Storm Clouds and Silver Linings: Navigating the Perfect Storm in Commercial Real Estate

It’s been a hot summer, hasn’t it. We can debate about the cause, but we can all agree that climate change is real, temperatures are rising, and as actuaries will confirm, the number of weather-related natural disasters has risen exponentially and caused billions of dollars in damage year-after-year for several years now. 

Things are really heating up, pun intended.

First Lien Capital is the eye of the storm, a calm and consistent investor and asset manager with decades of experience in loan workouts, modifications, bankruptcy oversight, dispute resolution, servicer oversight, and mediations.

Business is heating up for us. 

In addition to distress brought on by mother nature’s power, another systemic risk is echoing through the halls of commercial real estate. And it has to do with the cost of capital.

If you’re a thirty-something banker, you’ve never worked in a world where deposits mean something, and the cost of capital is more than zero. Your whole world changed about two years ago when the Federal Reserve started raising interest rates.  

For the older generation, these rate hikes are just a return to normal, but I still know many friends clamoring about how the Fed must lower rates (obviously to retain the inflated value of their assets). 

The Fed knows what it is doing and good for them. 

Markets are cyclical and must be left to their own devices to ensure free market normality. The concern, of course, is that many sponsors, landlords, and investors are highly leveraged and these higher capital costs will cause many to fail.

That is true, a fact that we cannot dispute. 

My father used to say anyone could make money in real estate when prices were rising. “What separates the men from the boys, son,” my father would opine, “is those that can survive and thrive when markets are disrupted.”

I believe the opportunity to prove my dad right is on our horizon.  

The following study was published by Paul Kupiec, Economist and Senior Fellow at the American Enterprise Institute, earlier this year and an excerpt is being reposted here with the permission of the author.

It’s a deep dive into some of the headwinds that face commercial real estate and more importantly, the impact that this market cycle may have on the banking system.  

The USA, by far, has the most banks and credit unions of any country in the world. 

Expect to see far less in the coming years.

Original Abstract Published May 15, 2024
Commercial Real Estate and Bank Systemic Risk

By Paul H. Kupiec

Detailed analysis of December 2023 bank regulatory data suggests that, because of unrecognized interest rate losses in the banking system, banks’ true commercial real estate loan concentrations are much larger than traditional supervisory CRE loan concentration measures suggest.  Taken together, the weak demand for several types of commercial properties, sustained unexpectedly high interest rates, and the concentration of CRE loans in many bank portfolios has created significant systemic risk in the banking system. A widely anticipated wave of CRE loan defaults could render a very large number of banks market value insolvent. Conditions appear ripe for a sequel to two unfortunate episodes in US banking history: the 1980s Savings and Loan Crisis and the 2008 Great Financial Crisis. There is a high probability that the financial system and wider economy may be shocked by a wave of bank failures large enough to test the public’s confidence in the banking system and the resources of the federal deposit insurance safety net.

Read the full study at aei.org.

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