Commercial Real Estate Is About to Cause a Milder 2008

Kyle Bass got 2008 exactly right...

Bass is the founder and chief investment officer of Hayman Capital Management.

He's known for his successful bet against subprime mortgages before the 2008 financial crisis. All in all, his company's main fund returned more than 200% as the subprime mortgage market collapsed.

Recently, Bass issued a dire warning for the banking sector...

He says that banks are going to lose between $200 billion and $250 billion in equity due to high interest rates, tighter lending conditions, and – most significantly – the office market.

In this case, "equity" refers to how much exposure banks have to various investments and loans.

And commercial real estate ("CRE") is poised to be a major source of losses for banks...

Banks reportedly have about $3.6 trillion in exposure to CRE – and there's fear that a lot of that exposure is going to sour soon.

Office space, in particular, is performing poorly. Recall that many office-building owners are already mailing back their keys.

We've seen how bad a real estate downturn can hurt the economy... And because banks hold so much equity in this corner of the market, a decline in CRE values would be a massive hit.

This could have a ripple effect on many different sectors of the economy. And today, we'll discuss how this might be yet another sign that banks are going to start backpedaling on lending soon...

The U.S. economy is in a period of extreme volatility...

In fact, it has been one of the most turbulent years since the onset of the pandemic.

And office real estate is among the sectors that have been hit the hardest...

This is mostly due to the fact that people – and businesses – have embraced remote work. According to the New York Times, about 68% of employers now allow work from home. And Forbes estimates that about 22% of the workforce will be fully remote by 2025.

This trend is only expected to continue, which means less and less demand for office space...

Last quarter, office vacancy rates hit a 30-year high of 18.2%, weighing heavily on the broader commercial real estate market.

And that's a huge problem for banks which, remember, have $3.6 trillion in CRE exposure. In total, that's equivalent to about 20% of their deposits.

If more office buildings start closing their doors, banks are going to struggle. Cash flows will dry up. And they'll be left with a huge inventory of office buildings and nobody to sell them to.

This is much like what happened in 2008 with the housing crisis, though it won't be as severe as the Great Recession...

That's because banks have stronger capital buffers today.

While they're expected to lose about $200 billion to $250 billion in equity, they have about $2 trillion in total equity. That would be about a 10% hit to the U.S. banking sector.

That's a big deal, but it's not likely to cause a systemic financial crisis. As we mentioned yesterday, the Federal Reserve is pushing for banks to raise their capital requirements, so they should be better prepared to handle such losses.

Nonetheless, a $250 billion blow to equity is bound to scare banks into tightening their lending standards further. And when banks start actually losing money on their loans, they'll lend even less in order to rebuild their financial reserves.

This means that businesses and consumers will have less access to credit... all while their cash balances are declining to multiyear lows. Without access to loans, many folks will struggle to make ends meet, triggering economic instability and waves of defaults.

It's time to be cautious...

A recession is right around the corner.

High interest rates are weighing on the economy. Household and business financials are taking a hit. And it's driving loan delinquency rates up.

At the same time, banks have every reason to keep tightening their lending standards.

As we said yesterday, it's creating a massive credit crunch that investors aren't ready for. And folks who have big expectations for the stock market need to be cautious...

Even if banks don't collapse like they did in 2008, a 10% drawdown to their equity will lead to sell-offs in the rest of the market.

Regards,

Rob Spivey
September 28, 2023

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