April 11, 2023

An Emerging Credit Crisis Could Reshape Real Estate

Experts at our recent Real Estate Capital Markets conference looked for historical precedents in the savings and loan crisis of the 1980s and the recession of the early 1990s.

The collapse of Silicon Valley Bank was just the beginning. Banks are facing a larger credit crisis that is only starting to emerge and could take years to play out. And this dynamic will bring formidable challenges for real estate, according to investors and economists attending this year’s Real Estate Capital Markets (RECM) conference, hosted by Goodwin and Columbia Business School.

Two speakers were particularly helpful in illuminating the larger economic and market context, agreeing on many issues but offering different historical references for understanding what might be coming down the pike. Scott Rechler, chief executive officer and chairman of RXR, sees the savings and loan crisis of the 1980s as most relevant. Eric Rosengren, former president and CEO of the Federal Reserve Bank of Boston, looks to the recession of the early 1990s, particularly because of the importance of real estate in what happened.

The following excerpts from their remarks (video and transcript), highlight important points of agreement but also the different historical precedents they turn to for thinking through today’s challenges.

Scott Rechler: In the 1980s, there was a regime change. We are going through a regime change now.

The following is a text version of the excerpt, edited for clarity. 

What we lived through in the last couple of weeks was our duration crisis. People were borrowing short term and investing long term, and there was a mismatch. In the 1980s, savings and loans and thrifts were putting out long-term mortgages against short-term borrowing, and then rates spiked. There were 3,000 banks and thrifts in the 1980s that either went under or were bailed out by the federal government. That is similar to the exposure that our regional banks have right now. There are 4,000 or so regional banks around the country that have duration risk.

More important, though, is credit risk, which has not really impacted us yet. That’s really the tail that will wag the next few years. In the 1980s, there was a regime change. Asset values were inflated by tax policy that allowed people to use depreciation from assets to offset income. Because of that, people invested in assets at higher values than the assets would have been worth economically. Tax law changed in 1986, and anything that was valued under the old tax regime had to be revalued under the new tax regime. That was a pretty painful process, because people had to recognize that what used to be worth X was suddenly worth a percentage of X.

We are going through a regime change now. Over a period of almost 15 years, we had near-zero interest rates. We were all running our businesses borrowing at near-zero cost. Now we’re entering into a more normalized interest rate environment, and we have to revalue everything. Think about the banks and the credit risk of revaluation. How many loans are underwater? How much equity has to be written off? We’re at the beginning of this process. I would frame it as a slow-moving train wreck — but once it starts, it’s going to pick up steam. It is similar to what happened in the 1980s, but because the effects of what is happening today are more widely distributed across the country, it’s going to take longer to work out. You can’t bail everyone out with an infusion of free money. This is much more systemic, affecting not only our banking systems but our municipalities and the economy more broadly.

Eric Rosengren: The 1990s recession was driven by real estate.

The following is a text version of the excerpt, edited for clarity. 

I agree we’re at the early stages of this. The first stage is about embedded losses from securities, which are on bank balance sheets. It will be interesting to see first-quarter reports from banks. What is the size of embedded losses on their “hold to maturity” portfolios?

The second stage is about credit risk. Regional banks are very exposed to the real estate sector. Firms that have already turned over the keys to office buildings tended to have short-term financing and be located in cities where working from home is prevalent (for example, some large towers in downtown LA have already been turned over to lenders). In a sense, those real estate firms were taking the same position as Silicon Valley Bank. They had short-term financing tied to LIBOR, and they were getting plenty of cash returns while interest rates were low. When interest rates rose suddenly, they had negative cash flow. Do they continue to invest in the building? Increasingly, at least in some cities, firms are likely to return property to banks. That will result in nonperforming loans on bank balance sheets. Banks have to hold reserves to cover those nonperforming loans, and that depletes capital.

But I’m not sure the savings and loan crisis is the right analogy. I would use the 1990s recession, which was driven by real estate. In New England, the mid-Atlantic states, and California, there were very large declines in real estate prices, including commercial real estate. In both the economic crisis that started in 2008 and in the 1900s recession, commercial real estate losses were an important part of bank losses. An unfavorable dynamic emerged where banks were poorly capitalized, real estate was already depressed, and banks were pushing real estate back into the market as they tried to reduce their own exposure from OREO [other real estate owned] accounts.

There is a risk that the same dynamic will play out today, but I think it would be a bit slow-motion. If you look at the nonperforming loans at regional banks right now, they’re not particularly elevated. My guess is we will see a very different picture next year at this time. The likelihood of a recession is highly elevated as a result.

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