Only two months ago, SL Green & Co. chief executive Marc Holliday was sounding happy. The head of New York’s biggest commercial landlord firm told Wall Street analysts that traffic to the company’s buildings was picking up, and more than 1 million square feet of space was either recently leased or in negotiations. The company’s debt was down, it had finished the structure for its 1 Madison Avenue tower in Manhattan, and local officials had just completed an extension of commuter rail service from Long Island to Green’s flagship tower near Grand Central Station.
“We are full guns blazing,” Holliday said on the quarterly earnings call, with workers headed back to offices after a pandemic that rocked developers as more people worked from home, raising the question of how much office space companies really need any more. “We can hopefully …continue on a path to what we think will be a pivot year for us in 2023.”
Then Silicon Valley Bank failed, and Wall Street panicked.
Shares of developers, and the banks that lend to them, dropped sharply, and bank shares have stayed low. Analysts raised concerns that developers might default on a big chunk of $3.1 trillion of U.S. commercial real estate loans Goldman Sachs says are outstanding. Almost a quarter of mortgages on office buildings must be refinanced in 2023, according to Mortgage Bankers’ Association data, with higher interest rates than the 3 percent paper that stuffs banks’ portfolios now. Other analysts wondered how landlords could find new tenants as old leases expire this year, with office vacancy rates at record highs.
How much an office crash could hurt the economy
There are reasons to think the road ahead will be rocky for the real estate industry and banks that depend on it. And the stakes, according to Goldman, are high, especially if there is a recession: a credit squeeze equal to as much as half a percentage point of growth in the overall economy. But credit in commercial real estate has performed well until now, and it’s far from clear that U.S. credit issues spreading outward from real estate is likely.
“There’s a lot of headaches about calamity in commercial real estate,” said Kevin Fagan, director of commercial real estate analysis at Moody’s Analytics. “There likely will be issues but it’s more of a typical down cycle.”
The vacancy rate for office buildings rose to a record high 18.2% by late 2022, according to brokerage giant Cushman & Wakefield, topping 20 percent in key markets like Manhattan, Silicon Valley and even Atlanta.
But this year’s refinancing cliff is the real rub, says Scott Rechler, CEO of RXR, a closely-held Manhattan development firm. Loans that come due will have to be financed at higher interest rates, which will mean higher payments even as vacancy rates rise or remain high. Higher vacancies mean some buildings are worth less, so banks are less willing to touch them without tougher terms. That’s especially true for older, so-called Class B buildings that are losing out to newer buildings as tenants renew leases, he said. And the shortage of recent sales makes it hard for banks to decide how much more cash collateral to demand.
“No one knows what is a fair price,” Rechler said. “Buyers and sellers have different views.”
What the Fed has said about commercial real estate
Federal Reserve officials up to and including Chair Jerome Powell have stressed that the collapse of Silicon Valley Bank and Signature Bank were outliers whose failures had nothing to do with real estate – Silicon Valley Bank had barely 1 percent of assets in commercial real estate. Other banks’ exposure to the sector is well under control.
“We’re well aware of the concentrations people have in commercial real estate,” Powell said at a March22 press conference. “I really don’t think it’s comparable to this. The banking system is strong, it is sound, it is resilient, it’s well capitalized.”
The commercial real estate market is a bigger issue than a few banks which mismanaged risk in bond portfolios, and the deterioration in conditions for Class B office space will have wide-reaching economic impacts, including the tax base of municipalities across the country where empty offices remain a significant source of concern.
But there are reasons to believe lending issues in commercial real estate will be contained, Fagan said.
The first is that the office sector is only one part of commercial real estate, albeit a large one, and the others are in unusually good shape.
Vacancy rates in warehouse and industrial space nationally are low, according to Cushman and Wakefield. The national retail vacancy rates, despite the migration of shoppers to online shopping, is only 5.7%. And hotels are garnering record revenue per available room as both occupancy and prices surged post-Covid, according to research firm STR. Banks’ commercial real estate lending also includes apartment complexes, with rental vacancies rates at 5.8 percent in Federal Reserve data.
“Market conditions are fine today, but what develops over the next two to three years could be pretty challenging for some properties,” said Ken Leon, who follows REITs for CFRA Research.
Still, most debt coming due in the next two years looks like it can be refinanced, Fagan said.
That’s one of the reasons Rechler has been drawing attention to the issues. It shouldn’t sneak up on the market or economy, and it should be manageable with the loans spread out across their own maturity ladder.
About three-fourths of commercial real estate debt generates enough income to pass banks’ recent refinancing standards without major changes, Fagan said. Banks have been extending credit using a rule of thumb that a property’s operating income will be at least 8% of the loan every year, though other experts claim a 10% test is being applied to some newer loans.
To date, banks have had virtually no losses on commercial real estate, and companies are showing little need to default either on loans to banks or rent payments to office building owners. Even as companies lay off workers, the concentration of job losses among big tech employers, in Manhattan, at least, means that tenants have no trouble paying their rent, S.L. Green said.
Bank commercial mortgage books
Take Pittsburgh-based PNC Financial, or Cincinnati-based Fifth Third, two of the biggest regional banks.
At PNC, the $36 billion in commercial mortgages on the books of the bank is a small fraction of its $557 billion in total assets, including $321.9 billion in loans. Only about $9 billion of loans are secured by office buildings. At Fifth Third, commercial real estate represents $10.3 billion of $207.5 billion in assets, including $119.3 billion in loans.
And those loans are being paid as agreed. Only 0.6% of PNC’s loans are past due, with delinquencies lower among commercial loans. The proportion of delinquent loans fell by almost a third during 2022, the bank said in federal filings. At Fifth Third, only $10 million of commercial real estate loans were delinquent at year-end.
Or take Wells Fargo, the nation’s largest commercial real estate lender, where credit metrics are excellent. Last year, Wells Fargo’s chargeoffs for commercial loans were .01 of 1 percent of the bank’s portfolio, according to the bank’s annual report. Writeoffs on consumer loans were 39 times higher. The bank’s internal assessment of each commercial mortgage’s loan’s quality improved in 2022, with the amount of debt classified as “criticized,” or with a higher-than-average risk of default even if borrowers haven’t missed payments, dropping by $1.8 billion to $11.3 billion
“Delinquencies are still lower than pre-pandemic,” said Alexander Yokum, banking analyst at CFRA Research. “Any credit metric is still stronger than pre-pandemic.”
Wall Street is worried
The riposte from Wall Street is that the good news on loan performance can’t last – especially if there is a broader recession.
In a March 24 report, JPMorganChase bank analyst Kabir Caprihan warned that 21% of office loans are destined to go bad, with lenders losing an average of 41% of the loan principal on the failures. That produces potential writedowns of 8.6%, Caprihan said, with banks losing $38 billion on office mortgages. But it is far from certain that so many projects would fail, or why value declines would be so steep.
RXR’s Rechler says that market softness is showing in refinancings already, in ways banks’ public reports don’t yet reveal. The real damage is showing up less in late loans than in the declining value of bonds backed by commercial mortgages, he said.
One sign of the tightening: RXR itself, which is financially strong, has advanced $1 billion to other developers whose banks are making them post more collateral as part of refinancing applications. Rechler dismissed rating agencies’ relatively sanguine view of commercial mortgage backed securities, arguing that markets for new CMBS issues have locked up in recent weeks and ratings agencies missed early signs of housing-market problems before 2008’s financial crisis.
The commercial mortgage-backed bond market is relatively small, so its short-term issues are not major drivers of the economy. Issuance of new bonds is down sharply – but that began last year, when fourth-quarter deal volume fell 88 percent, without causing a recession.
CMBS issuance
Loan type
Q1 2022
Q1 2023
Conduit
$7.9B
$2.3B
SASB
$19.1B
$2.7B
Large loan
$442.6M
$13.1M
CRE CLO
$15.3B
$1.5B
Total
$42.8B
$6.5B
Source: Trepp
“The statistics don’t reflect where it’s going to come out as regulators take a harder look,” Rechler said. “You’re going to have to rebalance loans on even good properties.”
Wells Fargo has tightened standards, saying it is demanding that payments on refinanced loans take up a smaller percentage of a building’s projected rent and that only “limited” exceptions will be made to the bank’s credit standards on new loans.
Without a deep recession, though, it’s not clear how banks’ and insurance companies’ relatively diversified loan portfolios get into serious trouble.
The primary way real estate could cause problems for the economy is if an extended decline in the value of commercial mortgages made deposits flow out of banks, forcing them to crimp lending not just to developers but to all customers. In extreme cases, that could threaten the banks themselves. But if developers continue to pay their loans on time and manage refinancing risk, MBS owners and banks will simply get paid as loans mature.
Markets are split on whether any version of this will happen. The S&P United State REIT Index, which dropped almost 11% in the two weeks after Silicon Valley Bank failed, has recovered most of its losses, down 2% over the past month and remains barely positive for the year. But the KBW Regional Banking Index is down 14% in the last month, even though deposit loss has slowed to a trickle.
The solution will lie in a combination of factors. The amount of loans that come up for refinancing drops sharply after this year, and new construction is already slowing as it does in most real estate downturns, and loan to value ratios in the industry are lower than in 2006 or 2007, before the last recession.
“We feel like there’s going to be pain in the next year,” Fagan said. “2025 is where we see our pivot toward a [recovery] for office.”
After graduating from Bentley University in 2011, he worked as a consultant at PricewaterhouseCoopers for nearly four years. He left PwC to help a family member turn their restaurant business around and re-entered corporate America in 2017 when he got a job at a major insurance company.
“I knew that I wanted to leave my W-2 job at some point,” the 34-year-old told Insider. “In order to do that, you need to generate cash flow on a monthly basis.”
He decided to try real estate investing on the side. Specifically, he wanted to set up short-term vacation rentals.
Based on his research, He was convinced that setting up Airbnb properties, although considered higher-risk than long-term rentals, could produce the most cash flow.
He was right: The San Diego-based investor purchased two investment properties in Scottsdale, Arizona in 2021 and 2022 and turned them both into bachelorette-themed Airbnbs. By mid-2022, the cash flow from his two short-term rental units was enough to cover his family’s expenses, allowing him to quit his day job.
His ‘recession proof’ strategy: continuing to invest in short-term rentals and diversifying with affordable housing units
He prefers short-term rentals because, “you can get super-high cash flow,” he explained. But, at the same time, “I never like putting all my eggs in one basket. Who’s to say another pandemic can’t hit again and everything goes empty?”
“For peace of mind, I want to know that there’s always other cash flow coming in from another asset class,” said He.
In May 2023, he expanded his portfolio and purchased his first affordable housing unit. It’s a single-family home in Fairfield, Alabama that he’ll rent on a long-term basis to a Section 8 tenant.
His plan is to continue growing his Airbnb business, which he still believes is the most effective way to produce cash flow, and use the profits to fund affordable housing units specifically for social workers and EMTs.
He is passionate about providing affordable housing, having seen first-hand how it can change a family’s outcome.
“My parents came over from China with about $1,000,” said He, who was raised in Boston. “My mom tells me the story about how one night when they were living in Chinatown in Boston, they were burglarized and lost about $5,000, over a year’s worth of wages in one night. That could be pretty devastating for most families but she told me she was on a waitlist for affordable housing and that gave her the hope and drive to keep going. Long story short, she finally got her affordable housing unit and she was in tears.”
He expects his affordable housing unit, which he’s currently renovating, to profit $200 a month minimum.
That’s less than what his Airbnb properties bring in, but it allows him to diversify his portfolio. Plus, he knows this rental income will be consistent, whereas short-term rental income can fluctuate.
As a Section 8 landlord, you can collect rent reliably, he explained: “Even if the Section 8 tenant loses their job, the government will come in and pay the rest of the rent. That is what I’m calling a recession-proof investment because the government will always pay their rent on time for your voucher holders.”
Section 8 landlords can also request approval for a rent increase once per year.
“I think it’s the perfect diversification strategy,” said He, whose long-term goal is to acquire 1,000 affordable housing units. “You can supercharge your capital with short term rentals, but you get to keep a diversified portfolio with affordable housing.”
Health and fitness clubs were heavily impacted by the government-mandated COVID-19 closures at the start of the pandemic in 2020. For LA Fitness and its parent company Fitness International, it equated to months of closed facilities that were generating no revenue but requiring monthly lease payments.
There was a great deal of conjecture about whether the “force majeure” provisions in leases would shield businesses that were required to close due to governmentally issued mandates from their payment obligations under their leases. These clauses typically relieve parties from the performance of some or all contractual obligations, and from the consequences of failing to perform those obligations, where performance is rendered effectively impossible by circumstances beyond their control. Many thought the COVID closure fit the bill for the application of such provisions to a tee, and litigation would surely ensue.
Lawsuits were indeed filed, and one of the first cases over this exact question to reach conclusion by a state appellate court was decided recently in favor of the landlord for an LA Fitness location in Bradenton. The state’s Second District Court of Appeal affirmed the lower court’s summary judgment ruling and found the health club would not be entitled to a refund of its lease payments made during the mandated closure period.
The company made all rent payments required under the lease during the lockdown, which was from March 17 to June 12, 2020, but it eventually filed suit in August 2021 seeking a refund of those payments. It primarily based its claims on the lease’s force majeure clause, arguing that it was excused from paying rent during the closure period, and it also relied upon the common law doctrines of frustration of purpose, impossibility of performance, and impracticability of performance.
In response, the landlord argued that the required closure did not preclude or restrict the tenant from performing its contractual obligation to pay rent, which it in fact paid. It also contended that the lease did not require the tenant to operate continuously, nor did it restrict the tenant’s permissible use solely to operating a health club. Therefore, it asserted that neither the force majeure clause nor the equitable doctrines of frustration, impossibility, or impracticability applied.
The trial court agreed, and it found that while the use of the premises “was limited by the COVID restrictions,” no evidence “suggest[ed] that [Landlord] precluded use of the premises or did anything to interfere with [Tenant’s] use of the premises.” It also found the landlord had not “failed to perform any ‘act’ required by the lease.”
Oscar R. Rivera is the managing shareholder of the Coral Gables-based law firm of Siegfried Rivera.
The court concluded that the force majeure clause did not apply to excuse the health club’s rent obligation, and the landlord was not in breach of the terms of its lease by refusing to abate the rent during the closure period.
In the subsequent appeal, the landlord advanced various arguments against the equitable doctrines, primarily maintaining that none apply if the relevant risk was foreseeable. It noted that the risk of government restrictions was foreseeable because the force majeure clause specifically mentions the risk of “restrictive laws.”
The tenant asserted that its rent obligation was excused during the closure period because the landlord was in breach of its contractual warranty that the tenant would have the right to operate a health club throughout the term of the lease.
The appellate panel unanimously disagreed, finding that the meaning of the language in question in the lease agreement only warranted that LA Fitness’s use of the premises as a health club would not violate any exclusive use rights that the landlord had granted or could grant to other tenants. The landlord never warranted that the tenant would have the right to operate a health club from the premises throughout the term.
As to the question of whether the closure constituted a covered event under the lease’s force majeure clause, the panel found that the government-mandated restrictions unquestionably were “restrictive laws.”
However, it rejected the tenant’s argument that the restrictions hindered or prevented it from performing its obligation to pay rent, which it had paid during the closure period, and found that the landlord had not agreed to forgive the tenant’s rent obligation if government-mandated restrictions prevented it from using the premises in a particular manner.
The panel concluded that it is “mindful of the hardships that Tenant and countless other businesses faced at the outset of the COVID-19 pandemic,” but neither the lease nor the equitable doctrines pled supported relief from the tenant’s payment obligations.
With this ruling, Florida businesses with similar lease provisions have been put on notice as to how the state’s courts are likely to view their arguments in analogous cases. The courts may sympathize with all the affected businesses and organizations, but they will rule in accordance with the applicable laws, contractual terms and legal doctrines, and they will be likely to find in favor of the landlords in similar cases.
The spring surge in Toronto house prices accelerated again in May, providing another sign of persistent inflation in parts of the Canadian economy before a key central bank interest rate decision next week.
The benchmark price of a home in Canada’s largest city increased 3.2 per cent last month to $1.14 million on a seasonally adjusted basis, the third straight monthly increase and the biggest since the market peaked in February 2022, according to data released Friday from the Toronto Regional Real Estate Board.
The average selling price, at $1,196,101, fell 1.2 per cent from May 2022 but rose 3.7 per cent from April 2023.
Home prices in Toronto and across Canada tumbled from record highs starting early last year as the central bank began a series of aggressive interest rate hikes to combat inflation. Immediately after the Bank of Canada paused that campaign this year, prices started to bounce back as buyers who had delayed purchases leaped back into the market, only to be confronted with a dearth of homes for sale. In Toronto, the benchmark price is already up 6.8 per cent since February.
“The demand for ownership housing has picked up markedly in recent months,” Jason Mercer, the Toronto real estate board’s chief market analyst, said in a release accompanying the report. “The supply of listings hasn’t kept up with sales, so we have seen upward pressure on selling prices during the spring.”
Though there is some indication the surge in prices is starting to lure sellers back — new listings rose 10.1 per cent in May from the month before — the real estate board data show that even after these homes were put up for sale, demand outstripped supply so much that the market only grew tighter.
One measure of how tight the market is, months of inventory, or how long it would take the market to work through its active listings at the current rate of sales, fell to only 1.3 months. Another measure, the sales-to-new-listings ratio, remained above 70 per cent, indicating more price gains to come, the real estate board said.
