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Since the start of 2023, there have been a number of headlines declaring the distressed commercial real estate market is going to cause a financial crisis. However, there have also been news stories assuring readers that issues in this market are unlikely to cause financial upheaval. The truth is, crises of any kind (financial, housing) are incredibly hard to predict. Even forecasters who accurately predicted a crisis in the past are unlikely to be able to predict an upcoming one.
That being said, there are current, noticeable trends happening in the commercial mortgage-backed securities market that are worth discussing. These trends can affect clients via fluctuating levels of overall wealth, the need to revise financial plans, and an evaluation of portfolio holdings. Importantly, news about these trends, whether they persist or are even accurate, can have a significant effect on clients’ financial decision-making. As a Financial Professional (FP), it is important to understand both the financial implications of established trends as well as the emotions that surround news of those trends, regardless of their veracity.
The COVID-19 pandemic changed many things. In the context of the commercial real estate market, the most important changes are (1) the move to remote/hybrid work schedules and (2) supply chain issues.
Regarding (2), supply chain disruptions led to reduced product supply, which, in turn, increased prices and sustained inflation. To combat inflation, the Federal Reserve Board has raised interest rates ten times since March 2022.1 The importance of (2) is that it has resulted in mortgage rates higher than we’ve seen in two decades.
During the COVID-19 pandemic, many companies moved to a remote work schedule. As lockdowns eased, some companies resumed normal work schedules or initiated a hybrid schedule (e.g., all employees must be in-person Tuesday – Thursday). However, these changes have not restored office occupancy rates to pre-COVID levels—the proportion of U.S. workers returning to the office has plateaued at about half of what it was before the pandemic.2 Speaking to this, the U.S. office vacancy rate was just over 16% at the end of Q1 2023—compared to about 12% in Q1 2020.3 In some major markets, the vacancy rates are above 23%.4 Combine this with the large-scale tech layoffs that happened in the past few months, and businesses have become increasingly averse to expanding their office space or renewing their leases.
During the pandemic, many investors went on a bit of a buying spree in the multi-family sector as borrowing costs were low and rents increased.5 However, increasing rents also increased property values; but since borrowing was relatively cheap, investors accepted the higher prices thinking that a continued trend in increasing rents would still give them a positive ROI. There were two problems with this approach: (1) approximately one-third of investors financed their purchases with a floating-rate loan6, and (2) rents have slowed as new supply enters the market. For the former, investors are looking at increased costs—either because of the increasing cost of interest rate protection on the loans7 or because of increased borrowing costs if they refinance at the much higher current rates. Regardless of the source, these increased costs are often making commercial rental properties a losing proposition.
The other factor affecting the profitability of multi-family rentals is a slowdown in rent growth. Apartment rents have fallen in every major metro area since August 2022.8 This is due in part to the increased cost of living, suggesting many renters are at the max of the income they can devote to housing costs, but also to a sharp increase in supply. It is estimated that almost 500,000 new apartments will be available this year alone.9 This increase in supply drives down rents due to more competition and also means rents could fall further as more and more renters hit the end of their leases and choose to find a cheaper apartment instead. This will further erode the profits of rental apartment investors who purchased during the pandemic.
Given the non-recourse10 nature of commercial mortgage-backed securities, many corporate landlords are choosing to let their loans default rather than continuing to throw money into a losing asset—defaults in June 2023 were 4.5% compared to 1.7% at the same time last year.11 With the dramatic surge in borrowing costs due to the increased interest rate, many corporations are realizing their commercial real estate holdings are worth less than the loans on them12, and this is only exacerbated if they attempt to refinance. While foreclosures on these commercial buildings won’t financially ruin their corporate landlords, it will have a ripple effect on financial institutions holding the debt, as almost $1.2 trillion of debt is backed by this type of real estate.13 Of most concern is the fact that $270 billion in commercial mortgages held by banks, the largest amount to-date, is set to expire this year alone.14 And most of that expiring debt is held by smaller banks that will be impacted significantly more by reduced cash-flows and valuations than larger banks.15
While this sounds troubling, it is important to keep in mind that banks have been more conservative in their lending approach compared to the period before the 2008 financial crisis, so these simmering issues with commercial property debt do not mean a banking crisis is imminent. Further, protections were put in place after the financial crisis that allow banks to keep loans on their books at full value, even if the property supporting that loan is worth less than the remaining loan balance. These measures were put in place with the expectation that many debtors would be able to repay at some point (i.e., when property values increase, or interest rates are lowered). This allows lenders and borrowers to get through rough patches without causing a banking crisis. Of course, if rates don’t decrease and defaults increase (i.e., if corporate landlords refuse to restructure) banks’ real estate portfolios will see a significant decrease in value.
While some clients may be invested in commercial real estate, most are probably not. For those who are, any decisions to change investments or sell should be carefully considered in the context of both the short- and long-run. The primary concern for most FPs will be managing the emotional reactions clients have to repeated news about a looming banking crisis, especially given the still-recent collapse of Silicon Valley Bank (and others). Ultimately, many clients may be overestimating the likelihood of a crisis occurring and overreacting as a result.
The adage is, “Hindsight is 20/20.” Given that the hindsight bias is ubiquitous and occurs as a normal (unconscious) part of information processing, the saying really should be, “Hindsight is 20/10.” We don’t just see things more “clearly” when we look backwards, we add to what we see—often creating a neatly-packaged narrative to explain everything that happened. This sense of inevitability is largely illusory—events appear more predictable than they are because we can only see them through the lens of what we know already happened. When analysts and journalists warn of an impending financial crisis, they point to indicators that should have been red flags before the last crisis—glaring, overwhelming red flags that almost no one picked up on at the time. And because of that, we all think we (or at least the experts) should be able to tell if another financial crisis is forthcoming.
In reality, outcomes are always affected by randomness (i.e., luck—both good and bad). This means that nothing can be ascribed to a narrative until looking back and stripping away the unexpected—replacing it with a perfectly predictable storyline. But the feeling of knowing and understanding is what really matters—clients will find predictions of a financial crisis more believable because there are some parallels between what is happening now and what happened in 2008. But this ignores the many dynamics at play, how supply and demand shift together, how consumer tastes can change rapidly, and how protections were put in place after the last crisis to prevent the same thing from happening again.
To help counter hindsight bias, FPs should present easily accessible counterfactuals to the prediction the client is concerned about. For example, if a client is anxious there may be a bank run because of commercial real estate issues, come up with one or two other outcomes that could occur just as believably. You have to make sure these alternatives are easy to think of and plausible—alternatives that are difficult to think of or that require overly complex lines of reasoning can make the hindsight bias worse (i.e., make them think the likelihood of a bank run is even greater). It is best to have one or two alternatives to discuss rather than relying on the client to come up with alternatives (again, if a client experiences difficulty thinking of alternatives, they will infer that difficulty means the alternatives are less likely to happen). Potential examples to use with clients include:
Notes: Total Vacancy represents the vacancy rates for the specified metro area; YoY Change is the percentage change in the vacancy rate from 12-months prior. Positive YoY Changes indicate higher vacancy rates compared to July 2022; negative YoY Changes indicate lower vacancy rates compared to July 2022.
To identify which clients may be most affected by hindsight bias (and thus believe financial/banking crises are more predictable than they are), you can use our Financial VirtuesTM survey, which identifies several financial blind spots that clients may have. One of these blind spots is the hindsight bias. Clients who score higher on the hindsight blind spot are clients you should be checking in with when analysts are predicting a replay of extreme events. Other blind spots can also make clients more likely to believe a crisis is inevitable—clients who are more prone to confirmation bias, overconfidence, and illusions of control are also more likely to overreact to expert predictions.
With Atlas Point’s Client BeFi Insights and Financial VirtuesTM survey, FPs can easily identify clients who may be overreacting to current events. While this identification, in and of itself, is important, our platform also provides you with specific recommendations and actions you can take to guide clients through current (and life) events. This means you can efficiently personalize your communications with clients—checking in with them when they need it the most.
News warning of a potential financial crisis caused by commercial real estate debt issues plays into individuals’ tendency to overreact to predictions of extreme events. Cognitive illusions make the past seem more understandable than it is, which in turn makes the future seem more knowable than it is. As an FP, it is imperative to understand the financial blind spots that can lead your clients away from their financial goals—and how those blind spots can be exacerbated by current events.
In next week’s post, we’ll turn to the residential housing market—reviewing recent trends and discussing how those trends (and news oft hose trends) can affect clients.
[1] Nowacki, Lauren. “2023 Fed Rate Hike Impact on Mortgages, Home Buying and More.” Rocket Mortgage, Jul 04 2023, https://www.rocketmortgage.com/learn/fed-rate-hike.
[2] Grant, Peter. “Office Landlord Defaults Are Escalating as Lenders Brace for More Distress.” The Wall Street Journal, 21 Feb 2023, https://www.wsj.com/articles/office-landlord-defaults-are-escalating-as-lenders-brace-for-more-distress-894938c0.
[3] “U.S. Office Vacancy Rates by Quarter 2017-2023.” Statista, https://www.statista.com/statistics/194054/us-office-vacancy-rate-forecasts-from-2010/.
[4] See [3] and [18].
[5] Rents increased 25% over two years starting in late 2020. See: Parker, Will. “Apartment Rents Fall as Crush of New Supply Hits Market.” The Wall Street Journal, 27 Feb 2023, https://www.wsj.com/articles/apartment-rents-fall-as-crush-of-new-supply-hits-market.
[6] Parker, Will, and Konrad Putzier. “Rising Interest Rates Hit Landlords Who Can’t Afford Hedging Costs.” The Wall Street Journal, 17 Jan 2023, https://www.wsj.com/articles/rising-interest-rates-hit-landlords-who-cant-afford-hedging-costs-11673900169.
[7] For floating rate loans, borrowers pay for protection in the form of interest-rate caps. This allows the borrower to avoid paying interest payments beyond a specified threshold (e.g., 5% interest). However, the cost of this protection has increased ten-fold in the past year. See: Parker, Will and Konrad Putzier, “Rising Interest Rates Hit Landlords Who Can’t Afford Hedging Costs.” The Wall Street Journal, 17 Jan 2023.
[8] Parker, Will. “Apartment Rents Fall as Crush of New Supply Hits Market.” The Wall Street Journal, 27 Feb 2023, https://www.wsj.com/articles/apartment-rents-fall-as-crush-of-new-supply-hits-market.
[9] See [7].
[10] Borrowers can simply walk away from the property without incurring further financial damages (i.e., to other parts of their business).
[11] Gittlesohn, John. “Starwood Defaults on $212.5 Million Atlanta Office Mortgage.” Bloomberg, 18 Jul 2023, https://www.bloomberg.com/news/articles/2023-07-18/starwood-defaults-on-212-5-million-atlanta-office-mortgage.
[12] The higher vacancy rates for office buildings reduces the property value. Couple that with increased borrowing costs via interest rates, and many landlords are left with properties worth less than the total amount of the loan (principal + interest). This can happen either via increased lending costs for borrowers with variable rates or via refinancing when the loan expires.
[13] See [11].
[14] Putzier, Konrad, and Peter Grant. “Commercial Property Debt Creates More Bank Worries.” The Wall Street Journal, 21 Mar 2023, https://www.wsj.com/articles/commercial-property-debt-creates-more-bank-worries-b36184ba.
[15] Banks with less than $250 billion in assets hold approximately $2.3 trillion in commercial real estate debt (this includes properties other than office buildings as well)—this is about 80% of such debt held across all banks in the U.S. See [14].
[16] Spiro, Nicholas. “Next Financial Crisis is Unlikely to be Triggered by US Commercial Property.” South China Morning Post, 4 May 2023, https://www.scmp.com/comment/opinion/article/3219332/next-financial-crisis-unlikely-be-triggered-us-commercial-property.
[17] Woodhouse, Skylar, and Amanda Albright. “Boston Offers Tax Breaks to Turn Empty Offices into Housing.” Bloomberg, 12 Jul 2023, https://www.bloomberg.com/news/articles/2023-07-12/boston-offers-tax-breaks-to-turn-empty-office-glut-into-housing.
A tax break of 75% can make a huge difference—for a building with an assessed value of $10 million, annual taxes could be $26,850 (vs. $246,800).
[18] “National Office Report.” CommercialEdge, July 2023, accessible here: https://www.commercialedge.com/wp-content/uploads/sites/75/2023/07/CommercialEdge-Office-National-Report-July-2023-1.pdf.