It’s exceedingly difficult to even guess what office buildings are worth today, as investors search out data on office-badge swipes and other measures of occupancy. Approximately zero people are optimistic.
But within the consensus of “Offices: Not Good!” there’s still plenty of room for disagreement, as Unhedged’s Ethan Wu observed last week.
Barclays’ Ajay Rajadhyaksha comes down on the “things aren’t good, but aren’t the next financial crisis” side of things. The bank’s economics team argues in an April 27 note that the worst fears of economic contagion from a collapse in office-property valuations could be overdone.
There are a few reasons for this.
1) Offices probably make up less than one-third of the US commercial real estate market, which Barclays sizes at $5.6tn. It’s tough to know exactly how many office CRE loans are out there, the strategists write. In fact, there is even debate over the correct way to the measure the market’s size, with the Fed’s $5.6tn measure conflicting with the Mortgage Bankers Association’s $4.5tn estimate, which excludes owner-occupied buildings (among other differences).
The macro team does some back-of-the-envelope math, and assumes that the share of offices (~25 per cent) in the more transparent conduit CMBS market is comparable to the broader market.
From the bank, with FTAV’s emphasis:
Apply this to the $2.1tn outstanding of non-multifamily loans that banks own, and we ‘guesstimate’ roughly $550bn in office CRE exposure for US banks. Among the big US banks, Bank of America (27% of CRE loan book) and Wells Fargo (22% of CRE loan book) have a significant part of their CRE loan book in office space. But there are also banks like JPMorgan, which has just 9% of its CRE loan book financing office buildings. All in all, the $550bn estimate for bank office CRE holdings, and $900bn for all office CRE outstanding, seems conservative to us.
2) At risk of repeating ourselves (and Unhedged), it’s difficult to know just how poorly offices are doing.
Some headline-grabbing defaults by big-name asset managers (Brookfield and Blackstone, for example) seem . . . strategic. Barclays points out that the firms have defaulted on non-recourse loans for “poor quality properties”.
Office availability, which measures how much space is vacant and how much space will open up in coming months, hasn’t climbed too dramatically since Covid-19, Barclays says. At least compared to San Francisco:
To be sure, the bank’s use of “availability” instead of “vacancy” could be disguising a higher probability of a company abandoning an office, or reducing its use of space, when it’s time to renew its lease.
But that brings us to our next point . ..
3) Office loans — and companies’ leases to use them — are long-term contracts. So there is a long chain of events that must occur for the popularity of WFH to cause widespread defaults on office loans.
From the note:
The borrowers of office CRE loans — aka office landlords — face problems when a large percentage of their leases roll over (and are presumably not renewed), or when their office loan is maturing (and is presumably not being extended or extended at far more expensive levels), or both. Simply a drop in property prices isn’t usually enough to spark a loan default; CRE borrowers usually hold on to a property that continues to generate cash above the debt service requirement, even if the property value has declined.
One interesting point: a good deal of Barclays’ argument rests on the idea that a financial or economic crisis can only be doomsday if there’s a sudden increase in defaults, but that’s a topic for another day.
The bank’s fourth and final argument is pretty clearly true, if primarily for the global systemically important financial institutions.
4) Since the financial crisis, “banks have multiples more capital, leverage is much lower, and policymakers are acutely aware of not allowing counterparty risk to go unreined,” says Barclays.
Barclays makes a GFC comparison to estimate potential losses in office loans:
The worst performance for any conduit vintage is 2007, where 23% of office CMBS went delinquent, thanks to the aftermath of the GFC. That is a peak number, that took several years to develop.
In our view, it would be very hard for bank office CRE performance to deteriorate that much; it seems very much an uber-conservative upper limit. On a $550bn office CRE book, that’s $125bn in loans going bad, in a worst case scenario. But even this would be spread out over at least a few years. The numbers just don’t seem large enough to make a dent in aggregate bank capital. In fact, a few banks have come out recently with their expected losses over the life of the loan under various economic scenarios, probability-weighted. PNC, for example, puts a cumulative loss number of 7.1% on the office book, and Wells Fargo is at 5.8%. And banks emphasise that this will take years to play out, not a couple of quarters.
The comparison is a little rough, to be sure, because offices weren’t the centre of the GFC storm; that was residential mortgages.
So what if the office-market meltdown does spread across markets? From Barclays:
We considered how this could possibly rise to the level of a macro issue and the most likely path would be as follows. Say a couple of small banks do get into deep trouble due to their office CRE loans. Assume that a large share of their office loans are all maturing at once, their borrowers are all in deep trouble and haven’t staggered out lease rollover, etc. This is all against the average numbers seen in Figures 4 and 5, but not impossible for some banks. Markets might immediately extrapolate from these examples, CMBS spreads could increase to crisis levels, and the issuance market for CRE and CMBS could effectively shut down.
And even in that case, the bank says, there is another bright side for Wall Street.
Remember, the GFC provided investors with an (arguably) once-in-a-generation opportunity to pick up securities at ultra-high yields when shit really hit the fan.
Investors in non-agency MBS post GFC will fondly remember that the asset class produced double-digit returns virtually every year for a few years from 2009. It wasn’t because the fundamentals were improving. And it wasn’t because there was new non-agency MBS issuance. Rather, in the aftermath of the GFC, there was so much concern about the asset class that the market collectively marked these bonds down to extreme valuations. And then, as the years passed, it became clear that even with historical losses, post-GFC valuations were so unreasonably low that the bonds had a lot of room to re-price higher. A similar outcome in office CRE is, we suppose, not entirely out of the question.
So, uh . . . prepare your dry powder and BTFD in CMBS!?