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That doughty — somewhat dull — Canadian insurance company known as Manulife does not often attract attention. This week, however, it caused a frisson in the real estate world.
Shortly before Jay Powell, Federal Reserve chair, announced that the central bank was keeping benchmark rates at 5.25 per cent to 5.5 per cent, Colin Simpson, Manulife’s chief financial officer, revealed that the group had written down the value of its US office investments by 40 per cent from a pre-Covid peak.
“I like to think our property portfolio is of reasonably high quality and quite resilient,” Simpson told Bloomberg. “But the structural forces of higher interest rates and trends around return-to-office make it a difficult market.” In plain English: working from home has hurt.
At first glance, that looks scary; 40 per cent is a big number. But in reality investors should celebrate. One bit of good(ish) news is that Manulife has relatively deep pockets, and thus can absorb this blow. The second, more important, point is that Manulife’s move shows that some players are finally getting more honest about America’s commercial real estate pain.
This is welcome — and belated. For as hopes of US rate cuts have intensified in recent months, CRE has tumbled into a debilitating pattern of “extend and pretend”: lenders have essentially rolled over troubled loans, hoping for a miraculous future Fed rescue.
However, Wednesday’s Fed meeting underscored a key point: Powell’s priority now is not to protect CRE, but to keep inflation under control at a time when consumer activity remains surprisingly lively and inflation is moving sideways around 3 per cent. Thus the trillion-dollar question is how many other players will now follow Manulife’s lead — and finally address one of the biggest hangovers from the past decade’s cheap money party?
The answer matters because the financial system is currently beset by a tottering pile of cheap CRE loans. Research from Newmark last year suggests over half of this emanated from banks; regional banks were particularly frenetic lenders when the Fed made money almost free during Covid-19.
However, funding has also come from private lenders and the commercial mortgage-backed securities sector, often bundled into collateralised loan obligations.
Since Covid, however, CRE values have fallen by 33 per cent on average, and as much as 60 per cent in some places, primarily for office buildings, according to Goldman Sachs. And while demand for high quality properties remains high, the outlook for low quality buildings is grim.
Flashes of pain are appearing in capital markets: this week it emerged that delinquencies were surging on CLOs. Some banks are stressed too: the New York Community Bank was recently forced into an emergency $1bn capital raise due to CRE losses, and this week the Klaros Group warned that more than 250 small banks out of the 4,500 existing banks in the US were also vulnerable.
But what is striking is not that some flashpoints have emerged, but how little pain has been crystallised so far. That is partly because capital market lenders are rolling over bad loans: Newmark recently told clients that “out of an estimated $163bn in 2023 CMBS maturities (based on original maturity date), $83.3bn remain outstanding” — ie borrowers have exercised “extension options”.
However banks are displaying forbearance too: Goldman Sachs estimates that $270bn of commercial mortgages which were supposed to mature in 2023 have been extended into 2024. As a result, a record high pile of cheap loans are supposedly due to mature this year. Newmark estimates that there is now around $1.3tn of troubled CRE debt, of which $670bn matures in the next two years.
Around a third of this debt pile was originated when rates were rock-bottom in the pandemic, it adds. Thus even if the Fed cut rates this summer, as Powell indicated on Wednesday, these borrowers face a refinancing shock: the Fed governors’ median projection is that rates “will be 4.6 per cent at the end of this year, 3.9 per cent at the end of 2025, and 3.1 per cent at the end of 2026”.
So what will happen next? A repeat of 2008 seems unlikely: the overall banking system is fairly well capitalised and since last year’s collapse of Silicon Valley Bank, the Fed has scrambled to create systems to contain contagion. Thus while the 2008 shock was about lender and borrower pain, today’s crunch is primarily about the creditors.
But the problem is that as long as these “pretend and extend” tactics are playing out, uncertainty will haunt the property sector, threatening to undermine American growth. What needs to happen now, in other words, is not just for lenders to become more transparent about their losses and write them down — as Manulife did — but distressed properties to start trading too. Only then can the pandemic-era excesses be resolved, either by tearing unwanted buildings down or repurposing them.
In that sense, then, the fact that the Fed sat on its hands on Wednesday is good news; indeed, for my taste it would do better to remain hawkish for longer. Investors need to get used to a world where money has a more normal price, in which they cannot always bet on a Fed “put”. If — or when — that happens with real estate, we will know that the past decade’s distortions are finally coming to an end.
