Work From Home Sours Financing for Office Buildings, Which Threatens Regional Banks

As you drive through cities and many suburbs near cities, you see lot and lots and lots of office buildings. Employees by the tens of millions used to get dressed and fight their way through traffic to get to these building every weekday, park, and go up to their desks to do their white-collar jobs.

The demand for new office space seemed endless, and so developers borrowed money to build more office buildings, and firms like real estate investment trusts (REITs) also borrowed money to buy such buildings in order to rent them out.

Covid changed all that. Suddenly, in early/mid 2020, nearly all office buildings went dark, and people started working from home. With affordable computers and internet access, and with Zoom and other conferencing tools, it was found that workers could get their jobs done remotely. Even after vaccines rolled out in early/mid 2021, concerns over contagious Covid variants kept offices closed. 2022 was when things started opening up again big time, and by end 2022/early 2023 there were stories in the news about companies ordering employees back to their desks.

By January, 2023 Bloomberg could report “More than half of workers in major US cities went to the office last week, the first time that return-to-office rates crossed 50% of their pre-pandemic levels.”  However, that movement seems to have stalled, and has even reversed in some cases, as workers have pushed back strongly against being forced back to the cubes.  Notably, Elon Musk initially banned remote work at Twitter after taking it over in November, but after rethinking the costs of maintaining offices, has shut down Twitter’s offices in Seattle and Singapore, telling employees to work from home

Per the Morning Consult, “The pandemic lockdown triggered one of the swiftest, most significant behavior changes in human history. People’s habits changed overnight, and through the successive lockdowns, shutdowns and new standards, these new habits became ingrained. The experience triggered new, positive associations with working from home, working out with virtual trainers, cooking, gardening and more. A vast web of neural pathways formed to hold these new associations – and that web runs deep.”

And thus, many office buildings remain largely empty, which in turn is resulting in rising defaults on the loans for these buildings. A number of high profile corporate owners in recent months have deliberately (in their own pecuniary interest) defaulted on their loans, forfeited their equity interest in a building , and handed the keys back to the mortgage lenders, who are now stuck with big losses on their loans and with holding a building that nobody much wants.

There are many ramifications of these trends. The one I will focus on is how this extended underutilization of offices affects the parties that lent money to build or buy these buildings.  In many cases, those lenders were smaller (regional) banks. They have much greater exposure to commercial real estate loans than the larger banks, which may cause serious problems in the coming months.

Eric Basmajian calls out some key differences between large and small banks in the U.S.:

At large US banks, loans make up 51% of total assets.  Small banks have 65% loans as a percentage of total assets. So small banks have a lot of loans, and large banks have a lot of cash, Treasury bonds, and MBS.

…At small US banks, loans make up 65% of assets. Of that loan portfolio, real estate is 65%, meaning a lot of real estate exposure….Within that real estate loan portfolio, almost 70% was commercial real estate lending.  So small banks have a high concentration of commercial real estate loans…. Within the commercial real estate category, the highest concentration is “non-residential property,” which can include office buildings, retail stores, and data centers.

….So small banks have a potentially large problem. Deposits are starting to leave after the SVB crisis in search of more safety, but also in search of higher yields on safe assets like Treasury bills.  Deposit outflows will make it hard for small banks to grow lending and may cause a deleveraging.  If deposit outflows are severe, deleveraging will cause banks to sell securities or loans.

Securities can be pledged at the Fed for a relatively high-interest rate. This keeps a bank solvent but at a material hit to earnings.  The loan portfolio is a much bigger problem because the value of these potentially permanently impaired assets will be called into question.

Basmajian summarizes:

There are major differences between large and small US banks.

Large banks hold a lot of reserves, Treasuries, MBS, and residential real estate loans. The asset mix at large banks is very conservative.

Small banks have most of their assets in loans, with commercial real estate holding the highest weight.   Small banks appear to have outsized exposure to highly impaired office buildings which could generate significant losses.

It will be critical to monitor lending standards and availability at small banks because, in the post-2008 cycle, small banks are the lifeblood of credit to the private economy.

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