The financial sector, and especially banking, has once again become a focal point of market and economic angst, as bank depositors have become skittish, and investors have questioned banking and financial industry fundamentals.
Unrealized market losses on bank holdings of very high credit quality bond holdings have been the main problem area for a small minority of regional banks that also had more unstable deposit bases. These unrealized losses were the result of the extraordinarily sharp and swift increase in interest rates which caused bond prices to fall.
However, unlike the 2008 banking crisis, overall loan credit quality was not the fundamental problem. But there is now growing concern over the commercial real estate (CRE) market, its impact on CRE loans, and ultimately its potential effects on financial institutions, capital markets, and the overall economy.
Like the public securities markets, the private CRE market has been significantly affected by sharply higher interest rates, which have not only depressed valuations, but have also greatly diminished transaction activity. This lack of transaction activity in certain challenged CRE sectors has contributed to a “frozen” environment, where limited information on actual CRE sales prices diminishes some key information that lenders need to value properties in order to extend credit.
Key dimensions of the commercial real estate market
Although the CRE market is large, it is much smaller than the residential real estate market, and its financing sources are more diversified. Total CRE debt outstanding is approximately $4.5 trillion. This compares to the $12 trillion in outstanding residential mortgage debt. The banking industry holds about 38% of outstanding CRE debt, mortgage-backed securities owners (packages of multiple CRE mortgages) hold about 22% of CRE debt, and insurance companies hold about 15% of outstanding CRE debt. The remaining 25% of outstanding CRE debt is held by Real Estate Investment Trusts (REITs), financial companies, pension funds and other financial entities.
Unlike the more homogenous residential housing market, the CRE market is considerably more varied with apartment, industrial, office, retail, lodging, and data center properties making up key sectors. Of these major property types, office and retail are experiencing serious fundamental challenges, while apartment, industrial, and data center properties have remained quite stable, if not strong. The market has thus become somewhat bifurcated with apartments and industrial sites being the darlings, while office, and especially class “B” office space, have become the problem children.
A growing concern is the wave of CRE debt refinancing that is required in the coming years. More than $700 billion of commercial property mortgages need to be refinanced this year, followed by more than $600 billion in 2024. Office and retail properties constitute about 30% of near term pending refinancings. Many of these refinancings will depend on the owner’s willingness and ability to inject more equity, and the current lender’s willingness to restructure mortgage debt.
Office and retail real estate – a secular problem
Secular changes impacting downtown office space and large retail centers are evident by increasing vacancy rates and diminished foot traffic. In just two short years, fueled in large part by the pandemic, electronic commerce, and the Amazon juggernaut, e-commerce retail sales grew about 15%, and now make up 22% of total retail sales. This has seriously eroded the value of certain types of retail properties.
The pandemic also catalyzed the major cultural change of working from home. This significant and ongoing shift in work has led to office vacancy rates moving from 12% nationally in 2019 to 17% today. In some major metropolitan areas vacancy rates top 30%.
These dramatic shifts in behavior have led to significantly reduced demand for retail and office related real estate which in turn leads to reduced values for these property types. These are long-term persistent trends that will have ramifications for property owners and their lenders. However, these negative trends will continue to be slow moving, unlike the residential real estate and mortgage crisis that suddenly gripped the financial sector and the economy in 2008-2009.
We expect that banks and other financial institutions will be dealing with CRE financing issues over an extended period of time. However, the ultimate workout resolutions for potential problem CRE loans will be aided by the meaningful amount of equity that was contributed to many deals by property owners upon the initial purchase/financing transactions. These initial lower loan-to-value ratios (LTV) for commercial properties contrast with the almost non-existent equity that prevailed during the residential mortgage financing binge of the mid-2000s. Still, refinancings and debt workouts will be a long and arduous process for troubled office and retail properties.
Although the banking industry does have significant exposure to CRE loans, problem areas remain mostly isolated in office and retail property types. Apartment, industrial and other special purpose real estate loans are generally performing reasonably well. Furthermore, the banking system has significantly strengthened its capital position and improved its credit underwriting since the financial crisis.
As mentioned previously, lower loan-to-value ratios that were negotiated at the onset of many financings are expected to mitigate losses from CRE related loans. Finally, the residential real estate and mortgage market remains very healthy, with residential property markets being aided by very limited supply and strong consumer fundamentals supported by a healthy labor market. In short, the banking sector will have to deal with problem CRE for some time, but it is not expected that these problems will metastasize into another existential crisis for the banking industry as a whole, or for the broader economy.
Securitized commercial mortgage market
Commercial mortgages, like residential mortgages, have long been packaged into securities. These commercial mortgage-backed securities, CMBS, are structured with various risk tranches, with some senior tranches earning AAA credit ratings. Recently some of these highly rated securities, which have larger proportions of office-related mortgages in their structures, have traded at significantly higher yield levels given elevated CRE risks.
However, these high-quality senior tranches are not trading at the deeply distressed levels that would signal erosion of the credit protection that these risk-mitigating structures offer investors such as financial institutions. Furthermore, this segment of the CMBS market is quite small compared to the vastly larger residential MBS market, posing little risk to the financial system or significant individual financial institutions.
Real estate investment trusts (REITs)
Publicly traded commercial real estate, as represented by REITs, performed very poorly in 2022, due to both the CRE risk issues articulated previously, as well as surging interest rates which impacted the entire market. REITs, although still lagging the broader equity market, have been range-bound through the first four to five months of 2023. The REIT market is quite diversified by property type. The challenging office and retail sectors of the REIT market make up less than 15% of the major REIT indices. Other larger sectors, such as apartment, self-storage, cell towers, manufactured homes, and industrial properties have performed much better on a relative basis.
REITS collectively as an industry have done an admirable job of keeping debt burdens and maturity schedules manageable during the past few turbulent years. Higher interest rates and reduced credit availability will be continuing issues for the real estate industry, especially the secularly challenged areas of office and retail. However, this may also lead to longer-term diminished supply of necessary real estate, which could become a possible tailwind for specific REIT categories and companies.
The secular changes of working from home and electronic retailing will continue to depress valuation in segments of the real estate market, as troubled properties go through the long and protracted workout process. Although these segments will clearly hinder CRE as a whole, we believe that the diversity of other strong property types, relatively prudent historical underwriting, and a still solid residential real estate market will likely prevent CRE from becoming a contagion to the financial system or the economy as whole.
Thrivent Financial CRE status
Thrivent Financial has been a very successful long-term investor in commercial real estate and CRE mortgages as part of its well-diversified and strong general account insurance portfolio. CRE loans constitute 14% of the Thrivent’s insurance general account. This CRE portfolio is highly diversified with a combined 65% invested in the strong performing segments of multi-family (apartment), industrial warehouse, life science/medical and manufactured housing. Only 2% of the CRE loan portfolio is exposed to downtown office space, while 9% is invested in the more stable suburban office market.
The commercial mortgage portfolio is well diversified by geography and is overweight in the stronger and growing regions of the Western and Pacific parts of the country. The slow or no-growth areas of the country, such as the East Coast and mid-Atlantic, are underweight.
The overall portfolio enjoys a very high credit rating with nearly 60% of the portfolio rated CM1, the highest rating category as established by the National Association of Insurance Commissioners (NAIC). This compares to an insurance industry peer group average of 38%. Lower rated CM3 loans make up only 4% of the portfolio as compared to 11% for the insurance industry peer group average.
Finally, only about 5% of the commercial mortgage portfolio will be maturing in the next two years. This significantly reduces near term refinancing risk and provides time for the CRE market to go through this corrective phase of the economic and real estate cycles.