Is the “WFH Nuke” About to Explode?

April 21, 2023

Another major tremor rattled through the economy this past week — this time it was in the commercial real estate (CRE) market.

Multiple news outlets, led by Bloomberg, reported:

The details were pretty unsettling. (All emphases are mine.)

(Bloomberg) — Brookfield Corp. funds have defaulted on a $161.4 million mortgage for a dozen office buildings, mostly around Washington, DC, as rising vacancies hit property values.

According to the report, the loan in default has been transferred to a “special servicer” — a third party company who works with the borrower to try to “resolve the default through some type of loan modification.”

This was not the first default that Brookfield has experienced recently:

Brookfield, a major office owner, previously defaulted on debt tied to two Los Angeles buildings, the Gas Company Tower and the 777 Tower. …  Another Brookfield office property in Los Angeles, 725 South Figueroa St., was transferred to a special servicer and placed on watch by Kroll Bond Rating Agency, according to a note Tuesday.

In still other CRE news…

Landlords including Columbia Property Trust, owned by funds managed by Pacific Investment Management Co., and a venture started by WeWork Inc. and Rhone Group have also defaulted on office debt.

See a trend developing?

In the days of trillion dollar deficits, $160 million may not sound like much. But, like pretty much everything else hitting the economy today, it’s part of a much bigger threat…

Unintended Consequences: Who’da Thought?

I’ve said it before, the only results the government has ever been able to deliver regularly, reliably and without fail… are unintended consequences

This is yet another one. And once again, it goes back to the pandemic lockdowns that turned the global economy on its head. 

During a time of uncertainty, global governments basically took a sledgehammer to their economies by shutting down everything except what were considered essential businesses.

In addition to breaking the global supply chain (which sparked the soaring inflation we’ve been dealing with for the past two years), they pumped trillions of dollars into the economy to keep the businesses they closed afloat.

This was bad enough, but…

By the time things started to get back to some semblance of normalcy, the “work from home” trend had entrenched itself in many businesses that had been struggling to operate. 

And today, with fewer and fewer employees headed back to the office — the aforementioned unintended consequence — the commercial real estate market was sent into convulsions. 

Last October I noted that Meta, in a bid to right its sinking ship, was slashing its real estate obligations:

The social media giant is exercising an option to terminate its lease at 225 Park Ave. South in Manhattan, where it occupied more than 200,000 square feet.

Meta is an extreme example but there’s no denying the trend is on the rise. According to office security swipe card provider Kastle Systems’ Workplace Barometer…

Office occupancy fell 2.2 points to 46.3% last week, according to Kastle’s 10-city Back to Work Barometer. All tracked cities experienced drops in occupancy except for Chicago, most likely due to employees taking time off for Easter, Ramadan or Passover. Houston, Dallas, Austin and New York City saw the biggest declines, falling by 3.5 points or more. Alternatively, Chicago rose by 1.5 points to 49.1% occupancy. The daily high was Tuesday at 57.2%, and the low was Friday at 24.5%.

An occupancy range of 24% to 57%. That’s a lot of unoccupied space. Indeed it may have been due to the holidays but the broader trend is also clearly evident. Bloomberg on the Brookfield default:

Among the dozen buildings in the Brookfield portfolio with the $161.4 million debt, occupancy rates averaged 52% in 2022, down from 79% in 2018 when the debt was underwritten

Offices that are vacant and unrented provide no revenue. Office space that is rented but only half occupied becomes a massive excess cost for the tenant company (who, like Meta, will eventually be looking to downsize). According to its special servicer’s report:

On the Brookfield mortgage, monthly payments nearly tripled from just over $300,000 before the Fed’s rate hikes last year, to about $880,000 in April… 

Commercial real estate analyst CommercialEdge summed it up in their latest National Office Report:

With interest rates trending upward, the economy slowing and demand for office space remaining muted, owners will continue to face difficulties in the foreseeable future… This is especially true for office owners with loans that are maturing in the next three years, which account for more than 9,500 buildings and 17% of all office stock.

According to Peter Kolaczynski, a senior manager there:

The timing is difficult for buildings that have loan maturities on the horizon. However, this won’t be just a 2023 problem but something we will monitor closely for the next three-plus years.

How much does that all add up to in dollars? According to Bloomberg, $400 billion in debt will mature in 2023 and another $500 billion will come due in 2024. Morgan Stanley projects, in all, $2.5 trillion in loans will be coming due in the next five years. That’s more than half of the $4.5 trillion in commercial real estate loans out there.

Which leads to another problem…

Commercial Real Estate’s Unique Dilemma

According to Trepp, a consultant to the commercial real estate and banking markets, commercial real estate loans differ from residential loans in a couple important ways. First the terms of the loans are much shorter averaging between two and 10 years (as opposed to 15 to 30 years in the residential market).

The second and more significant difference is that on commercial loans nearly all the payments go to service the interest. That means principal balances rarely ever get paid back. 

Which means borrowers will often owe a balloon payment amounting to as much as 80-90% of the original loan. 

Which means the ability to refinance becomes a critical part of the commercial market.

Without that ability to refinance, and who would pour money into a half-empty building, more defaults are imminent. The market is beginning to feel the stress already. 

Delinquencies in certain areas are already on the rise; namely the retail sector where delinquencies have risen 67 basis points over the past year, the office space sector which has spiked 162 basis points and the multifamily market that has exploded by 83%.

So Who’s Holding the Bag?

This is where the story gets scary. 

In the never ending quest for financing, these mortgages get chopped up, bundled and sold off as commercial mortgage backed securities (CMBS). They’re also funded by the life insurance industry, GSEs, and various other investment agencies. 

And then there are banks…

Where the CMBS market goes, issuance has been falling off since late 2021 — which means less funding from them.

Commercial Mortgage Backed Securities

Source: The Federal Reserve Bank of St. Louis

More recently the Wall Street Journal reported that life insurers are taking a step back as well…

A February survey by Goldman Sachs Asset Management found that 15% of insurers with commercial real-estate lending businesses said that they plan to shrink their activity this year, more than three times as many in the same survey last year.

On the other hand, small bank CRE loan originations have been on the rise since mid-2021. 

And where that bank lending goes, according to a recent report from Goldman: 

…small and medium-sized banks (<$250bn in total assets) account for ~80% of total commercial real estate lending

A separate report from JP Morgan would tend to confirm that data:

JPM calculates that per the Fed’s weekly H.8 data, small banks have accounted for the lion’s share of CRE lending relative to larger banks. …as of February 2023, small banks account for a staggering 70% of total CRE loans outstanding excluding multifamily, farmland, and construction loans.

Take a look at the charts below. The first chart shows small banks with over twice the exposure to CRE as large banks. The second chart shows the shift in lending that began in 2016

Commercial Real Estate Lending – Billions of Dollars

Source: The Federal Reserve Bank of St. Louis

Commercial Real Estate Lending — Percentage Change

Source: The Federal Reserve Bank of St. Louis

So what does all this add up to?

Remember that Banking Crisis?

It was only about a month back that the nation experienced its second largest bank failure when SVB went under. (Which was immediately followed by Signature Bank.)

The vulnerability to withdrawals (i.e. bank runs) that these small/regional banks demonstrated put the entire economy on high alert. 

Two weeks ago I wrote:

In terms of banks’ securities holdings that are at risk…

Banks’ total securities holdings (mainly agency-backed MBS and Treasuries) stood at $5.5 trillion in December 2022. This implies that securities have lost approximately $5.5 × 14.25% = $780 billion. This is slightly larger than the FDIC’s estimate of banks’ unrealized losses on securities at year-end 2022 of $620 billion. Regardless, these are large losses, equivalent to 28% to 36% of total bank equity.

Now, if everyone holds their breath and nothing changes in the next three to five years, this loss in value would amount to nothing. But if banks were forced to realize those losses, i.e. sell their securities, the damage would be huge.

Looks like things are changing already!

Apparently working from home is a lot more dangerous than it looks…

Make the trend your friend,

Bob Byrne
Editor, Streetlight Confidential