Even famous buildings in Los Angeles are fetching about half of their pre-pandemic prices.

From San Francisco to Washington, DC, the story is the same. Office buildings continue to be mired in a slowly simmering crisis. Employees who were required to work from home at the start of the pandemic have not yet fully returned, a situation that, combined with high interest rates, is destroying the value of a key category of commercial real estate. According to data from real estate analysis firm Green Street, prices for even higher quality office properties have plummeted 35 percent since their peak in early 2022.

Those forces have cornered the banks that hold much of U.S. commercial real estate debt — and analysts and even regulators have said the reckoning has not yet fully sunk through. The question is not whether big losses will come. It’s a matter of whether it’s a slow bleeding or a panic-inducing wave.

Last week brought a taste of the trouble brewing as shares of New York Community Bancorp plunged after the lender disclosed unexpected losses on real estate loans tied to both office and residential properties.

So far, “the headlines have moved faster than the actual stress,” said Lonnie Hendry, chief product officer at Trepp. “The banks are sitting on a lot of unrealized losses. If this slow leak is uncovered, it could be released very quickly.”

When a number of banks failed last spring – due in part to rising interest rates that had reduced the value of their assets – analysts feared that commercial real estate could trigger even bigger problems.

According to Trepp’s data, banks hold about $1.4 trillion of the $2.6 trillion in commercial real estate loans maturing in the next five years, and small and regional lenders are particularly active in the market.

Economists and regulators feared that heavy exposure to the sensitive industry could scare away bank depositors, particularly those with savings above the $250,000 limit for government insurance, and prompt them to withdraw their funds.

But government officials responded forcefully to the upheavals of 2023. They helped sell failing institutions, and the Federal Reserve created a cheap avenue for bank financing. The measures restored confidence and the banks’ nervousness disappeared.

That has changed in recent days with the problems at New York Community Bancorp. Some analysts dismiss it as an isolated incident. New York Community Bancorp took over failing Signature Bank last spring, exacerbating its problems. And so far, depositors are not withdrawing their money from the banks in large numbers.

But others see the bank’s plight as a reminder that many lenders are struggling, even if it doesn’t trigger a system-wide panic. The reprieve the government gave the banking system last year was only temporary: the Fed’s financing program, for example, is scheduled to end next month. The problems in commercial real estate continue.

Commercial real estate is a broad asset class that includes retail, multifamily, and factories. The entire industry has had a turbulent few years, with office buildings being particularly hard hit.

According to a recent National Bureau of Economic Research paper by Erica Southern California, Tomasz Piskorski of Columbia Business School and two of their colleagues.

While major lenders such as JP Morgan and Bank of America have begun setting aside money to cover expected losses, many small and medium-sized banks are downplaying the potential costs, analysts said.

Some offices, thanks to years-long lease terms, are still officially occupied, even if there are only a few workers working in them – what Mr Hendry called “zombies”. This can make them appear viable even when they are not.

In other cases, banks are using short-term extensions rather than taking over struggling buildings or renewing leases that are now unworkable – in the hope that interest rates will fall, which would help property values ​​rise, and workers will return.

“If they can extend the loan and maintain its performance, they can delay the day of reckoning,” said Harold Bordwin, principal at distressed real estate brokerage Keen-Summit Capital Partners.

Default rates reported by banks, at just over 1 percent, remain much lower than for commercial real estate loans traded on markets, which are above 6 percent. “This is a sign that lenders have been slow to recognize the construction burden,” said Piskorski, the Columbia economist.

But hopes of a turnaround in the office real estate market appear less realistic.

The trend towards returning to the office has stalled. And while the Fed has signaled that it does not expect to raise interest rates above their current level of 5.25 to 5.5 percent, officials have made clear they are in no rush to lower them.

Mr Hendry expects defaults could almost double from current levels by the end of the year, reaching between 10 and 12 per cent. And as the settlement progresses, hundreds of small and medium-sized banks could be at risk.

Mr. Piskorski and Ms. Jiang noted in their paper that the value of bank assets has fallen amid higher Fed interest rates, meaning increasing commercial real estate losses could leave many institutions in poor shape.

If that unsettles uninsured depositors and leads to the bank run that toppled banks last March, many could fall into total bankruptcy.

“It’s a trust game, and commercial real estate could be the catalyst,” Piskorski said.

Their study estimates that dozens to more than 300 banks could be affected by such a disaster. In a country with 4,800 banks, that may not be a devastating blow – especially because small and medium-sized lenders are not as connected to the rest of the financial system as their larger counterparts. However, a rapid collapse would risk a broader panic.

“There is a scenario where it spills over,” Mr. Piskorski said. “The more likely scenario is a slow bleed.”

Fed and Treasury officials have made it clear that they are closely monitoring both the banking sector and the commercial real estate market.

“Commercial real estate is an area that we have long known could pose financial stability risks or losses in the banking system, and this is something that requires careful regulatory attention,” Treasury Secretary Janet L. Yellen said during testimony this week the Congress.

Jerome H. Powell, the Fed chairman, admitted that “there will be losses” in a “60 Minutes” interview broadcast on February 4th. For big banks, the risk is manageable, said Powell. As for regional banks, he said the Fed was working with them to deal with the expected fallout and that some would have to close or merge.

“It feels like a problem we’ll be working on for years,” Mr. Powell admitted. He called the problem “significant” but said that “it does not appear to have the makings of the crisis conditions that we have sometimes seen in the past, for example in the global financial crisis.”

Alan Rappeport contributed reporting.

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2024-02-08 17:12:09