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A Q&A with Erica Jiang on the Newest Real Estate Crisis

A Q&A with Erica Jiang on the Newest Real Estate Crisis

Banks and building owners are in a moment of turmoil. What can be done?

Erica Jiang headshot

Assistant Professor of Finance and Business Economics Erica Jiang

[USC Photo]

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The commercial real estate market may be in the middle of A PERFECT STORM. Declining property values and high interest rates have increased stress on lenders. The turmoil reached an early boiling point, as EVIDENCED by the precipitous drop in New York Community Bank’s stock in reaction to the plummeting prices of their recent real estate sales.

With the Federal Reserve maintaining interest rates at a 23-YEAR-HIGH there may be little relief on the horizon for fledgling mid-size banks and building owners.

We sat down with ERICA JIANG, assistant professor of finance and business economics and expert on real estate and banking, for a discussion on what her research can tell us about the situation and whether certain safeguards can be put in place to protect banks’ capital.

Interviewer: Can you walk me through some of the different factors that are contributing to these plummeting commercial real estate values?

Erica Jiang: Of course. I want to first go over some conceptual points about what are the reasons that we believe CRE (Commercial Real Estate) has been viewed as having elevated stress risk. And then I can talk about some numbers based on my own research.

The commercial real estate market faces increased business risk. For example, office properties are under significant pressure due to remote and hybrid work patterns, and lower demand for offices can also negatively impact the demand for other commercial real estate properties like urban retail, multifamily units, and hotels. So declining fundamental demand is one major risk that contributes to this.

The other one is related to rising interest rates, which make it very difficult for the commercial real estate property owners to refinance their loans. This is going to increase the financial risk of CRE. And most of the CRE loans are going to mature in the next few years. What’s going to happen is that declining property valuation will make it very hard for those commercial real estate property owners to roll over the debt, and that’s eventually going to lead to maturity default.

Those are the two major risk factors that made CRE viewed as having an elevated stress risk.

Is there precedent for this kind of crisis in the commercial real estate market? Have these building owners faced something like this before where they have extremely high interest rates and declining property rates all happening at the exact same time?

EJ: Not as far as I know. Because of the pandemic, most of the companies actually allow their workers to work from home. As a result, there has been a declining demand for office space. This is definitely a new phenomenon in the commercial real estate market.

As for high interest rates, we did have a high interest rate back in the 1980s. We had the savings and loan crisis, but the commercial real estate loan was not the major concern back then. The main concern was more about residential mortgages and the stress of those mortgages.

The last CRE loan crisis was during the 2007–2008 financial crisis. During the financial crisis, there were at least 10% defaults on those mortgages, but it was not driven by the same reason. So this episode is really unique.

Were there any numbers that you wanted to get into beyond the couple that you already mentioned?

EJ: Yeah. What we did in our RECENT PAPER is try to assess the stress risk of commercial real estate. We used non-level data to compute two important measures of the stress risk.

One is called loan to value ratio, or LTV. And the other one is debt-service coverage ratio.

LTV tells us whether a loan is underwater. In other words, it’s whether the market value of the property is lower than the outstanding loan amount. You can imagine an underwater loan is going to be very difficult to refinance and also faces higher default risk.

What we find is about 15% of all CRE loans are underwater. And among all types of commercial real estate properties, the office loans face particularly high distress risk, about 45% of those office loans … So those loans are actually insolvent.

Another measure we looked at was the debt-service coverage ratio that tells us whether a property’s annual cash flow is sufficient to cover its debt obligation. We find that the average debt coverage ratio was about 2 to 3 when those loans originated. This is because many of those loans originated when interest rates were very low … also the demand for office buildings and demand for other commercial real estate properties was still high, and back then they were able to generate a lot of operating cash flow.

If this ratio falls below one, that means the property does not have sufficient cash flow to meet its annual debt payments. And we found more than 6% of those CRE properties have a debt-service coverage ratio below one by the third quarter of 2023. This was due to the decline in property cash flow.

Between high interest rates and low property rates, this seems to be a perfect storm for commercial real estate. Do you see any way out of it before interest rates decline?

EJ: In that paper, we did so-called “stress testing.” What we found is if we just have the CRE distress, the banking sector would have incentive to help those commercial real estate property owners through the distress. This is because, as a debt holder, if the bank is able to roll over the debt and help them through the current episode, when interest rates fall, eventually the bank will be able to recover some of the losses on the loan provided to CRE.

But what’s really problematic is that the banking sector is not doing well because of the interest rate. We have an earlier work where we showed the entire banking sector is having a huge exposure to the interest risk, and long term assets on banks balance sheets had a significant declining value.

As a result, many of the banks are actually insolvent because of the rising interest rate. This current banking sector really doesn’t have a lot of buffer to help the commercial real estate industry go through this. They don’t really have that much ability to withstand the credit risk.

Are we in danger of a banking crisis in terms of banks failing?

EJ: That goes back to [the failure of] SILICON VALLEY BANK (SVB) last year. Right after the closure of SVB, we had our FIRST PAPER out where we collected bank call reports. We were able to look at the balance sheet of each individual bank in the United States. We found the market value of all of those banks’ assets and then linked it to the deposit side and the liability side.

What we wanted to do in that paper was to see if 50% of depositors withdrew their money or 100% of uninsured depositors withdrew their money, how many banks were going to be at risk? We wanted to know how many banks will not be able to withstand such withdrawal.

We found about 186 banks will be at risk if half of their uninsured depositors withdrew their money. So that was the first piece. We also documented that a couple hundred banks will be at risk if 10% of their CRE loans actually default.

Some experts have said this is a 12 to 24 month process, and that this is something that the market just needs to work through its system. Do you think theres any way to increase the value of these properties in the meantime?

EJ: If the interest rate stays high, it’s going to be a risk that everyone needs to pay attention to. But of course, if we can rebuild the confidence of the depositors in the system, then presumably the bank lenders would be able to help the commercial real estate property owners either roll over the debt or just let them keep running.

In other words, there are two risk factors. One is fundamental, the other is interest rates. For the fundamental factor, I just don’t think there is any way we can deal with it, right? You cannot force people to go to work, and people have the right to choose where to work.

There could be something to be done related to the second risk factor. If we cannot expect interest rates to drop in the short run, then the question is how we can make the banking sector healthier so that it can provide additional loans to help the healthy commercial real estate loan properties through this period.

How do you imagine the CRE market stabilizing after all of this? What do you think the market is going to look like once banks and borrowers figure out what to do?

EJ: On the CRE front, I think a lot of builders and property owners will adjust their business model.

On the banking side, there are a lot of discussions about how exactly we can increase or decrease banks’ risk taking by forcing them to hold more capital.

This is really a major proposal we are pushing for. We have another work that talks about what is the optimal capital structure or how much capital can banks hold that does not affect their lending ability. This is a major question in terms of how much risk banks actually take and given their equity position, given the capital they hold, whether we are able to force them to take less risk.

Can you imagine that, maybe in one to three years, there is going to be less risk on these bank loans?

EJ: If we are able to actually have a new capital requirement, which is much higher than currently, I think it would definitely lower the risk in the whole banking system.

Would that be a matter of policy?

EJ: Yeah, I think this is a matter of policy, right? Capital requirement is one of the major regulations imposed on banks. If you ask the banks to ultimately choose how much equity they want to hold, the banks would have incentive to hold almost 100% of deposits. They don't want to have any equity on their balance sheet.

What regulation is supposed to do is to set a capital requirement so that all of the risk taking incentive is removed from the banking sector or at least the banks can behave in a socially optimal way.

What’s problematic is the banking sector is already experiencing a lot of losses because of the rising interest rate. The market to market losses, plus this additional CRE distress are going to further push a lot of banks to insolvency. That is where the problem is.