Ted Shaffrey/AP Photo
People walk by the TSX Broadway construction site in Times Square in New York on March 11, 2023.
As banks and bondholders scale back their holdings in office buildings and other commercial real estate (CRE), shadow lenders are growing to fill the gap.
Office and retail properties face plummeting valuations after the pandemic, as businesses have struggled to restart in-person work and shopping. That reality has become more acute in the wake of the regional banking crisis, since small and midsize banks are heavily exposed to CRE loans. Banks with under $250 billion in assets issue about 80 percent of commercial real estate loans, according to a Goldman Sachs study.
The March collapse of Silicon Valley Bank triggered widespread worries about a meltdown in the sector. When New York–based Signature Bank failed two days later, more headlines predicted fallout for CRE. New York Community Bank, Signature’s chief competitor, acquired the majority of the failed bank’s assets but skipped Signature’s commercial real estate portfolio, further fueling speculation about troubled CRE loans.
But while regional banks are more exposed to commercial real estate than systemically important banks like J.P. Morgan and Wells Fargo, chatter about their exposure is something of a red herring. Much of the risk lurks instead in alternative lenders such as real estate investment trusts (REITs) run by the asset managers Blackstone and Apollo, which have flourished since Congress passed the 2010 Dodd-Frank Act to regulate Wall Street, driving more activity into non-bank financial institutions.
Seeking the higher profits available in private markets, pension funds have invested heavily in REITs. Many are now preparing for heavy losses. The California State Teachers Retirement System (CalSTRS), for example, expects to see a sharp downturn in its real estate holdings, which make up 17 percent of the $306 billion fund. Office real estate is likely to fall by 20 percent, CalSTRS Chief Investment Officer Christopher Ailman told the Financial Times.
Alternative asset managers have grown dramatically in the past decade. Real estate investment funds, or trusts, make up 40 percent of the commercial real estate market in the euro area, up from 20 percent in 2013, according to a new report this month from the European Central Bank.
Rising interest rates have compounded risks in CRE, with monetary tightening accelerating banks’ pullback from the sector and encouraging the rise in unregulated private credit and debt funds. The pandemic and the trend to working from home has exacerbated these issues.
Europe has seen a faster return to work and now has a vacancy rate that is half the rate in the U.S. But the European market faces other headwinds, which are also encouraging private credit funds to step in.
In particular, stringent new decarbonization requirements for commercial buildings are straining office space financing, Nicole Lux, a research fellow at Bayes Business School in London, told the Prospect.
“There’s a lot of obsolete buildings now in Europe that could become stranded assets. They’ve become non-investible, because they don’t have the right [green] credentials,” Lux said. She estimates higher interest rates account for about 60 percent of the funding gap for CRE in Europe, with environmental standards, work-from-home, and other fundamentals making up the remainder of the credit crunch.
CalSTRS has a $1 billion holding in a Blackstone European property fund, one of many American pension funds with significant exposure to European real estate.
Since private credit funds are now stepping in to take commercial real estate off the books of traditional banks, the coming months may not see as many forced sales or insolvencies as market conditions would otherwise imply. In addition, offices represent only one-eighth of total commercial real estate loans since 2000, according to the Bureau of Economic Analysis.
But while some of the pressure in the CRE market could simply be shifted to private funds, which typically charge higher interest rates, investors in those funds are getting jittery. So many investors have pulled back from Blackstone’s REIT this year that the asset manager limited shareholder withdrawals, seeking to stem the outflows and restore confidence.
So far, however, investors remain skeptical. Blackstone limited redemptions for the fifth month in a row at the start of April. There were $4.5 billion in refund requests in March in Blackstone’s main REIT.
