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The Looming Crisis in Commercial Real Estate

by Declan Lording
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The Troubles in Germany

This week, Germany’s Deutsche Bank, which heavily focuses on commercial real estate, has entered into the spotlight. Bloomberg reports that the bank is preparing for the biggest property upheaval since the financial crisis 15 years ago. While the bank is increasing its provision for bad loans, its profits are at the bottom of its already downgraded range. This news may seem distant to those in the United States, but it holds significance for the global financial landscape.

Implications for the United States

Although the Deutsche Bank situation may not directly affect the United States, it’s important to note the potential consequences. $17 billion in commercial debt is coming due this year in the US. This poses two possible outcomes for mortgage loans. First, commercial landlords may attempt to refinance at higher rates. However, given the high vacancy rates and the expectation of rate cuts, this is unlikely. The second option is for landlords to repay the loans. Unfortunately, this is also unlikely as the value of the real estate far exceeds their means. The worst-case scenario is defaulting on these obligations, which would have a detrimental impact on the entire US economy.

Contagion Spreading

Germany’s Deutsche Bank is not the only institution feeling the pressure from commercial real estate exposure. Other lenders, including in the United States, are also under scrutiny. Real estate-focused lenders in the US saw a slump in bonds issued by them after Morgan Stanley analyst recommendations. This indicates that even major financial institutions are wary of the risks associated with the US commercial real estate market.

The Coming Consolidation

Over the next few years, we can expect major consolidations in the banking industry. There are several reasons for this, including the launch of Central Bank digital currencies and heavy losses that small to midsize lenders may face due to their exposure to commercial real estate loans. As the Federal Reserve is likely to cut rates towards the end of the year, these banks will continue to struggle with defaulting landlords and the need to refinance loans in a challenging market.

Janet Yellen’s Warning

US Treasury Secretary Janet Yellen recently acknowledged the troubles faced by commercial real estate lenders. She stated that losses in this sector will put stress on property owners. This stress can lead to an inability to meet financial obligations and loan repayments. Although Yellen maintained that the situation is manageable, her acknowledgment of the problem’s severity raises concerns.

The Unmanageable State of Commercial Real Estate

While Yellen claims that the situation is manageable, it’s crucial to critically evaluate the state of commercial real estate. The comparison between the third quarter of 2023 and the same quarter a year prior shows significant value losses in major US cities. San Francisco, Los Angeles, New York, Seattle, and Miami all experienced substantial drops in commercial real estate values. The root cause of these declines is the increasing vacancies in office spaces. The Wall Street Journal reports that office vacancies in the US hit a new record in early January, reaching nearly 20%. This data suggests that the situation is far from manageable.

The Impact on Regional Banks

If you bank with a small or midsize regional bank, it’s essential to be aware of the risks associated with commercial real estate loans. These banks may have millions in bad loans on their books, which could be delinquent or require write-offs. This poses a significant risk to the banks and could result in substantial losses. It is advisable to closely examine your bank’s exposure to this sector and consider moving your money elsewhere to mitigate potential risks.

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