Trouble is brewing as commercial real estate debt matures … putting numbers on the scope of the problem … the contagion risk … action steps to take today

The big news this morning is that OPEC+ nations announced yesterday they would cut global oil production by an additional 1.16 million barrels per day throughout 2023.

Oil prices are spiking on the news. West Texas Intermediate crude is up nearly 7% to more than $80 a barrel as I write Monday. Various oil-related stocks are soaring.

While falling oil prices are certainly behind some of this decision, it appears politics could be the lightning rod.

In short, last summer, the Biden Administration began draining the Strategic Petroleum Reserve (it’s now at the lowest level in 40 years) in an effort to reduce price-shock at the pump. The White House suggested it would refill the Reserve at prices around $70.

When Energy Secretary Jennifer Granholm suggested that wouldn’t happen due to maintenance issues at some of the Reserve sites, the Saudis were not happy. The Financial Times reported that Riyadh was “irritated” by Granholm’s comment. There’s much speculation that this move is payback.

In any case, oil now has a new tailwind beyond the seasonal tailwind of higher demand in the spring/summer. Put it together and it suggests higher prices to come.

Regular Digest readers know that legendary investor Louis Navellier has been bullish on top-tier big oil stocks, as well as a handful of high-quality small-cap energy stocks. This news only intensifies that conviction.

Here’s his bottom-line takeaway from today’s news:

As a result [of OPEC+’s move], I remain confident my Big Energy Bet will continue to pay off, as oil prices are likely to continue climbing higher. Our energy stocks are already well-positioned to prosper as oil demand increases in the spring and summer months, and now they’ll further benefit from the rise in energy prices due to the cut in oil production.

We’ll bring you more details on this tomorrow, as well as more from Louis. But for now, let’s shift gears to the commercial real estate market.

Last week in the Digest, we noted we’re beginning a “commercial real estate watch” segment to monitor this critically-important sector for the U.S. economy.

If its major players begin to fall due to high interest rates in the same way we just watched a handful of regional banks fall, it will make a recession very difficult to avoid.

Today, let’s dive deeper into this risk analysis.

Refinancing at today’s rates could be disastrous for many commercial property owners

Here’s the danger…

Roughly $1.5 trillion in commercial real estate debt is set to mature in the next three years.

Most of this debt was financed when interest rates were near zero. When the debt rolls over, commercial real estate companies will be refinancing in a market environment characterized by three things: higher interest rates, lower property values and less liquidity.

“Higher interest rates” are obvious and self-explanatory. Rates have more than doubled over the last couple of years. And though rates may not be at today’s levels, say, two years out, it’s highly unlikely they’ll be back to near-zero barring an economic implosion.

“Lower property values” reflect the reality of reduced commercial real estate revenues because so many office buildings are half-empty in the wake of Covid-inspired “work from home” trends.

Before the pandemic, roughly 95% of office space was occupied. This past December, that number was about 47%. This is resulting in lower rents. For example, in San Francisco, rents are down 15% compared to 2019. When your rental income drops, that reduces the overall value of the asset.

For one illustration, we can look once more to San Francisco. In December, an office building that sold for $397 million in 2019 was on the market for a 60% discount of roughly $155 million.

“Less liquidity” reflects the lending environment we’re heading into. With a series of bank failures in recent weeks, and the White House clamoring for tighter regulations on regional banks, there will simply be fewer dollars available for loans – especially for the commercial real estate outfits that appear on shakier financial ground.

Put it all together, and you have a toxic combination.

Here’s The Economist with some rather colorful descriptions of this toxicity from people who work in commercial real estate:

“Office is a dumpster fire,” says Daniel McNamara of Polpo, an investment fund.

His view of the wider market, which includes shops and warehouses, is only a little less grim: “It really is the perfect storm.”

Tom Capasse of Waterfall Asset Management, a debt-investment firm, has nicknamed places where the tech bubble has burst, including San Francisco and Seattle, “office hell.”

Just the tip of the iceberg

We’ve already seen a handful of major commercial real estate defaults, including Columbia Property Trust’s default on a $1.7 billion floating-rate loan, and Brookfield Asset Management’s default on more than $750 million in debt in Los Angeles.

But because of how long it takes these dynamics to play out, it’s likely we’ve only seen the first few waves of the coming tsunami.

Here’s more from The Washington Post:

So far, developers and the banks that lend to them haven’t been badly affected, because commercial real estate leases tend to span several years, unlike the one-year terms for most residential units.

But millions of these leases are going to expire over the next two years, potentially setting off a domino effect that could rattle the U.S. financial system.

The nightmare scenario would come if companies decide not to renew their leases or insist on much more favorable terms, driving the value of commercial real estate down across the board.

That would mean the loans many banks have made against office buildings are suddenly worth less than they are now, especially with interest rates much higher today than a year ago.

And that, in turn, could make depositors and investors doubt banks’ financial stability — potentially leading to the same kind of runs that brought down SVB and Signature this month.

Let’s put some numbers on this to better understand the scope of the problem

Regional banks are responsible for the overwhelming majority of loans to the commercial real estate sector. Bank of America puts the number at roughly 68%.

Now, let’s jump to analysis from JPMorgan:

We expect about 21% of commercial mortgage-backed securities outstanding office loans to default eventually, with a loss severity assumption of 41% and forward cumulative losses of 8.6%…

Applying the 8.6% loss rate to office exposure, it would imply about $38 billion in losses for the banking sector…

And here’s Markets Insider adding more context:

And the losses in commercial real estate could be worse this time around than it was during the Great Financial Crisis because the latter was driven by a relatively short-lived recession, while today’s dynamics are being driven by work-from-home trends that show no signs of letting up.

The potential for $38 billion in losses from the banking sector sounds rather ominous. Pushing on this, what’s the broader potential risk?

Scott Rechler is the CEO of RXR, a large property manager and real estate developer. Recently, he addressed that question, tweeting the following:

If we fail to act, we risk a systemic crisis with our banking system & particularly the regional banks, which make up 80% of RE lending.

There will be pressure on our municipalities, which derive over 70% of their tax revenues from property taxes…

We have been experiencing a proverbial slow-moving train wreck that has been picking up speed throughout this past year with the unprecedented spike in interest rates.

Elon Musk even chimed in on this, responding to analysis from the Kobeissi Letter.

About one week ago, Kobeissi, which provides commentary on global capital markets, noted how over the next five years, more than $2.5 trillion in commercial real estate debt will mature, adding that it is “by far more than any 5-year period in history.”

After discussing some of the points we’ve made in today’s Digest, the Kobeissi Letter concluded:

Refinancing these loans is going to be incredibly expensive and likely lead to the next major crisis…

Rapidly rising rates are teaching everyone a valuable lesson. There’s no such thing as ‘free’ money.”

Musk replied:

This is by far the most serious looming issue. Mortgages too.

So, what’s the action step for investors?

Markets are in bull mode. Let’s enjoy it while it’s here. But at the same time, prepare for what might be coming by assessing your portfolio’s exposure to regional banks and commercial real estate REITs.

Keep in mind, if you’re invested in various funds or broad ETFs, you might have exposure to these sectors without even knowing it. So, do a little research to makes sure you’re comfortable with whatever degree of exposure you have.

Beyond that, it’s yet unclear how this might play out.

On one hand, if the problem grows severe enough, it’s a fair bet that the Fed could just throw the whole “inflation” playbook out the window and charge in with fistfuls of dollars to save the day.

That could lead to a whole new equity asset bubble as the Fed effectively kicks the can down the road by papering over the problem with freshly-printed dollars.

Alternatively, if Powell allows various regional banks and commercial real estate players to fail, there will be broader fallout and contagion. We simply don’t know yet, and the timeline for how this plays out isn’t immediate. That’s why we’re going to keep updating this running segment.

What we can say is that this is a troubling situation that needs to be on your radar.

Have a good evening,

Jeff Remsburg