Commercial real estate is in trouble. Why you should be paying attention

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Economists are growing concerned about the $20 trillion commercial real estate (CRE) industry.

After decades of thriving growth bolstered by low interest rates and easy credit, commercial real estate has hit a wall.

Office and retail property valuations have been falling since the pandemic brought about lower occupancy rates and changes in where people work and how they shop. The Fed’s efforts to fight inflation by raising interest rates have also hurt the credit-dependent industry.

Recent banking stress will likely add to those woes. Lending to commercial real estate developers and managers largely comes from small and mid-sized banks, where the pressure on liquidity has been most severe. About 80% of all bank loans for commercial properties come from regional banks, according to Goldman Sachs economists.

“I do think you will see banks pull back on commercial real estate commitments more rapidly in a world [where] they’re more focused on liquidity,” wrote Goldman Sachs Research’s Richard Ramsden in a note on Friday. “And I do think that is going to be something that will be important to watch over the coming months and quarters.”

Recently, short-sellers have stepped up their bets against commercial landlords, indicating that they think the market will continue to fall as regional banks limit access to credit. Real estate is the most shorted industry globally and the third most in the United States, according to S&P Global.

So just how big of a deal is this threat to the economy? Before the Bell spoke with Xander Snyder, senior commercial real estate economist at First American, to find out.

This interview has been edited for clarity and length.

Before the Bell: Why should retail investors pay attention to what’s going on in commercial real estate right now?

Xander Snyder: Banks have a lot of exposure to commercial real estate. That impacts banking stability. So the health of the market has an impact on the larger economy, even if you’re not interested in commercial real estate for commercial real estate’s sake.

How bad are things right now?

Price growth is slowing and for some asset classes it’s starting to decline. Office properties have been more challenged than others for obvious reasons.

Now private lending to the industry is starting to slow as well — bank lending was beginning to dry up over a month before the Silicon Valley Bank failure even happened. Credit was getting scarce for all commercial real estate and a fresh bank failure on top of that only exacerbates that trend.

How do you expect banking turmoil to make things worse?

I think more regulatory scrutiny is coming for smaller banks, which tend to have a larger concentration of commercial real estate loans. That means small and medium-sized banks are going to tighten lending standards even more, making it more difficult to get loans.

Does the possibility of a looming recession play into this?

As credit becomes scarcer and more expensive, it’s hard to know exactly what buildings are worth. You get this gap opening up between sellers and buyers: Sellers want to get late 2021 prices and buyers are saying ‘we don’t know what things are worth so we’ll give you this lowball offer.’ That was already happening and the result of that price differential was bringing deal activity down.

There’s no broad agreement on asset valuations. Economic uncertainty will exacerbate that trend. And if you’re a bank, it’s a lot more difficult to lend against the value of a building if you don’t know what the value of the building really is.

So how worried should we be?

A lot of people hear commercial real estate and they think it’s all the same thing and the trends are they’re all the same but they’re not. The underlying fundamentals of multifamily and industrial assets remain relatively stable on a national level.

It’s different for office and retail properties. There’s been a fundamental shift in how we use office space and that has changed demand. That’s something you should have your eye on, especially as low-interest office loans come due. We’re running into a situation where office-owners have to refinance at a higher rate and only 50% of the building is being used. That doesn’t translate to good cash flow metrics for the lender.

I think retail also faces challenges. A lot of people are still sitting on excess pandemic savings that are beginning to be spent down and the Fed is certainly trying to nudge unemployment up a little bit. So I imagine that both of those things will impact retail spending and therefore impact retail as an asset class.

Economists forecast recession and elevated inflation

Stagflation, the combination of high inflation and a weakening economy, could make a comeback. The majority of economists expect a recession sometime this year and forecast that inflation will remain above 4%, according to The National Association for Business Economics’ latest survey, released Monday.

It appears as though the fog has lifted since last month’s survey, which showed a significant divergence among respondents about where they think the US economy is heading in 2023.

“Panelists generally agree on the outlook for inflation and the consequences of rate hikes from the Federal Reserve,” said NABE Policy Survey Chair Mervin Jebaraj. “More than seven in ten panelists believe that growth in the consumer price index (CPI) will remain above 4% through the end of 2023, and more than two-thirds are not confident that the Fed will be able to bring inflation down to its 2% goal within the next two years without inducing a recession.”

Still, more than half of NABE Policy Survey panelists expect a recession at some point in 2023. But only 5% believe the United States is currently in one. That’s nearly four times lower than the 19% who believed the US was in a recession in August.?

Banking turmoil brings us ‘closer right now’ to recession: Fed President Kashkari

The recent meltdown in the banking industry could tip the US into recession said Federal Reserve Bank of Minneapolis President Neel Kashkari.

“It definitely brings us closer right now,” he said during a CBS Face the Nation interview this weekend.?

“What’s unclear for us is how much of these banking stresses are leading to a widespread credit crunch. And then that credit crunch, just as you said, would then slow down the economy,” he added.

While Kashkari said that the financial system is “resilient” and “strong” he said that there are still “fundamental issues, regulatory issues facing our banking system.”