Brace for Impact: West Coast Real Estate Faces the Dark Side of Banking Selloffs

Published: 03-14-23    Category: Insight

MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.

San Francisco, California at night

In recent days, the banking industry has been plagued by a series of unsettling events, most notably the collapse of Silvergate Bank (SI), Silicon Valley Bank (SVB), and the closure of Signature Bank in New York. Now, as commercial real estate loan portfolios, particularly those on the West Coast, are feeling the brunt of these events, a surprising and possibly concerning new development has emerged. A sharp rise in interest rates over the last year combined with the inappropriate application of proper duration management to banks` bond portfolios, led to large, and largely unanticipated losses on these portfolios. But similar losses could be lurking in banks` commercial loan portfolios.

West Coast Commercial Lenders Prepare for SVB Collapse`s Aftermath

The demise of SVB, a significant participant in the tech sector has rocked the West Coast`s commercial real estate market. SVB`s demise caused a rippling effect in the sector due to its substantial exposure to the startup ecosystem, which includes commercial real estate loans, making lenders more cautious in their dealings. As a result, it is difficult for many commercial buildings to obtain financing on terms even adjacent to their last point of negotiation, especially those in the technology and innovation sectors. This will likely significantly affect the West Coast commercial real estate market, possibly slowing development and increasing vacancies.

A noticeable air of anxiety permeates the West Coast`s commercial real estate market as events continue. The sector, which formerly benefited from the rapid expansion of technology firms and innovation hubs, is now at the mercy of a volatile financial environment. Many are left unsure of whether this is the start of a more serious slump or merely a brief blip on the road to recovery. History and economics suggest when most are not only hoping but needing the latter to be the case, the former occurs.

New York CRE Exposure Increases Following the Closing of Signature Bank

Adding to this, there are now worries regarding the exposure of commercial real estate loans in the region following the recent closure of Signature Bank in New York (SBNY - NASDAQ). The closure has put many commercial real estate loans at risk, according to Trepp, a top provider of data, analytics, and technology solutions to the worldwide securities and investment management industries. As a result, lending policies have become more stringent and scrutinized, which might put extra strain on the city`s already-stressed commercial real estate sector.

The streets of New York, which were once alive with trade, now face the more ominous prospect of rising vacant spaces and declining development. The once-vibrant skyline of the city may soon bear testimony to a more depressing economic reality as lenders tighten their purse strings and borrowers race to find funding.

Consequences for the Larger Market:

Further ramifications for the commercial real estate market across the US are anticipated as a result of the banks` sell-off and heightened caution among lenders. Property developers and investors may find it challenging to fund new projects or especially to refinance existing loans if financing becomes more difficult to come by. This can cause the development and construction industries to slow down and loan defaults to rise, further stressing the market.

The effects of this potential escalation could be felt well beyond the West Coast and New York. While the banking sector deals with the fallout from its recent errors, commercial real estate markets nationwide are preparing for a potential tsunami of defaults and foreclosures. Investors and lenders alike are forced to ponder what, if any, steps may be made to turn the tide and bring stability back to the business in the midst of this growing sense of anxiety.

Duration Management Errors

The incorrect application of duration management to loan portfolios, which are similar to bond portfolios, is a significant element contributing to the current status of the commercial real estate market. It is clear that banks have not used duration management successfully as many still hold bonds yielding 1.5% while interest rates have risen by almost 425 basis points in just a year, creating large unrealized losses. Due to this oversight, portfolios of loans and bonds are now significantly more at risk when the market responds to increased interest rates.

For banks, duration management—the act of modifying a portfolio`s sensitivity to interest rate changes—is a crucial component of risk management. As rates change, improper term management can lead to significant losses, especially in a rapidly changing economic environment.

The Rub:

A vivid reminder of how intertwined the whole financial system is may be found in the current bank selloff and its yet-to-be-felt impact on commercial real estate loan portfolios. The commercial real estate market on the West Coast and elsewhere will be widely scrutinized for signs of resilience or further deterioration as the repercussions play themselves out. Lenders, investors, and developers must negotiate a landscape that is becoming more unpredictable while modifying their tactics to reduce risk and safeguard their assets; this is no short order.

A gloomy near-term future awaits certain elements of the commercial real estate sector as well as worries about banks` capacity to manage bond and loan duration effectively. There must be consequences for mismanagement, or it will grow. The likelihood that the next unexpected piece of banking industry news will be disproportionately bad increases as rumblings of potential European bank woes become more audible. The industry is currently at a pivotal point as it struggles with the effects of its previous decisions and charts a course forward in the face of a fast-shifting economic landscape.

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