$5.6T Commercial Real Estate Debt Looms

Following the financial turmoil at New York Community Bank, Aozora Bank of Japan and Deutsche Bank have also reported financial explosions! Is the domino effect starting again, and will even a Federal Reserve rate cut fail to save the situation?

Since the outbreak of the COVID-19 pandemic, the U.S. commercial real estate market has been in turmoil. However, recent financial explosions at New York Community Bank and Aozora Bank of Japan serve as a reminder that some banks may only just be beginning to feel the pain.

The banking storm spreads to Asia and Europe

On Wednesday, New York Community Bancorp issued a profit warning, stating that ongoing turmoil in the commercial real estate industry led the bank to significantly cut dividends and increase loan loss provisions. Its stock price plummeted by 38% that day, and on Thursday, the stock hit a 23-year low.

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The financial explosion at New York Community Bank seemed to trigger a domino effect. On Thursday, Aozora Bank warned of potential massive losses in its investments in U.S. commercial real estate, expecting a net loss of 28 billion yen ($191 million) for the full fiscal year, compared to a previous forecast of a profit of 24 billion yen. The bank's stock price fell by more than 20% that day.

Aozora Bank wrote down the value of its non-performing office loans by 58%. Overall, the bank's U.S. office loans account for approximately 6.6% of its investment portfolio, or about $1.89 billion. Aozora Bank stated that 21 office loans worth $719 million were classified as non-performing loans, so the bank increased its U.S. office loan loss provision rate from 9.1% to 18.8%.

Tomoichiro Kubota, a senior market analyst at Matsui Securities Co., said, "This is shocking." He added, "People expected the worst to be over, and banks had set aside enough provisions." However, this may not be the case.

In Europe, Germany's largest bank, Deutsche Bank, disclosed that its loss provisions for U.S. commercial real estate in the fourth quarter of 2023 increased by more than four times year-on-year. The bank set aside €123 million ($133 million) for its related investment portfolio, far exceeding the €26 million in the same period of 2022, and nearly double the amount set aside by the bank in the third quarter of 2023.

The successive flashing red warning signals not only indicate that a tsunami of office loan defaults may still occur but also that banks are still severely under-prepared in the face of the impending "massacre."

Is a wave of commercial real estate loan defaults inevitable? Regional banks face significant risks.The ongoing decline in commercial real estate values may expose banks to unpredictable losses on commercial property loans. As the pandemic has led to a shift towards remote work and interest rates have risen rapidly, borrowers in a tight financial position face increased costs for refinancing. Billionaire investor Barry Sternlicht warned this week that the office market could face losses exceeding one trillion dollars.

For banks, this implies the potential for more defaults as some landlords struggle to repay loans or simply vacate buildings.

"This is a significant issue that the market must consider," said Harold Bordwin, head of Keen-Summit Capital Partners LLC in New York, which specializes in renegotiating distressed assets. "Bank balance sheets do not take into account the fact that a substantial amount of real estate loans will not be repaid upon maturity."

Moody's Investors Service indicated that, following Wednesday's developments, the company is considering downgrading New York Community Bank's credit rating to junk status.

According to data from Trepp, a commercial real estate data provider, banks will have a combined total of about $560 billion in commercial real estate debt maturing by the end of 2025, accounting for more than half of the total real estate debt maturing during the same period. Regional banks are particularly vulnerable to the commercial real estate sector and are hit harder than large banks, as they lack the large credit card portfolios or investment banking operations that can withstand risks.

On Wednesday, the KBW Regional Bank Index fell by 6%, marking its worst performance since the collapse of Silicon Valley Bank last March. The index dropped another 3.2% on Thursday.

A report released by J.P. Morgan in April last year showed that commercial real estate loans account for 28.7% of small banks' assets, while the figure for large banks is only 6.5%.

Justin Onuekwusi, Chief Investment Officer at wealth management firm St. James's Place, said: "It is clear that the link between commercial real estate and regional banks is a tail risk for 2024, and if there are any cracks in the financial market, they may appear in the commercial real estate and banking sectors."

David Aviram, head of Maverick Real Estate Partners, warned: "Compared to the default situation that will occur in 2024 and 2025, the proportion of overdue loans reported by banks so far is just a drop in the ocean. Banks still face significant risks, and the upcoming interest rate cuts will not solve the banks' problems."

However, Federal Reserve Chairman Powell conveyed further bad news to the commercial real estate industry at yesterday's Federal Open Market Committee (FOMC) meeting, warning that a rate cut in March may not happen (of course, it's not certain if there's a shock). Moreover, most notably, the Fed removed the following sentence from its policy statement: "The U.S. banking system is sound and resilient."Skeptics have pointed out that the Federal Reserve no longer considers the "U.S. banking system to be sound and resilient" - is this a signal of recent economic turmoil, or was it previously just a lie? Now that the dominoes in the banking industry are falling again, does this mean that Powell will be forced to lend a helping hand?

In summary, the chaos in commercial real estate or regional banks is far from over, and may even intensify during the election cycle, which could pose challenges for the Biden administration.