The dark clouds over the commercial real estate market – and office buildings in particular – continue to gather as regional and community banks cut their loan exposure to the sector. Regional and community banks continue to dump commercial real estate loans under heavy regulatory scrutiny, and it may take a wave of public-private partnerships between building owners, lenders, and federal, state and local governments to prevent systemic financial crises in the months ahead.
The unfolding of one of the most substantial downturns since the mortgage crisis of 2008 has compelled banks to offload both properties and loans at attractive markdowns. This is a double edged sword. While the trend could present a promising opportunity over the next decade for opportunistic and strategic investors, it has the potential to disrupt core elements of the economy with significant short- and long-term implications.
Securing underwriting for an office building loan in the current financial climate is difficult, if not impossible, as banking regulators breathe down the necks of the regional lenders who were the mortgage backbone for the sector.
It’s not improving any time soon, either: In recent weeks, notable credit rating agencies such as S&P, Moody’s and Fitch, downgraded several regional banks, citing suboptimal conditions within the financial sector. Prominent institutions such as KeyCorp, Comerica, and M&T have all been impacted, and larger banks like JP Morgan Chase and Bank of New York Mellon have encountered deteriorating conditions and heightened oversight.
The cities where those troubled buildings sit are in a slow-motion crisis of their own. Falling building values have a dramatic effect on tax revenues – but the damage to cities goes much further.
Fewer office workers means less demand for other retail services like restaurants and dry cleaners, putting another circle of hurt into building values and tax collections. Fewer commuters means significant operating deficits for mass transit services. If cities look to economize through public safety and transit service cuts, risk triggering (or deepening) the “urban doom loop.”
The doom loop, of course, would lessen the demand for office space even more, as downtown conditions deteriorate and workers fight harder and harder not to come to the office.
McKinsey sees scenarios under which certain office building values could drop by more than 40%. The much-discussed transformation of office space into residential space might help, as could the encouragement of multi-use neighborhoods and buildings rather than purely commercial ones as many cities now suffer with.
With property owners, major financial institutions, and local governments all under deep threat, it’s a good bet that some kind of action to prevent disaster will be mustered. Public-private partnerships could address multiple levels of the crisis. What could help?
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Cities could significantly reduce land use restrictions and building code regulation, potentially allowing less expensive conversions of office buildings to residential and other uses.
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They can also wade into the thicket of permitting and inspections with a buzzsaw to allow any conversion or renovation work, once it starts, to move quickly.
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They could also consider tax rate reductions and create incentive zones to give landlords some breathing room and some help in re-establishing the value of their properties.
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Federal bank regulators could create troubled asset pools like 2008’s TARP program if enough loans are in bad enough shape to warrant it. The federal government will be back in the bailout business, and it will have to consider its willingness to do so.
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Banks can work with federal regulators and borrowers to re-craft standards and guarantees in a way that allows banks to go on lending while giving them a greater participation in the equity upside of the buildings they’ve already backed.
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Building owners can cut public-private partnership entities in on the ownership of buildings to give taxpayers an incentive participate. They can also create affordable housing spaces in buildings, contribute to special services districts, and get even more creative about building re-use and lease forms.
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Building owners, lenders, and government regulators could jointly seek more creative forms of building financing (like ground leases) and additional forms of debt syndication and securitization.
The gravity of the commercial real estate crisis requires a forward-looking and comprehensive approach. The private-public approach holds the potential to bridge gaps between banking vulnerabilities, regulatory oversight, economic shifts and evolving real estate demands.