Is the Commercial Real Estate Market a Potential Threat to the Banking System?
- The stresses in the CRE market do not appear to pose a systemic threat to the global banking system
- One step regulators might take to lessen pressures on the system could be allowing banks to modify and then reclassify loans
- Tighter banking regulations could lead to more opportunities for private credit investors
On May 11, Chief Investment Strategist Erik Ristuben, Senior Research Analyst Ryan Dembinsky, and Jack Fadule, Director, Investment Research, Private Markets, joined Morris Chen, portfolio manager at DoubleLine Capital, for a discussion on the commercial real estate market and its potential effects on the banking sector and the broader economy. Below is a recap of the key highlights from their conversation.
What’s happening in the CRE market?
Ristuben opened the discussion by noting that commercial real estate (CRE) debt has become a hot topic ever since March’s banking crisis, with concerns among investors that the entire market is under pressure—especially due to recent stresses among U.S. regional banks.
Dembinsky explained that in most sectors of the CRE market, these worries are likely overblown. The notable exceptions, he said, are the office and retail sectors. The retail sector isn’t as big of a concern, Dembinsky said because while it’s still weak, a great deal of this weakness has already been digested by the market. The main concern is with the office sector, he noted, explaining that office buildings comprise 20% of all outstanding debt in the CRE market.
Chen agreed, stressing that this part of the CRE market does look the most vulnerable. That said, in Chen’s opinion, the overall threat does not look to be systemic. “From my vantage point, this appears to be much more of an idiosyncratic problem. I think that many buildings will be OK, but that there will be a few that will experience degradation. A lot of the problems with the most vulnerable buildings are centered around the owner of the building, versus the overall banking system,” he noted.
Dembinsky concurred, adding that many of the managers he’s been talking to have also expressed this opinion. “My assessment in the multiple conversations I’ve had is that the broad money manager community agrees that this is probably more of an idiosyncratic bank issue rather than a major systemic risk,” he stated.
What can be done to lessen the stress on the system?
Chen said that one option could be private credit, given that both investors and borrowers now see commercial mortgage-backed securities (CMBS) products as less attractive due to market volatility and the ongoing high-rate environment.” Once financial markets and capital markets stabilize, I believe demand for CMBS loan products will probably return—but in the interim, I think private credit could bridge this gap,” he stated.
Ristuben asked Chen what the playbook to solving some of these issues for banks and other lenders is likely to look like going forward—including the degree to which regulators might get involved. Chen noted that many regional banks are currently living one quarter at a time and that it’s highly likely regulators will tighten lending standards for regional banks. He said one step that regulators might take is to allow banks to modify and then reclassify loans. “Think of this as amend and extend—with perhaps a regulatory move similar to the recent measures taken to support Silicon Valley Bank,” Chen said. This could give some relief to banks as it relates to capital reserve requirements.
As for how much of this has already been reflected in current market pricing, Chen said that a good deal of the weakness has already been priced in, but that there may be more to come in specific cases. Ristuben agreed but added that overall, the market appears to have already thrown out the baby with the bathwater in many cases. “This could present some opportunities for investors,” he observed.
How are REITs likely to hold up in this environment?
The conversation shifted to the state of real-estate-oriented liquid markets—in particular, REITs (real estate investment trusts)—which have performed poorly of late. Dembinsky said that he believes that most of the weakness in retail REITs has likely already been priced in, while office REITs probably have further to fall.
“In my opinion, this probably strengthens the case for investing in CMBS, as I do think they have lots of value in terms of yield. If you’re a patient investor who can stomach the dismal headlines around CMBS, then from an active management point of view, we certainly believe there could be plenty of opportunities there,” he stated.
Is the changing landscape opportunity for real estate financing creating potential opportunities in private credit?
Circling back to the potential for private credit to bridge the gap in financing, Ristuben asked Fadule what private debt managers’ views on the woes of CRE are. “I believe they definitely see this as an opportunity to step in and fill the void,” Fadule stated, noting that there are a plethora of ways that private credit managers can help banks deal with their balance sheet issues—many of which might not be obvious to the average investor.
One of these options is the risk transfer trade, Fadule said. “Right now, the market views banks with CRE loans on their balance sheets as problematic. And if a bank sells its CRE loans at a discount, this hits its capital ratios in a negative way. A risk transfer trade allows a bank “transfer” the risk of some of these loans to a private credit lender without having its capital ratio impacted,” he explained. Amid today’s tightening regulatory standards, the risk transfer trade could be particularly appealing, Fadule said.
The bottom line
Ristuben, Dembinsky, Fadule, and Chen wrapped up their conversation by reiterating that the stresses in the CRE market do not appear to pose a systemic threat to the global banking system. “CRE lending standards have meaningfully improved since the Global Financial Crisis, and the financial system as a whole—particularly in terms of loan and credit quality—is sound. However, the issues in the CRE market are serious and do need to be watched closely. Ultimately, I believe that if we do see continued idiosyncratic episodic bank failures due to CRE exposure, another regulatory response is likely in order to shore up liquidity,” Ristuben concluded.
These views are subject to change at any time based on market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.
This material is not an offer, solicitation, or recommendation to purchase any security.
Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.
Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
Please remember that all investments carry some level of risk, including the potential loss of the principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.
The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual entity.
Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.
The Russell logo is a trademark and service mark of Russell Investments.
This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an "as is" basis without warranty.
A message from Advisor Perspectives and VettaFi: To learn more on this and other topics, check out our full schedule of upcoming CE-approved virtual events.