Real Estate Defaults are about to Hit the Fan

Over the weekend, while I considered the U.S. economy, equities, and business growth, I found myself conjecturing about the next shoe to drop.

It became clear to me that the collapse of Silicon Valley Bank (SVB) foreshadows another giant reckoning for the US economy in the coming months:

Defaults in the commercial real estate industry.

I’m reasonably certain this will happen in one form or another. It’s likely to be a rolling series of defaults by both small/medium sized and large banks – rather than one event – which grow into a debt crisis. $300 Billion in real estate is coming due in the next six months to one year and 80% of these loans are owned by non-SIB (systemically important) banks.

As in so many recent travails, the Covid pandemic is the root cause of the coming storm. Worker preference for remote and hybrid work has permanently impacted, and ultimately weakened, the office real estate market.

The signs are there for anyone who wants to see them:

• Light downtown traffic Monday through Friday.

• The continued use of Zoom as frequently today as any point over the last 2-3 years.

• Lease abandonments by big companies—e.g., Amazon, Facebook, and others—over the past six months.

• Vacancies at record levels (30% these days vs. 5% during bull real estate markets).

You can see it in any of the downtowns of major US cities: They’ve become near-empty ghost towns.

Office buildings represent $2.5 trillion of the total $16 trillion commercial real estate market nationwide. That’s huge.

The number of big office landlords defaulting on their loans is also increasing. Add to this the anticipated arrival of a general economic recession, and we can see that it’s about to get harder to find growing companies to fill space in buildings, or healthy companies able to pay exorbitant rents.

The run on, and ultimate default of, SVB, combined with sticky inflation and interest rate hikes by the Federal Reserve Bank only serve to aggravate the problem. Companies are slashing headcount via RIFs while tightening their belts and looking to cut costs in general anywhere they can. Long-term real estate leases are one area ripe for cost-savings. Meanwhile, interest rate increases directly impact real estate companies’ ability to fund new projects and service debt.

For many economists, the way to avoid these pending and massive series of defaults is to hand out trillions in government subsidies while also printing lots of money. With the US economy already hobbled by trillions in debt left over from Covid and battered by inflation, Republicans and many Democrats do not want more of the same policy-wise, thus there is little support for both subsidies or printing money. This may lead to an extended period of recession or a worsening economic situation.

For those who think the recent bank defaults mark the end of the economic malaise caused by COVID … thanks for your optimism. This foretelling of the coming new crisis is not a negative mindset or paranoid. It’s just the next set of consequences we will logically encounter, or the next shoe to drop.

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