The Looming Commerical Real Estate Crisis

After the tremendous amount of stress that the collapse of Silicon Valley Bank (SVB) put on the economy, a lot of people started examining bank holdings and bank positions to see if there were other assets that could be significantly impacted by a continuation of rising rates. One of the largest concerns (with a lot of potential risk) is commercial real estate.

Why is commercial real estate a potential issue?

Over the next 5 years more than 2.5 trillion dollars of commercial real estate will mature (rates will need to be adjusted). This is far more than any other 5-year period in history. Interest rates have nearly doubled, and occupancy rates are sitting at approximately 60%-70% (they are typically 85%-90%). Most commercial real estate properties use floating-rate loans; meaning after a 2-5-10 year period the rate of the loan will be adjusted to the current market rate. Therefore, refinancing these loans will be incredibly expensive in the upcoming years due to the significant increase in interest rates.

Expensive debt = higher monthly payments.

Higher monthly payments + low occupancy rates = defaults.

To make matters worse, roughly 70% of all commercial real estate loans are held by small to medium size banks. This means a rise in commercial real estate defaults could be catastrophic compared to what we saw with SVB.

What types of commercial real estate could be at risk?

The commercial real estate sector that was impacted the most during the COVID-19 pandemic was the office space sector. When employees were sent home during the pandemic, the majority of them never returned back to the office. Most companies realized they were saving an enormous amount of money by keeping their employees working from home. This led to low occupancy rates in office spaces over the past 3 years.

It’s not just office space that’s at risk. Small businesses, which have a large commercial real estate footprint, are filing for bankruptcy faster than they did in the peak of the pandemic. Below is an article from ZeroHedge with more details.

Commerical real estate moving forward.

If interest rates continue to rise, the likelihood of a commercial real estate crisis grows. At its last meeting, the Fed did not indicate it would cut or stop raising rates, but rather focus on taming inflation. This could be problematic for a lot of Americans (not just ones who own commercial real estate). 401Ks, pension plans, and the banks you hold your money in are all tightly tied to commercial real estate. Similar to 2008, there is now a lot of pressure on these assets that wouldn’t be going away soon. One bad move by the Fed could send damaging ripple effects through the economy.

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