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"One of the greatest disservices you can do a man
is to lend him money that he can't pay back."
Jesse H. Jones
February 13, 2024 | Updated | Several readers of The Institutional Risk Analyst have asked of late: “how big is the commercial real estate mess in the US?” Answer, losses in the trillions of dollars over time. Think about the Texas oil bust of the 1970s, which led into the S&L crisis of the 1980s.
The Great Depression started with deflation in the financial markets a century ago, but more recent bubbles in the US have been fueled by real estate speculation. In one potential future, the Great Crash of 2029 begins with shocks to commercial real estate in 2022, shocks that go mostly unheeded.
In the wake of the market reaction to the earnings surprise from New York Community Bank (NYCB), there is growing awareness of a problem in commercial real estate. This problem, however, is a lot bigger than the mortgage loans owned by banks and REITs, public and private. Much of the mortgage debt for commercial properties has been sold to investors in the bond market. And the growing insolvency of commercial buildings in major cities is a dead weight on economic activity and job creation, not to mention the fiscal stability of major urban centers.
We can all pretend that the collapse of valuations for many commercial and multifamily properties is not a major problem. Or we can act now to address the problem of moribund real estate before the deflationary effect of falling commercial real estate values affects other parts of the economy. Banks may be the most obvious sector hurt by property deflation, but equity owners, tenants and vendors also are disrupted.
When landlords fatally damaged by two years of loan moratoria during COVID abandon a multifamily building, the tenants in the building face reduced levels of service and heightened insecurity. If there is no private buyer for the foreclosed apartment building, even at the reduced value, then the asset eventually becomes public housing. Progressive New York City already houses more than 360,000 people in public buildings.
Historically, when a landlord in NYC had a long-term tenant vacate an apartment, any apartment, the unit was renovated, brought up to code and the rent adjusted accordingly. A full gut and apartment rehabilitation in NYC today starts in six figures. Under New York’s progressive 2019 rent control law, though, landlords cannot recover the cost of renovations, so the apartments are simply locked and kept off the market.
The commercial insurer of the building, keep in mind, prohibits the rental of units not up to code. Indeed, New York law has penalties for landlords who rent substandard apartments. But nobody in Albany under progressive rule cares about costs or anything else. Meanwhile, the value of buildings with rent controlled units is falling, making them difficult to finance with a bank. The building has fewer tenants, lower net operating income, higher cap rates for prospective investors and thus lower appraised value. Deflation.
Falling valuations for commercial real estate is not only a problem for the US. The global economy faces stiff deflation due to 1) COVID and 2) massive property speculation in Asia, the EU and the US fueled by low interest rates. Changes in work behavior following COVID have left many – but not all – commercial assets facing enormous losses. But on top of these COVID-related issues lies the equally serious problem of aspirational pricing in global commercial real estate.
We’ve noted the top-line valuation number from NAREIT of $20 trillion for all US commercial real estate, but estimates vary widely. Property values surged between 2022 and the end of 2023. And we’ve seen even higher estimates than NAREIT, what we call aspirational pricing. The Real Estate Roundtable said that commercial property could be worth $22 trillion in 2021, before the post-COVID feeding frenzy and subsequent collapse.
The Mortgage Bankers Association, using data from the Fed and Trepp, says total debt on commercial and multifamily real estate is about $5 trillion. Banks hold less than 25% of multifamily and commercial mortgage debt, says MBA, but the value of the underlying property has raced ahead of official inflation rates. Insurance companies, for example, own over $700 billion in commercial mortgages, which are held at book value. Insurers also invest in the equity of commercial real estate.
It’s fair to say that the average value of the properties behind the mortgages held by banks and other lenders has fallen over the past two years. If there is $5 trillion in mortgage debt under commercial and multifamily properties, there are several times more trillions of equity that is now compromised. Yet the ebb and flow of commercial real estate in the US tracks the expansion of the economy in the post WWII era.
Since the Roaring Twenties, the ebb and flow of American finance has changed the nature of risk. Whereas deflation on the farm, private speculation and clumsy actions by the Federal Reserve Board caused the Great Crash of 1929, in the 21st Century the various arms of government – particularly the Federal Reserve and the US Treasury – are the largest sources of risk to the US economy.
The Fed’s tolerance for higher inflation to facilitate burgeoning federal debt issuance boosted valuations for all real property, residential and commercial alike. During COVID, lower interest rates drove down cap rates and drove up property values around the US and the world. COVID plus the low-interest rate regime since 2008 set up the US property market for a major correction. But the larger and steady inflation of asset prices over half a century and more now compounds the pain on the way down.
The steady inflation of the dollar since the Civil War has fueled nominal economic growth and driven increases in asset prices. But inflation has caused the greenback to lose more than 95% of its purchasing power over the past century. The real value of a $1 in 1920 equals almost $20 today. Investors seeking to protect themselves from this steady diminution of the real value of the dollar have invested in stocks and real estate. Indeed, the huge increase in the nominal value of stocks and all types of real assets speaks to the constant theme in human existence: inflation.
Goetzmann and Jorion (1997) in their classic NBER paper argue that equity returns in the 20th Century averaged 6% after inflation, as measured by government statistical agencies. But equity returns on commercial real estate, which typically carry 50% leverage to the value of the property or 50% LTV, have been far higher than stocks if you include the price appreciation of the asset. Look at the movement in average prices for CRE, as shown in the FRED chart below.
Pension funds, endowments, sovereign wealth funds, private equity firms and family offices have piled into commercial real estate on a global basis, in some cases combining internal leverage within funds with external leverage provided by lenders and REITs. The use of leverage in China commercial real estate has been extremely aggressive, as illustrated by the collapse of China Evergrande and other developers. In many cases, Chinese liquidators are repudiating debts held by foreigners and giving preference to domestic creditors.
Note in the chart above that after the initial price declines following the end of the COVID lockdown, global investors rushed back into existing and new CRE and multifamily assets. This flood of investment drove up prices by double digits even as the FOMC began raising interest rates. The speculative upsurge, however, had a limited duration and now has begun to reverse as realized losses on commercial assets have widened. Anything over 50 LTV in commercial real estate is unsecured. But the losses due to changes in work behavior add another dimension to the equation.
So what is to be done? Policy makers in Washington need to start thinking about dusting off the Reconstruction Finance Corp of the 1930s to help finance the restructuring of an awful lot of now moribund commercial real estate. We are talking here not just about the CRE loans in default now or next year, but a whole class of urban commercial properties that are impaired because the original use case is no longer relevant. Think about office buildings on Third Avenue in Manhattan from 34th Street to 59th Street.
Trillions in commercial properties need to be restructured and probably redeveloped for other uses. We need to put aside the crazy notion, for example, that most commercial properties can be economically repurposed for residential use. If you don’t have large commercial tenants paying big dollar rents in a commercial building, residential tenants are not going to be able to pick up the slack. This means that the existing commercial buildings must come down and be replaced, with all of the attendant cost and environmental impacts.
The RFC was created by Congress at the request of President Herbert Hoover in 1932. “The RFC provided liquidity to struggling institutions through investments in preferred stock and debt securities,” notes the Congressional Oversight Panel January 2010 Oversight Report for Unwinding TARP. “Initially, the RFC provided liquidity for healthier institutions but was prevented from offering long-term capital to weaker institutions by restrictions such as high interest rates, collateral requirements, and short-term lending requirements. The Emergency Banking Act of 1933, however, gave the RFC the ability to offer investment capital, while looser collateral requirements expanded the RFC’s lending capacity. Ultimately, under President Franklin Roosevelt, successive expansions of authority helped the RFC evolve from its initial role as a short-term lender into an agency that provided federal support for the credit markets and became a major part of the New Deal program.”
Why did Hoover create the RFC? Because he recognized that the Crash of 1929 had created a deflationary wave that was consuming the US economy, a terrible process of debt liquidation described by economist Irving Fisher. In the late 1920s, a businessman from Houston named Jesse Jones, who organized the private rescue of several busted banks in Houston, came to Washington seeking help. He remained for almost 20 years and described his work in the classic book, "Fifty Billion Dollars: My Thirteen Years with the RFC."
The role played by the RFC was to break the deflation in asset values that was destroying the US economy and buy time by funding these assets with long-term debt. Irving Fisher wrote in 1933:
"Deflation caused by the debt reacts on the debt. Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes. In that case, the liquidation defeats itself. While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed. Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed. Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: The more the debtors pay, the more they owe. The more the economic boat tips, the more it tends to tip. It is not tending to right itself, but is capsizing."
When Franklin Delano Roosevelt was elected in November of 1932, Jesse Jones nominated himself Chairman of the RFC. The other directors appointed by President Hoover had resigned following the election. But Roosevelt would not take office until the following March. The Banking Crisis of 1933 exploded in February, as we discussed in “Ford Men":
"In 1933, the United States was in its fourth year of economic depression and many U.S. banks were on the verge of insolvency or worse. While the condition of the Detroit banks was probably as bad as or worse than anywhere else in the country, Ford’s actions touched off an explosion that exacerbated already-acute bank-solvency problems all across the nation. Henry Ford the inventor and industrial colossus singlehandedly turned the banking crisis of 1933 from a very bad situation into a national calamity... On February 14, 1933, all banks in the state of Michigan were closed for eight days by order of Governor William A. Comstock. This began a domino effect that would lead to the collapse of the nation’s financial system three weeks later. Michigan was forced to default on its bonds and the state government was crippled, a default that rippled through the savings and balance sheets of individuals and companies around the world."
When FDR took office on March 4, 1933, every bank in the US was closed. By the end of 1933, Congress had created the FDIC and passed other emergency reform laws that gave FDR and Jones massive powers. After Roosevelt, “Jesus H. Jones,” as the President called him, was the most powerful man in America.
Al Crowley, the financier behind FDR, organized the FDIC in 1933 and then later ran the Lend-Lease program through WWII. If your bank could not qualify for FDIC insurance after the 1933 bank holiday, then you went to see Jesse Jones. He'd tell you to go home and raise new capital, which he'd match. Otherwise he'd throw you and the other bank directors in jail.
Jesse Jones restructured the US economy, including hundreds of banks and dead companies. Jones eschewed partisan politics at the RFC and relied upon the private sector to do much of the work of restructuring. And there was nobody in Washington dumb enough to argue with Jones. The federal government provided the financing via the RFC’s bond issuance, which also financed FDR’s gold purchases. The RFC performed a receivership function for busted banks and companies through the Great Depression and WWII. It was wound up only in 1957, a year after Jones' death.
Why is something like the RFC needed today? Because the numbers involved in the restructuring of trillions of dollars in busted urban commercial real estate are too big for the banking industry or the FDIC or even the Federal Reserve System to handle. The Resolution Trust Company of the 1980s is also a relevant model, but the RTC was designed to restructure dead S&Ls and dispose of real estate in a reasonably short period of time.
The financing and restructuring of urban commercial real estate in most US cities is a massive, long-term task that requires trillions in financing. But even before plans are made to knock down old offices and build new residential assets in major cities, the bigger question is how the city will support the cost of operating going forward. Cities were created centuries ago as commercial centers first and foremost. If progressive politicians in cities like New York, Chicago and San Francisco chase away the business community, who is going to pay to operate a modern city much less redevelop old buildings?
Readers of the Premium Service of The IRA recall that we expect to see another upward surge in home prices when the FOMC finally drops short-term interest rates. Volumes will rise for a while, but the lack of new home construction will push average home prices up dramatically. Within a couple of years after volumes peak, however, we expect interest rates to rise and residential home prices to correct sharply lower. Between now and then, the US needs to develop a national plan for dealing with the massive amount of busted commercial property that is accumulating in cities and towns around the country.
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