Transcript: Will commercial real estate hurt regional banks?

This is an audio transcript of the Unhedged podcast episode: ‘Will commercial real estate hurt regional banks?’

Ethan Wu
Shares in New York Community Bancorp fell 40 per cent yesterday after a pretty brutal fourth-quarter earnings call. The regional bank took losses on two real estate loans, one on an apartment building and one on an office building. 

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It all raised uncomfortable questions about the state of the commercial real estate sector, which a lot of folks, from regulators to market participants, have been worried about. Today on the show, what’s going on in commercial real estate and is it gonna blow up the economy? This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I’m reporter Ethan Wu here in the New York studio, joined by the man who is definitely not gonna blow up the US economy: Robert Armstrong.

Robert Armstrong
You sell me short, Ethan. I find that a little hurtful.

Ethan Wu
Well, if you can cause a bank run with your columns, maybe it’s a different story. And from London, commercial property correspondent Joshua Oliver.

Joshua Oliver
Hey, Ethan.

Ethan Wu
Josh, I don’t know what you’re blowing up over there in London.

Joshua Oliver
Nothing, if I can help it.

Ethan Wu
(Laughter) Hopefully. Hopefully. Well, glad to have you here. We need someone that understands this stuff. Before we get into CRE in some detail, I mean, we should start with this New York Community Bancorp story. I think it gave, you know, markets a rightful spook yesterday. Rob, you wrote a piece about this today in the Unhedged newsletter. What’s going on with NYCB?

Robert Armstrong
Ethan, with troubled banks, as with cockroaches, there is never just one. So it is very sensible, whenever a bank falls by 40 per cent in a single day, looks to be under stress, it’s natural to wonder what else is crawling around? Who is the next bank that’s gonna have trouble?

Now, in the case of New York Community Bancorp, I will say that there is at least one important extenuating circumstance: that this bank did two big acquisitions in the last couple of years, the second of which was quite famous because they bought the assets and liabilities of Signature Bank, which is one of the ones that blew up in the Silicon Valley Bank mess. That was a kind of marriage arranged by the banking regulators. And it is normal for a bank to have some digestive problems after doing large acquisitions.

That said, those two losses that you referred to and on top of those losses, a pretty big provision for future losses — that’s real. And if there’s gonna be trouble in commercial real estate, some bank has to be the first to really get hit by it. And so it is correct to say maybe New York Community Bancorp is the first of many.

Ethan Wu
Canary in the coal mine, I think is where a lot of people’s minds go when they see any bank, especially a regional bank, struggling with commercial real estate. I mean, Josh, let me throw to you about this. This is your patch. Describe the fears that people have about what’s going on in CRE spilling over into the banking system.

Joshua Oliver
Yeah, I mean, from a real estate point of view, it’s not a news story. It’s a story that’s been going on for, you know, a year or more. Basically, what’s happening is almost all commercial real estate has debt on top of it.

And here, actually, it’s worth pausing and just saying, you know, we talk about commercial real estate in the US or in Europe or wherever, you know, think about this as all commercial buildings. So, you know, walk down the street and think about how many commercial buildings there are around you. You know, it is a huge generalisation to talk about it as all one market, but many of these buildings do tend to have debt on top of them and because of interest rates, values are falling. How that plays out, you know, depends on the individual circumstances of what different asset owners and different lenders have done.

But obviously, in the long period of very low interest rates that we had, a lot of people levered up too far, values are coming down. There are challenges to offices from, you know, working from home and other trends. And so, you know, the first person who has a problem is the owner of the building who loses their equity. And then once they’ve lost their equity and decided that it’s not worth investing any more into a building that doesn’t make sense, one that doesn’t have tenants or that isn’t gonna have tenants or that costs too much money to keep, they will toss the keys. And the owner hands back to the lender, and then it becomes the lender’s problem. And so that’s when, you know, a real estate problem starts to filter up to be a bank problem.

Robert Armstrong
Josh, to try to make this more tangible and put it in the context of New York, where the bank that had such tough news yesterday is, I walked down a street in midtown Manhattan. I look around at hundreds of billions of dollars worth of office buildings. Isn’t it safe to say the value of those buildings versus four years ago is down by a third? Would that be a good guess?

Joshua Oliver
A third if you’re lucky. (Ethan and Robert laugh)

Robert Armstrong
That surprised me. I thought it could be worse than that.

Joshua Oliver
Well, maybe I’ll be more fair to real estate owners. Maybe it’s more than a third if you’re unlucky. But pretty serious.

Robert Armstrong
Yeah. So that’s a lot of dollars of assets. And that’s a big haircut. And so basically now, if there was more than 70 per cent leverage on those buildings, any building in that situation, the loan is now worth more than the building.

Joshua Oliver
Yeah. And there are plenty of those situations out there in New York, you know, in London and in other places. I mean, not, I hasten to add, by any means every building but, you know, I could, you know, I could name you some in each of the different markets and the list just keeps getting longer.

The other issue I think that we have, since we’re talking about office, which is, you know, typically the biggest or one of the biggest sectors in commercial real estate, is that, you know, this interest rate cycle, which, you know, just happens in property. Everybody kind of, it’s factored in to an extent, is happening to come at the same time as a particular idiosyncratic office problem to do with working from home coming out of Covid. And, you know, this is bigger than just interest rate cycle. This is, you know, a generational rethink about where do people wanna work, how much do they want to come into offices, what offices look like. And so that has really hit the kind of occupier demand, particularly in America, where you all don’t seem to go to work and, you know, to a lesser extent in London and then in Europe. And so, you know, at the same time that people are dealing with the interest rate problem, they are also dealing with a particular office problem.

And I would add on top of that, at the moment, everyone wants more sustainable offices. There’s a lot of upgrades to older buildings that are required and to bring workers back at this time of working from home, you need your office to be really nice. And so that’s again more money you have to put in. So there’s like all these different reasons that people have to put money into buildings that they don’t wanna put in — you know, topping up equity, upgrades to this and that at the same time that the demand is falling away.

Ethan Wu
Well, Rob and I are doing our part. We’re here in the New York studio helping keep New York office occupancy rates up.

Joshua Oliver
Present company excepted, yes.

Ethan Wu
Listeners, if you are listening to this podcast from home, you are actually the problem. Think of the poor property lenders.

Joshua Oliver
Think of the poor property investors and get on the train. (Robert laughs) You guys are the real heroes here because New York is obviously, you know, particularly bad. I spent a lot of time there last year and the commute sucked, right, you guys spending all this time on the train. So actually, there was some interesting research I was looking at, looking at commute times in different major cities and return to office. And there does seem to be some sort of, you know, decent link there where, you know, London is the worst in Europe because we have longer commutes and less return to office. Other major cities in Europe are better, you know, so people are reasonably more reluctant to be dragged into an office in the city centre when it takes them longer to get there and they’re wasting more of their day.

You know, I think what this all adds up to is like not offices are gonna go away by any stretch of the imagination, but there will be structurally less need for offices in most cities. So, you know, you’re gonna take a chunk out. And one of the things that hasn’t landed yet is how big is that chunk. Because basically, you know, the office demand fills the available office stock from the top down. And so you’re pouring the demand in and it goes to the very best offices first. And it trickles down, trickles down. And at some point all the demand will be used up, and there will be a certain category of buildings that are just not gonna have a future as offices so they need to find some other purpose. And, you know, and for that category of building, you’re not talking about a third less of their value as an office building. You are talking about a much, much bigger number. Sometimes all of their value is gone. And, you know, it is what they call, you know, land for alternative purposes.

Ethan Wu
You’re talking about a building where the costs of getting it to marketable quality are higher than the residual value in the building.

Robert Armstrong
It’s at less than zero. Yeah, it’s an economic void.

Joshua Oliver
You are talking about a piece of land that has a building on it, and the building is just a problem, right, because it just costs money and it would be worth more if the building wasn’t there. And, you know, you’ve seen this in other categories of real estate, like in retail where certain malls just weren’t gonna be malls anymore and you had to find something else to do with that land. And that actually can be successful. Like you’ve got schemes now where they’re building residential or they’re building something else or mixed use. So land in the centre of New York or the centre of London will find a purpose but it’s about, first of all, the losses and then the investment that has to go in along the way.

Ethan Wu
So the natural question here to ask is, some of these buildings are going to be worth a hell of a lot less. I mean, who’s holding the bag, right? This completely could be a problem that the economy can sail through. The question is, are we gonna get a regional bank that blows up in the meantime?

Robert Armstrong
Yeah. The great lesson of the financial crisis was that it’s not the level of distress or losses that matters so much as where that distress and loss is concentrated. Is the loss concentrated in a link in the great economic chain that is then broken, and then there are all these second-order contagions that ruin everything else? Now, there is one reason, strictly from the point of view of the banking system today not to worry, which is a classic way a regional bank with a lot of exposure to a troubled asset class would break is that they would take the losses, that asset losing value. Their solvency would suddenly be a bit in doubt, and the uninsured depositors are ran for it. That is simply unlikely to happen today, because Federal Reserve and the other regulators come in and protect the depositors. That’s what we learned with SVB and Signature and the others back in March. So depositors now having watched that happen are much less likely to run, which means banks can absorb losses without risks to stability in a way they might not have been able to do before last March. So that’s a small, reassuring point.

Ethan Wu
So, Rob, that’s definitely one reason to maybe worry a bit less about CRE blowing everything up. And you know, Josh has hinted I think at a few others, which is, I mean, this is a very slow-moving sector, right? A lot of the losses that originated in the 2008 financial crisis were not actually crystallised for investors until like 2015. It took years and years and years for these to materialise. There’s very few liquidity events unlike some markets where they’re every day or, you know, every week. We’re talking about years for liquidity events to happen. They don’t really happen until you have to actually refinance the building.

And I think these all create a certain amount of buffer space between a valuation reset in commercial real estate and kind of broader problems with the banking system. You know, you could get a regional bank that blows up. It’s definitely within the realm of possibilities. It’s in the probability distribution. But I don’t know if it’s something that we need to all be, you know, all that panicked about.

Joshua Oliver
I would add on that, you know, reasons to be, slightly reassured list also just that we’re all talking about it and paying attention. You know that tends to make financial risks less likely to bite you. But Ethan, you’re absolutely right. You know, these things, real estate just moves incredibly slowly and people will be hoping that if they can survive for long enough, the interest rate cycle will lift them back out of trouble and they’ll be able to carry on. You know, the motto in real estate has become survive until 2025.

And people talk about, we talk about refinancing and, you know, refinancing-driven sales. People talk about it’s like a wall of refinancing. And I’ve always kind of felt like that was a bad analogy because a wall would hit the market all at the same time with the same effect. And what you have in commercial real estate is, you know, you can calculate how much refinancing there is in any given year, but the way that it arrives is at different times for different asset owners with different results in different circumstances.

So, you know, the analogy I like is it’s more like one of those like internet games where you have a little character who moves along and they have to like jump over one obstacle and duck under another obstacle and just trying to keep on going. And you know, and like, you know, you can have one little obstacle is coming in breach and the next obstacle is, you know, a refinancing event, and people are just trying to get through. And so if some of them get through, a few of them will fall off, a few buildings have to be sold. You know, people will try everything they can just to, you know, make it through until the market recovers. That will hopefully result in not having the kind of cataclysmic, the one big cataclysmic event.

Robert Armstrong
That’s your takeaway, folks. Commercial real estate is Donkey Kong. (Ethan laughs)

Joshua Oliver
I was thinking, Rob, about the game you play when Chrome doesn’t load and you are the little Tyrannosaurus rex who bounces up and down. But, Donkey Kong, if you like.

Ethan Wu
The T-Rex just has to survive until 2025.

Robert Armstrong
I refuse to laugh at that joke.

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Ethan Wu
All right, guys, back in a moment with Long/Short.

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Welcome back. This is Long/Short, that part of the show where we go long a thing that we love, short a thing that we hate. Josh, are you long or short something?

Joshua Oliver
Yeah. Controversial. I am long return to the office, I think.

Robert Armstrong
Wow.

Joshua Oliver
Not necessarily because I think it’s a good thing, but because I think it will happen. And I think, you know, that we will work in the office less obviously in the future than we did before Covid but I still feel like we’ve got a ways to go towards getting to the equilibrium and that the, you know, the powers that be are massing to try and force people back to the office because I feel like at that, you know, business leadership level, the consensus is hardening that people need to turn out more.

Robert Armstrong
I am 100 per cent making a massively leveraged trade on the other side of that. (Ethan and Joshua laugh) Working from home is an absolute human good. Now, it may be we’re a little bit less efficient working at home, but look, commuting is pure evil. That is hours of human life set on fire and used for nothing. Working from home is a glorious thing that must be protected at all costs. And so I am short return to office hard.

Joshua Oliver
I think, Rob, the mistake you’re making is assuming that because something is a human good, corporate America is gonna allow it.

Robert Armstrong
Now that’s just cynical.

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Ethan Wu
All right, Rob and Josh, thanks for being here. We’ll have you both back very soon. And listeners, we’re back in your feed on Tuesday with another episode of Unhedged. Catch you then.

Unhedged is produced by Jake Harper and edited by Bryant Urstadt. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhecz. Cheryl Brumley is the FT’s global head of audio. Special thanks to Laura Clarke, Alastair Mackie, Gretta Cohn and Natalie Sadler. FT Premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com/unhedgedoffer. I’m Ethan Wu. Thanks for listening.

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