US commercial real estate market update - March 2023

US banking turbulence uncovers CRE risk

Just as the market was beginning to take the Federal Reserve at its word, a confluence of domestic and international banking crises complicated the picture. The markets are once again searching for a narrative to help make sense of the path forward.

From mid-February through early March, speeches by various Federal Reserve (“Fed”) officials stressed the point that the Fed remained committed to battling inflation and had a way to go.

These speeches culminated with a hawkish testimony on Capitol Hill by Fed Chair Jerome Powell on March 8. During the Semi-Annual Monetary Policy Report to Congress, Chairman Powell stressed the need for additional rate hikes to battle inflation, amidst continued robust economic growth and a tight labor market.

During his testimony, a stronger-than-expected employment report was released, validating the Fed’s hawkishness and helping to shift market expectations to be more in line with the Fed’s forward commentary, at least until news about a brewing banking crisis began to shake markets.

Smaller banks play big role in US CRE market

There are currently two types of banking crises playing out – the first deals with US regional banks and the second with a major global bank. While the second is more significant to the global financial system, the first is much more relevant to commercial real estate markets because of the important role that these banks play in US CRE markets.

The banking sector in the US has consolidated dramatically over the last 30 years, from around 18,000 banks in the late 1980s to fewer than 5,000 today. Despite the shrinking number of smaller bank lenders, over the years these smaller banks (defined as domestically chartered banks not in the top 25 when ranked by assets), often called regional banks, have played an outsized role in CRE lending.

US banking: consolidation

Recently, these smaller lenders have accounted for nearly two-thirds of all CRE lending (67%), up from approximately 56% five years ago. According to recent Federal Reserve data, regional banks currently have about $1.6 trillion of CRE loans on their balance sheets, compared to the $816 billions of CRE loans at the large domestically chartered banks.

US small banks lead commercial real estate lending

For two major reasons, the current banking troubles differ significantly from the crisis that hit global markets during the 2008 global financial crisis (GFC):

The overall US banking system is significantly better prepared today than it was going into the GFC. Reforms that followed the GFC helped to build bank balance sheets and capital positions to be able to weather unexpected hits. Through higher required capital requirements and stress testing excises (e.g., DFAST, CCAR), today’s banking institutions and their regulators have a better understanding of how banks are set up and how they might perform under potential grey-sky scenarios.

The current banking crisis is not systemic in nature – mostly due to the size of the most criticized institutions. The banking system as a whole could reasonably absorb more small bank failures and still function.

US commercial mortgages by lender type

The current crisis does pose a major threat to certain sectors of the economy, including CRE. Given the importance of the smaller banks to this sector, as mentioned above. It is my view that the recent regional bank troubles may serve as a catalyst for a CRE credit cycle and increased price discovery – as banks with high concentrations of CRE loans come under greater scrutiny or explore ways to free up trapped capital.

Recent market developments

Economy

• Recent Fed testimony on Capitol Hill showed Fed’s hawkish commitment to the path forward for rate hikes; however, that commitment has been complicated by recent bank failures and concerns related to financial stability. At the time of writing, the markets are pricing in smaller rate hikes before multiple rate cuts throughout the remainder of 2023.

• The US labor market remains strong despite highly publicized large layoffs announced across sectors, but most notably tech; much of the tightness continues to stem from stubbornly low participation rate. February’s unemployment rate rose to 3.6%, up 0.2% from January; nonfarm payrolls rose 311,000 in February, while average hourly earnings rose a cooler 0.2%, slightly decreasing concerns over wage price inflation.

• Per the most recent Consumer Price Index (CPI) release, February prices rose 0.4% from the month prior. CPI rose 6% year on year, down from 6.4%, but still well-above the Fed’s target range.

• In Washington, the White House released its FY 2024 budget proposal, outlining the Biden Administration’s spending and tax priorities for Congress. The Administration’s plans claim to fully pay for the proposed spending increases while reducing the overall deficit by $3 trillion and raising taxes by $2 trillion over 10 years. The proposal will likely be revised via negotiations, especially as the debt ceiling debate remains open with the deadline approaching.

Markets

• Following the end of 2022 Q4 and full-year earnings season, FactSet reported that for Q1 2023, the estimated earnings decline for the S&P 500 is -6.1%, which will mark the largest earnings decline reported by the index since Q2 2020 (-31.8%), if this expectation proves accurate.

• Both equity and credit markets were rocked by volatility and interruptions (multiple trading halts affecting single-name securities and widening spreads), following a major sell-off of regional banking stocks.

• The yield on the 10-year Treasury note neared 4% before taking a plunge to 3.70%, as banking concerns hit the market.

Commercial real estate

• Increased pressure on regional bank stocks and concerns around financial stability within this sector of lenders continues to bring increased scrutiny and attention to CRE markets.

• Year-to-date CRE structured credit issuance (CMBS, CLO) remains muted, as pipeline activity dwindles and those deals already in the pipeline will likely be delayed given the recent spread widening.

• The current pace of CRE transactions trails the prior year by nearly 40% across the US, illustrating the challenging and uncertain macro environment.