Will commercial real estate hurt regional banks?

0:06Pushkin. Shares in New York Community Bancorp fell 40 % yesterday after a pretty brutal fourth quarter earnings call. The regional bank took losses on two real estate loans, one on an apartment building and one on an office building. It all raised uncomfortable questions about the state of the commercial real estate sector, which a lot of folks from regulators to market participants have been worried about. Today on the show, what's going on in commercial real estate and is it going to blow up the economy? This is Unhedge, the markets and finance show from the Financial Times and Pushkin. I'm reporter Ethan Wu here in the New York studio.

0:43Joe, joined by the man who is definitely not going to blow up the U.S. economy, Robert Armstrong. You sell me short, Ethan. I find that a little hurtful. Well, if you can cause a bank run with your columns, maybe it's a different story. And from London, commercial property correspondent, Joshua Oliver. Hey, Ethan. Josh, I don't know what you're blowing up over there in London. Nothing if I can help it. Well, hopefully, hopefully. We're glad to have you here. We need someone that understands this stuff. Before we get into CRE in some detail, I mean, we should start with this New York Community Bank Corp.

1:15story. I think it gave markets a rightful spook yesterday. Rob, you wrote a piece about this today in the Unhedged Newsletter. What's going on with NYCB? Ethan, with troubled banks, as with cockroaches, there is never just one. So it is very sensible whenever a bank falls by 40 % in a single day, looks to be under stress. It's natural to wonder what else is crawling around. Who's the next bank that's going to have trouble? Now, in the case of New York Community Bank Corp., I will say that there is at least one important extenuating circumstance, that this bank did two big acquisitions in the last couple of years, the second of which was quite famous because they bought the assets and liabilities of Signature Bank, which is one of the ones that blew up in the Silicon Valley Bank.

2:09Yes. That was a kind of marriage arranged by the banking regulators. And it is normal for a bank to have some digestive problems after doing large acquisitions. That said, those two losses that you referred to, and on top of those losses, a pretty big provision for future losses, that's real. and if there's going to be trouble in commercial real estate, some bank has to be the first to really get hit by it. And so it is correct to say maybe New York Community Bank Corp is the first of many. Canary in the coal mine, I think, is where a lot of people's minds go when they see any bank, especially a regional bank, struggling with commercial real estate.

2:58I mean, Josh, Josh, let me throw to you about this. This is your patch. Describe the fears that people have about what's going on in CRE spilling over into the banking system. Yeah. I mean, from a real estate point of view, it's not a new story. It's a story that's been going on for a year or more. Basically, what's happening is almost all commercial real estate has debt on top of it. And here, actually, it's worth pausing and just saying, when we talk about commercial real estate in the US or in Europe or wherever, think about this as all commercial buildings. So, walk down the street and think about how many commercial buildings there are around you.

3:33It is a huge generalization to talk about it as all one market. But many of these buildings do tend to have debt on top of them. And because of interest rates, values are falling. How that plays out depends on the individual circumstances of what different asset owners and different lenders have done. But obviously, in the long period of very low interest rates that we had, a lot of people levered up too far. Values are coming down. There are challenges to offices from working from home and other trends. And so, the first person who has a problem is the owner of the building who loses their equity.

4:07And then once they've lost their equity and decided that it's not worth investing anymore into a building that doesn't make sense, or it doesn't have tenants, or it isn't going to have tenants, or it costs too much money to keep, they will toss the keys. And the owner hands back to the lender and then it becomes the lender's problem. And so that's when, you know, a real estate problem starts to filter up to be a bank problem. Josh, to try to make this more tangible and put it in the context of New York, where the bank that had such tough news yesterday is, I walk down a street in midtown Manhattan.

4:40I look around at hundreds of billions of dollars worth of office buildings. isn't it safe to say the value of those buildings versus four years ago is down by a third would that be a good guess a third if you're lucky that surprised me so it could be worse than that to real estate owners it's maybe it's more than a third if you're unlucky yes pretty serious yeah so that's a lot of dollars of assets and that's a big haircut. And so basically now, if there was more than 70 % leverage on those buildings, any building in that situation, the loan is now worth more than the building. Yeah. Yeah. And there are plenty of those situations out there in New York, in London and in other places.

5:33I mean, not, I hasten to add by any means every building, but I could name you some in each of the different markets and the list just keeps getting longer. The other issue I think that we have since we're talking about office, which is typically the biggest or one of the biggest sectors in commercial real estate, is that this interest rate cycle, which just happens in property, everybody's factored in to an extent, is happening to come at the same time as a particular idiosyncratic office problem to do with working from home coming out of COVID. And, you know, this is bigger than just an interest rate cycle.

6:12This is, you know, a generational rethink about where do people want to work, how much do they want to come into offices, what offices look like. And so that has really hit the kind of occupier demand, particularly in America, where you all don't seem to go to work, and, you know, to a lesser extent in London and then in Europe. And so, you know, at the same time that people are dealing with the interest rate problem, they are also dealing with a particular office problem. And I would add on top of that, at the moment everyone wants more sustainable offices, there's a lot of upgrades to all the buildings that are required, and to bring workers back at this time of working from home, you need your office to be really nice.

6:50And so that's, again, more money you have to put in. So there's all these different reasons why people have to put money into buildings that they don't want to put in, topping up equity, upgrades to this and that, at the same time that the demand is falling away. Well, hey, Rob and I are doing our part. We're here in the New York studio helping keep New York office occupancy rates up. Present company accepted, guys. Listeners, if you were listening to this podcast from home, you are actually the problem. Think of the poor property lenders. Think of the poor property investors and get on the train.

7:19You guys are the real heroes here because New York is obviously particularly bad. I spent a lot of time there last year. And the commutes suck, right? You guys spending all this time on the train. So actually, there was some interesting research I was looking at, looking at commute times in different major cities and return to office. And there does seem to be some sort of decent link there where London is the worst in Europe because we have longer commutes and less return to office. Other major cities in Europe are better. So people are reasonably more reluctant to be dragged into an office in a city center when it takes them longer to get there.

7:52They're wasting more of their day. I think what this all adds up to is not offices are going to go away by any stretch of the imagination, but there will be structurally less need for offices in most cities. So you're going to take a chunk out. And one of the things that hasn't landed yet is how big is that chunk? Because basically, the office demand fills the available office stock from the top down. And so you're pouring the demand in, and it goes to the very best offices first, and it trickles down and trickles down. And at some point, all the demand will be used up and there will be a certain category of buildings that are just not going to have a future as offices.

8:30So they need to find some other purpose. And for that category of building, you're not talking about a third less of their value as an office building. You are talking about a much, much bigger number. Sometimes all of their value is gone. And it is what they call land for alternative purposes. You're talking about a building where the costs of getting it to marketable quality are higher than the residual value in the building. Yeah, true. It's less than zero. It's an economic void. Yeah. You are talking about a piece of land that has a building on it and the building is just a problem, right?

9:04Yeah. Because it just costs money and it would be worth more if the building wasn't there. And you've seen this in other categories of real estate, like in retail where certain malls just weren't going to be malls anymore, and you had to find something else to do with that land. And that actually can be successful. You've got schemes now where they're building residential, or they're building something else, or mixed use. So land in the center of New York or the center of London will find a purpose, but it's about, first of all, the losses and then the investment that has to go in along the way.

9:33So the natural question here to ask is, some of these buildings are going to be worth a hell of a lot less. I mean, who's holding the bag, right? This completely could be a problem that the economy can sail through. The question is, are we going to get a regional bank that blows up in the meantime? Yeah, the great lesson of the financial crisis was that it's not the level of distress or losses that matter so much as where that distress and loss is concentrated. Is the loss concentrated in a link in the great economic chain that is then broken and then there are all these second order contagions that ruin everything else?

10:13Now, there is one reason, strictly from the point of view of the banking system today, not to worry, which is a classic way a regional bank with a lot of exposure to a troubled asset class would break, is that they would take the losses, that asset losing value, their solvency would suddenly be a bit in doubt, and the uninsured depositors ran for it. That is simply unlikely to happen today because Federal Reserve and the other regulators come in and protect the depositors. That's what we learned with SVB and Signature and the others back in March. So depositors now, having watched that happen, are much less likely to run, which means banks can absorb losses without risk to stability in a way they might not have been able to do before.

11:11last March. So that's a small reassuring point. So Rob, that's definitely one reason to maybe worry a bit less about Siri blowing everything up. And Josh has hinted, I think, at a few others, which is, I mean, this is a very slow moving sector, right? A lot of the losses that originated in the 2008 financial crisis were not actually crystallized for investors until like 2015. It took years and years and years for these to materialize. There's very few liquidity events Unlike some markets where they're every day or every week, we're talking about years for liquidity events to happen. They don't really happen until you have to actually refinance the building.

11:47And I think these all create a certain amount of buffer space between evaluation reset in commercial real estate and broader problems with the banking system. You could get a regional bank that blows up. It's definitely within the realm of possibilities. It's in the probability distribution. But I don't know if it's something that we need to all be all that panicked about. I would add on that reasons to be slightly reassured list. Also, just that we're all talking about it and paying attention. That tends to make financial risks less likely to bite you. But Ethan, you're absolutely right. These things, real estate just moves incredibly slowly.

12:22And people will be hoping that if they can survive for long enough, the interest rate cycle will lift them back out of trouble and they'll be able to carry on. The motto in real estate has become survive until 2025. five. And people talk about, we talk about refinancing and refinancing driven sales. People talk about it as like a wall of refinancing. And I've always kind of felt like that was a bad analogy because a wall would hit the market all at the same time with the same effect. But what you have in commercial real estate is, you can calculate how much refinancing there is in any given year, but the way that it arrives is at different times for different asset owners with different results and different circumstances.

13:00So the analogy I like is it's more like, one of those internet games where you have a little character who moves along and they have to jump over one obstacle and duck under another obstacle and just trying to keep on going. You could have one little obstacle as a covenant breach and the next obstacle is a refinancing event and people are just trying to get through. If some of them get through, a few of them will fall off, a few of them have to be sold. People will try everything they can just to make it through until the market recovers, that will hopefully result in not having the kind of cataclysmic, the one big cataclysmic event.

13:40That's your takeaway, folks. Commercial real estate is Donkey Kong. I was thinking, Rob, about the game you play when Chrome doesn't load and you are the little Tyrannosaurus Rex who bounces up and down. But Donkey Kong, if you like. The T-Rex just has to survive until 2025. I refuse to laugh at that joke.

14:03All right, guys, back in a moment with Long Short.

14:16Welcome back. This is Long Short, that part of the show where we go long a thing that we love, short a thing that we hate. Josh, are you long or short something? Yeah, controversial. I am long returned to the office, I think. Wow. Not necessarily because I think it's a good thing, but because I think it will happen. And I think, you know, we will work in the office less, obviously, in the future than we did before COVID. But I still feel like we've got a ways to go towards getting to the equilibrium and that the, you know, the powers that be are massing to try and force people back to the office.

14:49Because I feel like at that, you know, business leadership level, the consensus is hardening that people need to turn out more. I am 100 % making a massively leveraged trade on the other side of that. Working from home is an absolute human good. Now, it may be we're a little bit less efficient working at home, but look, commuting is pure evil. That is hours of human life set on fire and used for nothing. Working from home is a glorious thing that must be protected at all costs. And so I am short return to office hard. I think, Rob, the mistake you're making is assuming that because something is a human good, corporate America is going to allow it.

15:40No, that's just cynical. All right, Rob and Josh, thanks for being here. We'll have you both back very soon. and listeners, we're back in your feed on Tuesday with another episode of Unhedged. Catch you then.

15:58Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, Greta Cohn, and Natalie Sadler. FT premium subscribers can get the unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.

16:45Thank you.