The 800-Pound Gorilla: Office Real Estate

What’s the outlook for the office real estate sector and regional banks?

In “Sonny Kalsi: Navigating Bank Failures and Commercial Real Estate Holdings,” a Guiding Assets podcast from CFA Institute, Paul Andrews, head of Research, Advocacy, and Standards at CFA Institute, speaks with Sonny Kalsi, co-CEO of BentallGreenOak (BGO), a leading global real estate investment management adviser and provider of real estate services with approximately $83 billion in assets under management (AUM), about the sector’s prospects.

Financial market practitioners and observers have grown increasingly anxious this year about the health of the economy and particularly about the banking sector’s exposure to the real estate sector. The collapse this year of Silicon Valley Bank (SVB) and Signature Bank, as well as the hasty acquisition of First Republic Bank, has convinced some market players that regional banks, which are already under financial stress, may now face a potential crisis in the shaky commercial real estate sector. Of greatest concern is the banking sector’s exposure to the office sector.

Andrews opened his discussion with Kalsi with the systemic risk issue: “With many banks holding large portfolios of real estate, what do you see as the end game, particularly from both a systemic risk angle as well as the banking angle?” he asked.

Many big banks have retreated from real estate lending, and their lending to commercial real estate especially has gone down on a percentage basis, Kalsi said. But the non-bank sector has stepped in to help bridge the lending gap. “Non-bank lenders are often getting repo financing from those same big banks. Regional banks are now providing a huge amount of real estate lending and are probably at least one-third of the real estate lending that’s been happening and have been a big part of the incremental real estate lending for the last five years,” he explained. “So, the long answer to your question is, I think, the regional banks have a fair amount of exposure there.”

The two big issues to consider are liquidity and the condition of office real estate, according to Kalsi. “There’s no financing available. The big banks aren’t providing it, and the regional banks are now no longer providing it.” 

Because commercial real estate is a large category, Kalsi believes there are sections of it that will be less problematic. He cited the industrial and multifamily sectors as examples. Multifamily is also buoyed by government-sponsored agencies that provide financing, he said. The office sector is a headache, he warned. “It’s not really the canary in the coal mine,” he said. “It’s the 800-pound gorilla sitting squarely in the middle of the room!”

Regional Banks’ Challenge

“So, what are the regional banks going to do? Are we just sitting on another time bomb?” Andrews asked.

“Yes, I think It could be a time bomb,” Kalsi said, “but I think it’s going to be a time bomb with a long fuse.” Unlike a security, which is a short-term instrument that can be rolled over in the capital markets, many bank loans are structured such that the banks must themselves pull the trigger to create a default. “So, there are plenty of assets right now that are in technical default,” he said. “There might be lack of compliance with different covenants, maturity, defaults, etc., where a lot of the banks are just rolling them over because they know that their borrowers are in an illiquid market and not in a great position to refinance them.”

Regulators will therefore hold great sway over whether and when the default time bomb goes off, Kalsi asserted. “You could argue that on the one hand the [regulators] caused this by the interest rate environment, right?” he said. “A lot of people got caught flat-footed. I didn’t think rates were going to go up at the pace that they did, but we knew rates were going up. So, I am a little bit surprised that some of these lenders got caught as flat-footed as they did. It’ll be interesting to see how the regulators approach this.”

If regulators compel lenders to mark to market their positions, the result could be something ugly, Kalsi warned. “But if the regulators take it easy on them and give them time, then I think this is going to be a slow process.”

Most Beleaguered Sectors 

“I’ve said jokingly that office has replaced retail as the worst six letter word in real estate,” Kalsi said. For perspective, he noted that 10 years ago it was the retail sector that faced an “apocalypse.” “No one was shopping in stores anymore,” he said, and although retail asset values are down 30% to 50% over the last 10 years and many tenants have gone bankrupt, those retail tenants that survived face less competition and thus there is a better business environment for them now. “So, retail has found its footing somewhat and is doing okay,” he said.

“I think that’s what’s going to happen with the office sector. But remember, I said 10 years. The office sector is going to take a while to find its footing. Therefore, we must decide to be patient to work through that, and regulators will have to decide if they’re going be patient or if they’re not,” Kalsi said.

So, if regulators are patient, we won’t face another huge systemic risk event?

“I hope that we don’t face another systemic risk event,” Kalsi replied. “I’m not going to name names, but there are certain lenders out there for which 30% to 40% of their book is commercial real estate,” he said. He declared that those banks have issues, pointing to the failures at SVB, First Republic, and Signature Bank this year as examples of the kind of failures that could be in the offing. “I’m not a banking expert. But if I were a betting man — which I am — I don’t think we’re done with three banks. I think we’re going to see more.”

“The members of CFA Institute are asset owners, asset allocators, intermediaries, etc. How would you look at this issue from a practical standpoint? What should they be focused on?” Andrews asked.

“Some of them own assets on a direct basis, some probably indirectly, whether it’s through the REIT market or whether it’s through fund managers. I think one thing you’ve got to ask yourself is ‘Do I have the right people managing the ship for me right now?’ I think that’s part of it. So that’s number one,” Kalsi said.

Number two is how to think about the asset class. “We’re talking about defense. We’re talking about what do we do about our existing portfolio. How do we think about that, and how do we manage our way through it? One thing we hear a lot about right now is the denominator effect — equity markets are down therefore alternatives now represent a bigger percentage of most of these folks’ portfolios. Is that a bad thing? And maybe that’s the direction where people should be going here. One thing about the global financial crisis that was clearly informative is the people who had more time wound up with a better recovery value than people who had to do a forced sale.”

But even amid a conversation about the potential pain threatening the real estate market, “there’re also some great investing opportunities,” Kalsi said. “For example, it’s a great time to be a lender right now. If you can be a lender — and by the way, we have a big loan book; lending is about 25% of what we do — it’s a great time to put new capital to work in that space. So, I think part of this is not only how do existing investors and CFA Institute members think about playing defense on what they own? But how do you think about going on offense as well?”

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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