Although the spring real estate market has slowed drastically from the pandemic days, the bottom has not fallen out. Quite the opposite has occurred, in suburban markets and sunbelt cities, real estate keeps charging higher. A good example is Boulder, CO, a suburban market of Denver, where prices in March are up 3% from last March to almost 900k. With the birds out and real estate humming along, what is hiding beneath the surface? What recent time period are we beginning to resemble?
What is in the current real estate market data?
New home sales rose in March, climbing for the fourth month in a row as mortgage rates eased and buyers looked to new construction as an alternative to the tight inventory of existing homes for sale.
Sales of newly constructed homes were up 9.6% in March from February, but were down 3.4% from a year ago, according to a joint report from the US Department of Housing and Urban Development and the US Census Bureau.
On the flip side, commercial real estate prices continue to fall due to rising rates and decreased demand. Office and retail properties continue to be hit the hardest and by all indications there is considerable more downside risks.
What is hiding beneath the current real estate numbers?
Although the residential spring market is outperforming almost all expectations, there are huge issues lurking beneath the surface. The most prominent issue is the recent bank failures.
Many on Wall Street are calling all clear on the bank crisis after the few failures did not propagate. Unfortunately, on the ground I am seeing a radically different scenario unfold that should make you nervous.
- Call volume up substantially: We are a private lender and get calls many times when conventional financing is not available for whatever reason. Our call volume is up double digits since the same period last year which is a huge indicator that credit conditions are tightening drastically.
- Closing more loans that should be A paper: We are now closing more deals that should be closed by smaller community banks. These are deals with low leverage, good credit, good income, etc… but many smaller banks are now capital constrained and unable/unwilling to make the loan.
- Response to recent job posting: I recently posted a job for our office in Atlanta doing light accounting/post closing. Originally I wasn’t getting the response I wanted when I had the job title accounting so I changed it to generically say Banking. As soon as I made the change online, I received 20-30 A quality candidates a day that banks had let go. This is a huge indicator or what is coming, banks would not let these quality people with commercial banking experience go if they did not expect a much more prolonged and severe downturn. Many of the candidates had years of experience that is irreplaceable, and an employer would not let them go unless they were forced to.
The three items above point to a much deeper crisis brewing beneath the surface and show small/midsize banks pulling back substantially. Ultimately the enormous reduction in credit will flow through to the economy.
Starting to see similarities with the 1980’s Savings and Loan Crisis
We can always find a point in history that guides our current thinking. Although, each time period is unique many of the same trends emerge. In our current cycle, we are seeing a huge decline in commercial real estate while residential is holding solid. This reminds me of the 80s savings and loan crisis, where banks failed due to sharp increases in rates.
The root cause of the S&L crisis was the rapid deflation of real estate prices caused by rising interest rates which sounds eerily familiar to today. Although there is no way that we will end up with rates at 18% like the 80s, rates have already doubled from lows. Even at today’s level with rates not going much higher, a considerable number of real estate deals no longer make sense as the cash flow off the property cannot cover a doubling of interest payments when loans come up for renewal.
How can we repeat a banking crisis with all the new regulations
Unfortunately, the regulators are typically a day late and a dollar short. A good example are the two recent bank failures. Very similar to the Savings and Loan crisis, there was a rapid rise in rates that decreased the value of long term bonds. This mismatch led to a run on the bank and a cash crunch that was not avoidable. This ultimately led to thrift failures. We have a similar situation today
The risk of declining longer term securities will continue as rates go higher/remain high. Furthermore, the risk in this cycle is the value of commercial properties. Over the last twenty years we have been in a low interest rate environment, this low rate environment has come to an end leaving many commercial properties unviable at current levels. Furthermore, some office properties in Urban cores are likely not viable at any level other than the dirt they reside on.
Regulators are just starting to grasp the risk of commercial real estate loans held by small/midsize banks. Unfortunately, the damage is already done as if the regulators increase audits and make banks write the loans down even further to market, there will be more runs on the bank, but if they do nothing the skeletons will remain. It is a no-win situation that will ultimately end very badly for hundreds of banks, their shareholders, borrowers, and the general economy.
How will this cycle be similar and different than the S&L crisis
How is today Similar to S&L crisis?
- Bank failures, albeit not the same quantity: The two recent bank failures were the tip of the iceberg, there is allot lurking beneath the surface
- Commercial prices plunge: This cycle will be much more focused than the general plunge of basically all real estate during the S&L crisis. Look for this downturn to hit office and retail the hardest while other sectors like warehouse/industrial hold up considerably better
How is today Different than the S&L crisis?
- Rates will not rise as high: I don’t foresee rates hitting 18%, we are likely pretty close to being done with substantial hiking by the federal reserve
- Residential will be impacted: In the 80s; there was not a huge impact to residential real estate, fast forward and residential has gone up substantially higher creating more risk even with smaller rises in interest rates.
Based on the information today, the Savings and Loan crisis is the most closely related economic cycle. Just like in the Savings and Loan crisis, rapid rises in rates led to thrift failures just like the bank failures we are seeing today. Many economists are now calling all clear on bank failures and hedging towards a soft landing which is misguided based on past cycles.
The Savings and Loan crisis unfortunately provides a much different roadmap than current predictions. Look for considerably more bank failures, substantial drops in commercial property values, impacts to residential prices, and a “tough economy” for some time. I’m going to agree with Mark Twain that history doesn’t repeat but rhymes. The similarities between now and the 1980s are eerily familiar.
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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