Regional banks and real estate investors face a dark reality

I was yesterday afternoon sitting there contemplating whether I would today once again poke my stick into the hornets’ nest of the Chinese economy in general, and of course the property fiasco in particular when I received from a US reader an email. It was from a personage who happens to own a home not far from here and with whom I have had the pleasure to both lunch and dine. He is currently either in California or in Mexico…or somewhere else. The email he sent was accompanied by an attachment which was a Bloomberg news service article titled, “The Brutal Reality of Plunging Office Values Is Here”. He himself headed the email, “The next shoe is dropping”.
 
Evergrande, Vanke and Country Garden, the Chinese behemoths, might have been the newsmakers in terms of overstretched real estate players, albeit that they are developers rather than investors in property, but there remains in the US and in Europe a not significantly smaller elephant in the room. The crisis in US regional banks, which was triggered by the collapse of Silicon Valley Bank and which threatened to launch a domino-like crumbling of the entire sector, was driven by the liability side of those institutions’ balance sheets. As the regionals are the principal lenders to the real estate sector, the fear was that, were they to go to the wall and were they to be put in liquidation, there would be deluge of real estate assets up for sale.
 
As we had learnt during the GFC, it was not bad assets which had caused the crisis but a drying up of funding which in turn forced banks to liquidate assets into a market with a toxic imbalance between sellers and buyers. There was a race to the bottom, and I guess I must admit that the larger part of my retirement nest-egg was earned as a freelance broker during the heady months of thin market transparency following the foundering of Lehman Brothers, that good old pirate ship which could surely have justified flying the Jolly Roger as a corporate flag. There was at the time, by the way, a lesson to be learnt by regulators which they refused to acknowledge. Credit markets are not equity markets and whereas in the latter transparency and liquidity go hand in hand, in credit it is the other way around. Transparency is the killer of liquidity. At the time, we spent many an hour debating the subject with regulators, but they refused to listen and, in my book, public debt markets are a shadow of their former selves, weighed down by the regulatory millstone of MiFID II (2014).
 
So, the article in question looked at US commercial real estate. Having scraped through the liability crisis, the regionals are now faced with an assault on their assets, and this is one which cannot be fended off by either the Federal Reserve System or the Office of the Comptroller of the Currency, the key bank regulator. The cold wind of collapsing real estate asset prices is no more a matter of marks to market. Marking to market has for a long time been the holy grail of asset valuation and many so far meek attempts have been made to introduce mark to market for liabilities too. Marking liabilities to market is tantamount to walking backwards and blindfolded along the edge of a cliff but that might be a subject for another day.
 
The problem with marking to market is that the value attached is only theoretical. It is not until the rubber hits the road, a buyer and a seller have agreed a price and closed on it that it has any meaning. After 40 years at the coalface, I can assure you that cases where mark to market valuations underestimate the true value of an asset are few and far between, the most obvious one of which is when traders at year-end attempt to mark their books as low as they can get away with so as to elegantly smuggle a bit of P&L across the line and to give themselves a push-start into the New Year. There has also been a screen behind which investors have been able to hide. If an asset has not traded and there is therefore no known contemporary market price, then there must be some justification in holding an asset at the last known one. I have been there, have seen it but have myself never actually done it. Overvaluing and not marking down simply because it has not traded and there is therefore no market price is common. Enthusiasts for private credit might take note. Being unregulated, private debt funds can quite legally play hard and fast with asset values. Not my cup of tea, I can assure you.   
 
There is a problem with strict mark to market and some of this comes to light in the Bloomberg article in front of me. Take the distressed seller of an illiquid asset – and commercial real estate is the epitome of a market with limited liquidity – which must hit whatever bid presents itself. Other holders of comparable assets, the natural buyers, will already have their hands full so that the backstop bid will inevitably come from a specialist distressed asset investor. These guys are the vultures of the markets although, unpopular as they are, vultures are an essential part of the food chain. The universe of overpriced office space is under pressure and the article points out that even some of the most prestigious projects are trading as low as 45% of the highest price at which they traded when money for nothing was on offer.  
 
As formerly long-term cheap funding is running off and loans need to be rolled over, both lending banks and real estate investors are being faced with a dark reality. The money costs more and the asset on which it is secured is worth less. The bank won’t lend US$ 500 million secured on an asset now thought to be worth only US$ 250 million. A bit of jiggery pokery is possible if the valuation differential is in single figures but with the precipitous decline in asset values along with the equally tricky increase in the cost of money there is no way to continually block out the cold light of reality. Office blocks will go onto the slab, sold at huge discounts – let’s be realistic and call the discount a loss – and the banks will have to take the hit. Both Treasury Secretary Yellen and Fed Chairman Powell assure markets that although the losses will be large, they are manageable but less optimistic observers reckon there to be the best part of a trillion dollars of overvaluation to be accounted for. Some of it will be realised, some of it won’t. Either way, there is another wave of stress about to affect the US regional banking sector.
 
Europe has so far kept its head down while behaving as though the real estate woes in China and the US might be kind enough to pass it by. The UK is a little different from the rest of the continent as it does not have the regional banking infrastructure in the way of France, Italy, Spain, or Germany even though the GFC had in those countries let to considerable consolidation. But there remains a scad of European regionals which carry substantial exposure to an equally overvalued commercial real estate sector. Germany learnt a huge lesson at the tail-end of the GFC when real estate mutual funds, of which there were many and which had always been popular with Hans and Heidi SixPack, discovered the critical issue of asymmetric liquidity. Investors could withdraw money at will but selling assets and creating the cash needed to meet the withdrawals was a different matter entirely.  
 
The commercial real estate sector, like many leveraged businesses including high-yield bond borrowers, benefitted during the years between the GFC and the Covid crisis from a near-unlimited supply of low-cost, long-dated borrowing opportunities. Although interest rates have been rising for over two years, having locked in cheap funding has for some time immunised borrowers. As that runs off, a slow car crash is unfolding. Need I remind you that a slow car crash is a car crash nonetheless? 

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