Landlords with office properties mired in a mountain of debt coming due might think twice before hoping for a U.S. recession that sparks interest rate cuts from the Federal Reserve.
“Don’t wish for a recession and lower rates,” said Deutsche Bank’s Ed Reardon and his team of credit researchers, in a midyear outlook. “Recession will cause spreads to widen and lead to demand destruction for CRE.”
In other words, lower rates won’t solve all the problems of landlords needing to shore up property financing, particularly if a wounded economy results in a further drop in tenants and rents.
After all, office rents in the wake of the early 2000s recessions took seven years to recover (see chart), while hotel revenue per available room (RevPAR) took 4.5 years to rebound, according to Deutsche Bank data.
U.S. office rents took seven years to recover in past recessions.
Deutsche Bank, REIS, STR
What’s more, Deutsche Bank researchers found that office vacancies never returned to the high, single-digit levels seen before the 2000s.
Office vacancy rates in the first quarter already topped 23% in San Francisco, New Jersey, Dallas, Houston and Chicago, according to Jones Lang LaSalle data.
In another ominous sign, the trend since 2020 has been for physical office occupancy rates to dwell in the half-empty category, according to Kastle Systems’ 10-City Bank to Work barometer.
Fed’s Powell: Expect losses
Risks to financial stability from troubles in the estimated $ 21 trillion commercial real-estate market has been something both the U.S. Treasury Department and Fed have been monitoring.
“We, of course, are watching that situation very carefully,” Federal Reserve Chairman Jerome Powell said Wednesday about commercial real estate, in a press conference on the Fed’s decision to hold rates steady in June, while staying open to two more potential increases this year.
“There’s a substantial amount of commercial real estate in the banking system, a large part of it is in smaller banks,” Powell said, adding that “we do expect there will be losses,” which could be slow to unfold, rather than “suddenly hit.”
Fallout is gathering steam
Early signs of the slow-moving fallout already can be seen in an uptick in delinquent loans and more borrowers walking away from problem properties, especially in cities with an urban core already threatened by industry-specific downturns, low foot traffic and public-safety concerns.
See: Westfield surrenders keys to downtown San Francisco shopping mall to lender
Borrower stress has been most visible in the commercial mortgage-backed securities market (CMBS), where Wall Street packages up property loans into bond deals. While a smaller slice of the lending market, monthly bond reports provide a more immediate look at property-level performance than loans sitting on bank balance sheets.
Trading in those bonds also reflect concerns about potential losses, with some riskier bonds tied to trophy assets and big-name borrowers trading hands recently pegged as low as 66 cents on the dollar.
See: Debt on trophy office buildings is starting to buckle as loans come due
The Fed has been trying to reduce demand for goods and services as part of its inflation fight, mainly by sharply increasing its policy rate to a 5%-5.25% range from nearly zero in the past 15 months.
Fed Chairman Jerome Powell also has been hoping to avoid going overboard and risk throwing the economy into a recession.
Stocks were higher Thursday after the Fed left rates unchanged, with the Dow Jones Industrial Average DJIA, +1.29% up about 450 points, or 1.3%, the S&P 500 index SPX, +1.34% 1.3% higher and the Nasdaq Composite Index COMP, +1.30% gaining 1.2%, according to FactSet data.
Property loans often are priced based on the 10-year Treasury TMUBMUSD10Y, 3.731% yield, which was near 3.73% Thursday. Goldman Sachs pegged coupons on new CMBS property loans as topping 7% in May, up from closer to 3.5% last year.