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Banks Fear Downgrade as Commercial Real Estate Flounders
November 24, 2020

Banks Fear Downgrade as Commercial Real Estate Flounders

by The CE Shop Team

How Will COVID-19 Hurt Commercial Real Estate & the Banks Backing Their Holdings?

The past decade has seen a remarkable rise in our economy as a whole. Almost every industry has seen massive gains, both in the spreadsheets and in the stock market. However, with the onset of coronavirus back in March, a high level of uncertainty has loomed over every economic sector, including commercial real estate.

Banks Look to Be Downgraded Heading Into 2021

The 2010s saw a massive increase in commercial real estate development, all fueled by the $5 trillion dollars in debt secured by companies through the banks. It is this staggering number that worries analyst teams and, more importantly, banks around the country.

“Commercial real estate (CRE), in our view, tops the list of sectors that are most at risk of declining asset quality amid the coronavirus pandemic,” stated one analyst team led by S&P Global Ratings’s Stuart Plesser.

How banks absorb the impending hit from CRE firms defaulting on their loans depends on the sectors they’re involved with and the amount of exposure they have to the industry. Plesser’s team expects that a 3% “base case” loss in commercial real estate could easily be absorbed by exposed banks while a 10% loss could lead to several downgrades in the near future.

However, there is a wide range of speculation across the industry. Here’s what these busy bees are saying on the street:

Federal Reserve: Lenders should expect a 6.3% average loss under a “severely adverse scenario,” with a high-end loss of 10.2%; affects loans held by banks with a $48 billion dollar loss per quarter over nine quarters.

Bank of America Global: Loss of sales only add up to 2.0% at most of all CRE transactions; need to monitor real estate investment trusts (REITs) over the next year; publicly-traded REITs currently down 25.0% in subsectors.

Standard & Poors Global: “Base case” scenario foresees a 3.0% loss in CRE, with a 10.0% “worse outcome” loss that could lead to credit downgrades of banks.

Which Commercial Real Estate Sectors Are Most Vulnerable?

Commercial real estate depends on tenant businesses paying rent. But when the entire country is shut down due to COVID-19, the ability for these storefronts and office spaces to pay on time becomes improbable. Thus, the sectors most likely to take the biggest hit in commercial real estate deal with office and retail space. This makes complete sense if you observe how CRE operates in these subindustries:

Retail: Coronavirus’s spread forces the government to initiate “stay-at-home orders,” limiting store hours and in-store purchases. People stop shopping at brick-and-mortar stores, causing a significant drop in revenue. The store then can’t pay its rent to landlords, who either directly report this to the firms or are the firms themselves. And then finally, the firms cannot pay the banks, who suddenly have bad debt on hand.

Office: Stay-at-home orders force companies to work remotely. Companies realize remote work actually saves money, leads to higher productivity, and better talent recruitment. Then commercial real estate firms are stuck with vacant office space and no revenue stream to actually repay the banks.

Meanwhile, warehousing needs for storage (eCommerce, self, pharmaceutical, grocery, etc.) are prevailing much better than these other sectors. Leading the charge within these sectors -- both with the usage of facilities and purchasing of them -- is none other than the margin pirate/supervillain/philanthropist himself, Jeff Bezos, and his company, Amazon. These sectors are considered coronavirus-proof and have grown substantially because of quarantining and social distancing guidelines.

Worst Outcome: What Happens to the U.S.?

Worldwide famine. World wars. Alien invasion where Mel Gibson and Joaquin Phoenix defend our world with jugs of water... While there could be a significant impact on the real estate and stock market, the end result of the worst outcome would lead to a few things:

  • Stock market correction within REITs, derivative ETF and Mutual Fund investments, and publicly-traded stocks involved with or possessing large exposure to the CRE sector could take a big hit.
  • Credit ratings of banks could be downgraded.
  • Banks may be less willing to provide mortgages without steller personal credit ratings.
  • Lending companies like Quicken Loans taking on a bigger chunk of the mortgage market.
  • Commercial real estate firms will seek debt financing from non-bank lenders (NBL).
  • A decrease in demand for homes due to lack of financial backing (i.e. fewer mortgages being processed means less money available for home purchases).

Commercial Real Estate Agents Considering a Move Into Residential?

With uncertainty surrounding the commercial real estate industry, many CRE agents are considering a switch into the residential field. Margins are higher in commercial real estate, but at the end of the day, people don’t need to go to stores anymore to get consumer goods, and workers don’t necessarily need to be in the office thanks to technology like Zoom. However, people still need homes. The demand for a roof over one’s head is as old as time and won’t be going away anytime soon. Investing in a career that meets this near inelastic demand can provide the stability you need as we venture into 2021.

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