WHAT’S the outlook for the office real estate sector and US regional banks?

In Sonny Kalsi: Navigating Bank Failures and Commercial Real Estate Holdings, a Guiding Assets podcast from CFA Institute, Paul Andrews, the institute’s head of research, advocacy, and standards, spoke with Sonny Kalsi about the sector’s prospects. Kalsi is co-CEO of BentallGreenOak, a leading global real estate investment management adviser and provider of real estate services with about US$83 billion in assets under management.

Financial market practitioners and observers have grown increasingly anxious this year about the health of the economy and particularly about the banking sector’s exposure to the real estate sector.

The collapse this year of Silicon Valley Bank (SVB) and Signature Bank, as well as the hasty acquisition of First Republic Bank, has convinced some market players that regional banks, which are already under financial stress, may now face a potential crisis in the shaky commercial real estate sector. Of greatest concern is the banking sector’s exposure to the office sector.

Andrews opened his discussion with Kalsi with the systemic risk issue: “With many banks holding large portfolios of real estate, what do you see as the end game, particularly from both a systemic risk angle as well as the banking angle?”

Kalsi said many big banks have retreated from real estate lending, and their lending to commercial real estate especially has gone down on a percentage basis. But the non-bank sector has stepped in to help bridge the lending gap.

“Non-bank lenders are often getting repo financing from those same big banks. Regional banks are now providing a huge amount of real estate lending and are probably at least one-third of the real estate lending that’s been happening. They have been a big part of the incremental real estate lending for the last five years,” he explained. “So, the long answer to your question is, I think, the regional banks have a fair amount of exposure there.”

The two big issues to consider are liquidity and the condition of office real estate, according to Kalsi. “There’s no financing available. The big banks aren’t providing it, and the regional banks are now no longer providing it.”

Because commercial real estate is a large category, Kalsi believes there are segments that will be less problematic, such as the industrial and multi-family segments. Multi-family is also buoyed by government-sponsored agencies that provide financing, he said.

But the office sector is a headache, he warned. “It’s not really the canary in the coal mine,” he said. “It’s the 800-pound gorilla sitting squarely in the middle of the room.”

Regional banks’ challenge
“So, what are the regional banks going to do? Are we just sitting on another time bomb?” Andrews asked.

Kalsi replied: “Yes, I think It could be a time bomb but I think it’s going to be a time bomb with a long fuse.” Unlike a security, which is a short-term instrument that can be rolled over in the capital markets, many bank loans are structured such that the banks must themselves pull the trigger to create a default.

“There are plenty of assets right now that are in technical default,” he said. “There might be a lack of compliance with different covenants, maturity, defaults, where many banks are just rolling them over because they know their borrowers are in an illiquid market and not in a great position to refinance them.”

Regulators will therefore hold great sway over whether and when the default time bomb goes off, Kalsi asserted. “You could argue that on the one hand the (regulators) caused this by the interest rate environment,” he said. “A lot of people got caught flat-footed. I didn’t think rates were going to go up at the pace that they did, but we knew rates were going up. So I am a little bit surprised that some of these lenders got caught as flat-footed as they did. It’ll be interesting to see how the regulators approach this.”

If regulators compel lenders to mark to market their positions, the result could be something ugly, Kalsi warned. “But if the regulators take it easy on them and give them time, then I think this is going to be a slow process.”

Most beleaguered sectors
“I’ve said jokingly that ‘office’ has replaced ‘retail’ as the worst six-letter word in real estate,” Kalsi said. For perspective, he noted that 10 years ago it was the retail sector that faced an “apocalypse”.

“No one was shopping in stores anymore,” he said, and although retail asset values are down 30-50 per cent over the last 10 years and many tenants have gone bankrupt, those retail tenants that survived face less competition and thus a better business environment. “Retail has found its footing somewhat and is doing okay.”

“I think that’s what’s going to happen with the office sector … The sector will take a while to find its footing. Therefore, we must decide to be patient to work through that, and regulators will have to decide if they’re going to be patient or not,” Kalsi said.

If regulators are patient, would we face another huge systemic risk event?

“I hope that we don’t face another systemic risk event,” Kalsi replied. “I’m not going to name names, but there are certain lenders out there for whom 30-40 per cent of their book is commercial real estate.” Those banks have issues, he said, pointing to the failures at SVB, First Republic, and Signature Bank as examples of failures that could be in the offing.

“I’m not a banking expert. But if I were a betting man – which I am – I don’t think we’re done with three banks. I think we’re going to see more.”

Members of CFA Institute are asset owners, asset allocators, intermediaries, said Andrews. “How would you look at this issue from a practical standpoint? What should they focus on?”

Kalsi said some may own assets directly or indirectly through the real estate investment trust market or fund managers. “One thing you have to ask yourself is ‘Do I have the right people managing the ship for me right now?’… That’s number one,” Kalsi said.

The second point is how to think about the asset class. “We’re talking about defence and about what to do about our existing portfolio. How do we think about that, and manage our way through it? One thing we hear a lot about right now is the denominator effect – equity markets are down, therefore alternatives now represent a bigger percentage of portfolios. Is that a bad thing?

“Maybe that’s the direction where people should be going. One thing about the global financial crisis that was clearly informative is the people who had more time wound up with a better recovery value than people who had to do a forced sale.”

But even with the potential pain threatening the real estate market, “there’re also some great investing opportunities”, Kalsi said.

“For example, it’s a great time to be a lender right now. If you can be a lender – by the way, lending is about 25 per cent of what we do – it’s a great time to put new capital to work in that space. So, I think part of this is not only how existing investors and CFA Institute members think about playing defence on what they own, but how do they think think about going on the offence as well.”

The writer is an editor, with a focus on institutional investment management.