The Coming Real Estate Crisis

Why the real estate market is starting to look shaky

Ric Edelman: It's Thursday, July 13th. There is a huge real estate crisis coming. Let's first look at the public housing sector. There are nearly 2000 public housing agencies across the country. These agencies own and manage housing for low income families. These renters pay below market rent. The alternative is for them to be homeless. But now many of them can't even afford their subsidized payments.

In New York City, the City Housing Authority is collecting only 65% of the rent that it collected last year. That's the lowest amount of rent in its history. Before Covid, they collected 90% of what they were owed. This means New York City's housing authority doesn't have the money to maintain its buildings, the heat elevators, rats, leaky roofs, fixing lead and mold. Lots of residents are so mad at the decrepit conditions of their residences that they're not paying rent, and that's creating a vicious cycle.

We're talking 270 developments that house 340,000 people. The shortfall of the housing authority is $500 million. New York's housing agency is flat out of money. They've canceled dozens of contracts. They've eliminated 150 jobs. And they say they need $40 billion to get all the buildings back to decent conditions. They've got to replace 108 elevators, but they can only afford to replace eight of them. This problem is the same all over the country. And I haven't even mentioned the commercial real estate market or the retail real estate market or the residential real estate market. So hey, let's go mention them. 

US junk loan defaults are surging more so this year than in the last two years combined. And there's more to come. It's a $1.4 trillion marketplace. Companies that aren't very profitable or valuable, the only way they can borrow money is to pay exorbitant interest rates. These are called junk bonds. There have been 18 defaults so far, $21 billion.

And it's not just junk loans that are collapsing. The largest US banks have incurred the biggest jump in loan losses since the pandemic began. The nation's six biggest banks. We're talking JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, Morgan Stanley. They've written off a combined $5 billion in defaulted loans in just the last three months. They're getting ready to set aside another $7.5 billion to cover more loans that they think are going to go bad in coming months. These numbers are double what they were a year ago.

The biggest category of loan defaults are credit cards, but the second biggest is commercial real estate. So we're talking weakness in both consumers and businesses. These are big clouds ahead because remember, real estate caused the 2008 credit crisis. In fact, a finance professor at Stanford, his name is Amit Seru, says a banking crisis is coming. And we can blame the real estate market. There have already been several high profile bank failures this year due to fast rising interest rates. Millions of people working from home, not going to the office and the threat of a coming recession. 

You add it all up, Professor Seru says, and we could see a repeat of ‘08 already.

The US bank system's market value of its assets is $2 trillion less than its book value. Banks across the country have lent nearly $3 trillion in commercial real estate loans. That's about a quarter of the average bank's assets. And most of these loans are from small and mid-sized banks. The local lender who lends to local real estate builders, those loans were made when interest rates were near zero. But a lot of those loans are coming due over the next couple of years. And that means that those real estate builders and developers, they're going to have to refinance their loans at today's higher rates. And that means a lot of them are going to default even if they don't default. The higher payments means their costs are going to go up and that means they're going to have to raise rents. It's either that or the value of their properties are going to fall.

That's bad news for the insurance companies, the pension funds and the endowments that all invest in them. Real estate is also threatened by remote workers. Professor Seru says 40% of the labor force was working remotely during the pandemic, and even now, only half of workers in the ten largest cities in the country are back in the office. That all translates to less demand for commercial office space. 

The result: The equity value of real estate investment trusts is down 55% since Covid. He says that means a 33% reduction in the value of the buildings. Can the banks handle this? He says if the default rate on commercial real estate rises 10 to 20%, banks are going to lose as much as $160 billion.

And it's not just some finance professor at Stanford who's worried. Financial stability experts at the Federal Reserve are also watching all of this really closely. The Fed has just issued its financial stability report, and it says the increase in interest rates over the past year has increased the risk that commercial borrowers will not be able to refinance their loans and that the magnitude of a correction in property values could be sizable. In other words, expect a crash in commercial real estate.

In New York City, there's 94,000,000 feet of office space available for lease. That's a record. The vacancy rate is 17%, and New York's not even the worst. Nationally, the vacancy rate is 20%. Manhattan has more empty office space than Houston and Dallas/Fort Worth combined. Manhattan neighborhoods that have some of the emptiest office buildings: the financial district in Lower Manhattan, 25% vacancy rate; Times Square in Midtown, 20% vacancy rate. Before the pandemic, 1.5 million people worked in New York City, commuting from New Jersey and Connecticut. They spend tens of billions of dollars on food and shopping and entertainment, like at Broadway.

But now half of them are home. They're not coming into the city to work. They're not bringing their money with them. Not only is the economy hurting, but property taxes are down as well. Those property taxes are a third of the New York City budget. Not anymore. And so we've got a big problem.

In fact, in New York, some of the best known real estate developers are dumping their buildings. There's one company that owned a 33-story office tower at 61 Broadway. It's defaulted on its loan, walked away from owing $240 Million. It just handed the keys back to the bank. Silverstein Properties, they built the World Trade Center. They're selling a 20-story building on Fifth Avenue for $66 million less than what they owe Blackstone, which bought One Liberty Plaza for $1.5 billion five years ago. They just sold it for $1 billion, a 33% loss.

So far this year, investors have only paid half a billion for Manhattan office buildings. That's the lowest volume since the 2008 credit crisis. And this is not just in New York City, where this is happening in Philadelphia. The owner of the Center Square office complex couldn't pay off a $368 million balloon mortgage when it came due. Landlords across the country owe $1.5 trillion for commercial mortgages over the next three years. Almost all of them are interest-only loans.

Fitch Ratings says 35% of the pooled securitized commercial mortgage loans are coming due this year, one out of three. And they're not going to be able to refinance based on current interest rates or the property's rental income or their market values. Fitch says it's 35% aren't going to be able to refinance. Costar says it's not 35%; it's 85% in Los Angeles. A real estate investment fund has already defaulted on $750 million worth of mortgages on two skyscrapers.

Private equity firms slashed the value of the Willis Tower in Chicago by a third. Landlords have to refinance $137 billion of office loans this year, $500 billion over the next four years. Park Hotels and Resorts,  they own the Hilton San Francisco at Union Square and the Park 55 in San Francisco. They have stopped making payments on both of those hotels. $725 million on loans were due in November. They can't refinance them. Those two hotels have 3000 rooms. They're in the heart of San Francisco's shopping district. They employ 1000 union workers. Those two buildings combined are worth a $1.5 billion. And the landlord just walked away. Nordstrom, Crate and Barrel, H&M, they've all closed their stores in San Francisco. Tech companies are subleasing their space. The city's commercial real estate is now selling at huge discounts. Tourism is down 30% in San Francisco.

All told, $88 billion in mortgage securities are at risk, 42% of it tied to apartment buildings. These are collateralized loan obligations. These are mortgages packaged into bonds that are sold to investors. A lot of buildings in Arizona, Texas, Nevada are financed with them. 2% of them are already delinquent. New loans are hard to find. Lenders aren't lending. Borrowers aren't borrowing because they can't afford the rates.

At the same time, construction and insurance costs have all skyrocketed. The result? Renovation projects are running out of money. Stock prices for big office landlords are near historic lows. SL Green. Vornado Realty Trust. Empire State Realty Trust. The stock prices are in the toilet since 2020. Shares of office REITs are down 48%.

Banks are now trying to ditch the loans they've already made. HSBC is selling hundreds of millions of dollars of commercial real estate loans at a discount, so it's not stuck with bad loans. Pac-west has sold $2.5 billion of construction loans for $0.92 on the dollar, an 8% loss. Wells Fargo has $142 Million in commercial real estate loans. They say they're going to lose money on a lot of them. Citizens Bank is trying to sell its entire portfolio of $1.8 billion of commercial property loans customers. Bancorp has cut its commercial real estate lending and increase the number of current loans it's trying to sell at PAC West. They've got aggregate principal value of their loans of two and one half billion. They've sold at a discount.

And forget about commercial real estate. How about residential real estate? The sales of previously owned homes is down this year more than at any time in the past 11 years. The National Association of Realtors says sales are down 23% year over year. 

That's just the real estate world. Look at the insurance world. Munich RE says global losses from wildfires over the past five years was $69 billion and insurers have paid out $40 billion in claims. Four out of five of the most costly wildfires in the past decade have all been in California, and so State Farm announced they are no longer going to sell homeowners insurance to anybody. In California, Allstate has stopped selling new policies. California is now the most uninsurable state in the country. But it's not just California - Florida, Texas, Colorado, Louisiana, New York - they're all in trouble. Premiums are three times the national average.

So you've got to understand, if you are trying to buy a house or build one and you can't get homeowners insurance, you're not going to buy that house. You're not going to build that house that's going to crash the real estate economy. If you already own a house and you can no longer get insurance, it means you're at massive risk. If your house gets damaged by a wildfire or a landslide or a flood or any other natural disaster. And good luck selling the house. Nobody's going to buy a house that is uninsurable. This is a problem. A lot of people were investing their money in real estate over the past decade because real estate over the past decade has done really well.

A lot of investors bought into apartment buildings, and now they're discovering they're losing all their money. One big company is called Apple's Way Investment Group. They have $500 million of apartment buildings throughout the South, 7000 units. They're one of the biggest landlords in Houston. Where do they get their money? By inviting small investors to invest? You get to invest ten or 20 or 50 grand. You own a piece of the company. The company, though, does all the work. It buys the buildings, it rents out, the apartments. It collects the rent. You get your share. You also pay 2 or 3 or 4% in fees to the company, but you get the rental income.

But now rising interest rates means that the company is no longer able to get the rent that it needs to pay its bills because of the bigger mortgage costs. 3000 apartments at four rental complexes have already been lost to foreclosure, and those investors have lost all their money. And we are just at the beginning of this economic downturn.

And by the way, this is not just a US thing. China is experiencing the same thing. Enormous debts through massive building while the cost of borrowing was near zero. Projects today can't refinance. They can't repay their debts. One province in China owes $380 billion, a third of $1 trillion. This is a global phenomenon, just as it was in 2008.

As a financial advisor, you have to warn your clients. You have to help your clients make big decisions about the real estate they own. If they're thinking of selling, they need to do it sooner rather than later. If they're thinking of buying, they need to reevaluate what the future price of that property may be in the next one or 2 or 3 years. Can they afford the cost of the mortgage they're going to get? Is the property they're planning to buy insurable? How much of your portfolio is allocated to real estate? Is this the time to be buying it or should you be waiting or on the other hand, have some real estate prices already fallen so much that it is already a buying opportunity?

As a financial advisor, you cannot assume that it's business as usual in the American economy. Real estate drives this economy. Weakness in the real estate market translates into the banking sector, which translates into the financial sector, which permeates throughout the entire stock market. We saw this movie in 2008. Don't have a blind eye to it in 2023. Talk to your clients now about their portfolios.

My wife Jean's podcast, Self-Care with Jean Edelman is now her own independent podcast, and her new podcast premieres each week every Thursday. Jean's really passionate about sharing her knowledge and insights with you on self-care, mindfulness and overall wellness. You can listen to Jean's podcast anytime you like, everywhere that you get your podcasts. Subscribe at Self-Care with Jean.com. Head over there right now.

-----