Commercial Real Estate Debt: Calm Before the Storm or the Pause That Refreshes?

Sometime during the mid-afternoon of July 17, 1967, a band of six mountaineers set off from Camp VII at 17,900 feet on Mount McKinley in their quest to reach the summit.  Four others of their party had summited the mountain two days earlier after an eight-hour climb from Camp VII with nearly perfect weather.

The weather for the second summit team was initially cold but clear with good visibility and very little wind.  Members of the second team undoubtedly were hoping for a repeat of the first team’s experience.  But as evening came on, a dense cloud moved over the summit, a kind of fog.  The second team radioed the National Park Service that they were stymied by the fog with only 300 feet of visibility and “couldn’t go up, couldn’t go down.”  They ended up bivouacking for the night high on McKinley.

It was the proverbial calm before the storm.  The fog began to dissipate on the morning of July 18, enabling the second team to catch a glimpse of the summit and get their bearings. After a short while the fog drifted in again, but this time with the aid of their compass bearings the second team was able to navigate their way to the summit.

Thus far there had been fog but little wind.  What the fog had done was to mask the approach of a giant storm.  The storm hit with hurricane-force winds well over 100 miles per hour just as the second team had finished high-fiving themselves and began their descent.  None of them survived.  The first summit team, having descended to Camp VI at 15,000 feet barely survived themselves.  They got their minds off their desperate situation by singing a popular song from the Animals, “We Gotta Get Out of This Place.”

For the moment, on the surface of things, the stock market seems to be doing well.  On Friday, November 10, 2023, the Dow Jones Industrial Average finished up 391.16 points and the S&P 500 was up a strong 67.89 points.  Just below the surface, though, things don’t look quite so rosy.  The advance /decline line for November 10 was actually slightly negative, at 1.13 decliners for 1.0 advancing issues.  Strange for such a strong day in the major market averages.  But what was really telling was the number of issues making 52-week highs and 52-week lows.  85 issues made new 52-week highs.  Want to guess how many issues made new 52-week lows?  70?  90?  110?  Nope, 393 issues made new 52-week lows on November 10.

So are we looking here at the calm before the storm or the pause that refreshes?  “Sell in May and go away” was not good advice this year because the stock market advance that began in late October 2022 continued all the way through July 2023.  The market was in retreat through the end of October 2023 but then began a rally that now remains in force.  It seems a good bet that the market will continue rallying through the end of 2023, in part because money managers will want to show their investors on the year-end financials that they were long stocks during 2023.  Perhaps there will even be a “January effect” for 2024, with a continuation of the rally.  The question is the duration of the rally beyond that point.

There definitely are big clouds on the horizon, those clouds being the commercial real estate market and the banks that hold the paper on the multitude of depreciating office buildings that litter our cities.  Just as we say that history doesn’t repeat but it rhymes, we might say there is now a distressing parallel to the subprime mortgage/mortgage-backed securities/collateral debt obligation crisis of 2007-2009 that ended up destroying Bear Stearns in March 2008 and Lehman Brothers in September 2008.

Here are some of the relevant facts. Commercial real estate defaults are now at a 14-year high.  Of the approximately $2.8 trillion in mortgages on commercial real estate held by banks (per Bloomberg), $626 billion is troubled.  Of this $626 billion, $315 billion in commercial real estate mortgages mature by the end of 2025.  Thus far, the average price drop in commercial real estate is about 31 percent.

Prospects for refinancing such debt are exceedingly poor.  Reports are that the owners, rather than throwing good money after bad, are simply handing the keys over to the lenders.  The Pandemic Era trend toward remote work/work from home has hugely sucked out demand for office space across the entire nation.  WeWork, the nation’s largest tenant with 20 million square feet of commercial real estate, has just filed bankruptcy and likely will throw millions of square feet onto an already weak market as it rejects leases during the bankruptcy process.

Banks hold the paper on much of the nation’s commercial real estate.  Their suspicious stock valuation metrics hint that many of these banks are now either insolvent or nearly insolvent.  A low price/earnings ratio and a solid dividend can be a sign of a good investment prospect, but they can also reflect the market’s judgment that a company with these attributes faces a dismal future.  We live in a world with high-flying p/e ratios:  Apple, 29.78; Netflix, 43.46; Disney, 70.06; McDonald’s, 23.56.  So what are we to make of famous banks that have price/earnings ratios below 10?  A great investment prospect or a disaster waiting to happen?

Here is the data on bank price/earnings ratios:  Bank of America, 7.71; Wells Fargo, 8.81; Citibank, 6.59; J.P. Morgan, 8.60; Zions (Utah), 6.03; Farmers and Merchants Bank of Long Beach, 6.87.  Citibank pays a 5.01 percent dividend, Bank of America, 3.49 percent, Zions, 5.04 percent.

And, by the way, the banks likely are sitting on large paper losses on longer-dated U.S. Treasury obligations held by them.

Just as the subprime mortgage crisis was held off for a long period of time by creative accounting tricks permitted (and likely even encouraged) by corrupt and compliant regulators, so it may be that this pattern is again repeating as regards commercial real estate and the banks.  (One can imagine a fat, balding, Democrat-leaning government regulator slamming his fist on the table and yelling, “We can’t let this happen on Joe Biden’s watch!”). It’s time to re-read “The Big Short” by Michael Lewis and to watch “The Big Short” movie, focusing on the frustration of Dr. Burry and Mark Baum as more and more subprime debt went into default while the prices on the underlying mortgage—backed securities held firm, seemingly defying economic reality.

Government bailouts for the Big Players are a way of life in American economic life, and the onus is not on those who favor and approve the bailouts but on those who oppose them.  Recall that the worst part of the 2007-2009 meltdown happened when the decision was made not to bail out Lehman Brothers.

But what would happen if a number of major money-center banks failed all at once, and with over $30 trillion in U.S. Government debt outstanding, it was determined that the country just couldn’t afford to bail them all out?  Would that be somewhat like the hurricane-force winds hitting the second summit team on Mount McKinley?

However, don’t worry, be happy, because (paraphrasing Ronald Reagan) Jerry Powell is from the Federal Reserve, and he’s here to help.

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Image Credit: Wikimedia Commons