An Overlooked Opportunity

By Clear Perspective Advisors on October 17, 2024

The Onset of the Commercial Real Estate Fears

The Federal Reserve began its rate-hiking cycle two and a half years ago in March 2022. At the time, inflation was on its incline and the consumer price index (CPI) increased 8.5% y/y that month. Pandemic-induced stimulus and supply/demand imbalances led to once-in-a-generation inflation, and the Fed’s answer was to hike interest rates at 11 consecutive meetings from near zero to 5% in just over a year.

All seemed well until Silicon Valley Bank (SVB) failed in the spring of 2023, spurring concerns across regional banks. Questions emerged surrounding bank capitalization, asset quality, and fears of a widespread “run on banks”. Signature Bank and First Republic quickly followed SVB as deposits were pulled and underwater fixed income portfolios needed to be quickly liquidated in order to fill withdrawal requests.

The Fed’s near-infinite interest rate rise off its decade-long zero interest rate policy (ZIRP) made fixed income portfolios rapidly decline. Bonds that were issued in 1-2% interest rate environments quickly lost value in a 5% economy, and bank portfolios began to be questioned – specifically commercial real estate (CRE) loans. The post-covid world quickly turned virtual and there was less need for large, corporate office space. High interest rates declined real estate valuations, specifically office space which declined by 50% in cities like San Francisco and Los Angeles.^[1] Buildings that had been purchased for over $150 billion in 2018 have recently sold for less than $50 million in New York City and financial hubs around the world.^[2] Furthermore, a looming debt-maturity wall made investors question the viability of these properties; over $1.2 trillion of commercial mortgages will mature by 2025. This debt will need to be renewed at a much higher rate, and the value of these properties is being examined in a new economic regime.

Chart 1: The Commercial Real Estate Market Faces a $1.2 Trillion Debt Maturity Wall^[3]

Has Anything Changed?

2022-2023 sparked fears in the real estate sector due to an unknown interest rate path. How high would the Fed raise interest rates, and for how long would they be held at that rate? The MSCI World Real Estate Index fell by a third from the start of 2022 to October 2023 and the national office vacancy rate hit 19.6% in Q4 2023, an all-time high and the highest rate since 1991^[4]. Sales volumes also took a hit, and it is estimated that CRE properties lost $590 billion in value last year.^[5]

Chart 2: Office Space Valuations Fell by Over 40% in Many Major U.S. Cities^[6]

But it appears that CRE valuations may have troughed in 2023. J.P. Morgan expects commercial mortgage-backed security (CMBS) issuance to rise 25-30% this year relative to 2023 and expects multi-family, retail, and industrial properties to perform well. The interest rate picture is also much clearer as the Fed began its rate-cutting cycle last month with a 50 bp deduction. Markets, and the Federal Open Market Committee, are expecting more rate cuts to come and project the Fed Funds Rate to be 3.1-3.6% by 2025 – down from 4.75-5% currently.

Rate cuts will further support the real estate and CRE sectors. CRE prices have risen 3% in 2024 and bids for CRE loans have come in much closer to face value than previous years.^[7] Additionally, a number of prominent companies are enticing workers back to the office; Amazon, Disney, JP Morgan, and Starbucks are just a few that are pushing employees back to four plus in-office work weeks. Back-to-office models will further support office demand and assist what has been the worst-performing CRE sector since the pandemic.

Chart 3: Commercial Real Estate Prices Are Rebounding in 2024^[8]

Where Are We Seeing a CRE Turnaround?

Wells Fargo’s (WFC) recent third-quarter earnings report shed light on the much-improving CRE market. Its net loan charge-offs fell by 32% q/q for its CRE loans and 30% q/q across all commercial loans. Net loan charge-offs are the total amount of debt a company expects to never be paid, and declining charge-offs point to an improving loan book. Its allowance for loan losses (money set aside for projected loan losses) is $14.3 billion, down from $14.6 billion in December 2023, and has remained steady at 1.58% of total loans.

The company’s total CRE loan portfolio is $141 billion, down from $145 billion in June and $152 billion last September. CEO Charles Scharf mentioned on the Q3 earnings call that “credit performance improved from the second quarter” and WFC saw lower losses in both its CRE and commercial and industrial loan portfolios.

Scharf noted that the office space remains weak and expects additional charge-offs while maintaining a strong allowance coverage ratio. Its current ratio of allowance for loan losses to total net loan charge-offs (money set aside to cover losses divided by actual losses) is 3.2x, above June’s 2.7x and lower than last September’s 4.3x. To note, office loans make up approximately 3% of WFC’s loan portfolio. WFC is well positioned for any further weakening of office and CRE broadly.

Overall, we expect financial institutions exposed to the CRE sector to see a turnaround amid lower interest rates. Banks will likely report lower losses and keep adequate levels of allowance for losses on their balance sheets. A better interest rate environment will improve valuations and increase financing activity for the sector.

Chart 4: CRE Lending is Expected to Improve in Coming Years^[9]

^[1] Source: Bloomberg. As of November 6, 2023.
^[2] Source: Bloomberg. As of June 10, 2024.
^[3] Source: Mellon. As of April 2024.
^[4] Source: Moody’s. As of January 8, 2024.
^[5] Source: Yahoo Finance. As of December 30, 2024.
^[6] Source: Bloomberg. As of November 6, 2023.
^[7] Source: Bloomberg. As of September 24, 2024.
^[8] Source: Bloomberg. As of September 24, 2024.
^[9] Source: Bloomberg. As of September 24, 2024.