Howard Marks became a billionaire in large part by specializing in distressed debt.
The Co-Founder and Co-Chairman of Oaktree Asset Management (since 2019 majority-owned by Brookfield Asset Management) has also been fond for years of dispensing investment advice through his memos.
Warren Buffett has said he reads Marks’ memos straight away when they are released.
We have featured excerpts from these memos from time to time and this is another one of those times because his new memo is entitled Lessons from Silicon Valley Bank.
We have zeroed in on the conclusion of Marks’ latest musings because it deals with the worries surrounding commercial real estate.
Is the sector a slow motion train wreck or are the problems manageable?
Keep reading to get insights on the topic from one of the market’s most experienced and deepest thinkers and for a link to the full memo from Marks.
by Howard Marks
While I don’t foresee widespread contagion – either psychological or financial – arising from the SVB failure alone, I can’t end a memo on U.S. banks without mentioning one of the biggest worries they face today: the possibility of problems stemming from loans against commercial real estate (“CRE”), especially office buildings.
The following factors are influencing the CRE sector today:
- Interest rates are up substantially. While some borrowers benefit from having fixed interest rates, roughly 40% of all CRE mortgages will need to be refinanced by the end of 2025, and in the case of fixed-rate loans, presumably at higher rates.
- Higher interest rates call for higher demanded capitalization rates (the ratio of a property’s net operating income to its price), which will cause most real estate prices to fall.
- The possibility of a recession bodes ill for rental rates and occupancy, and thus for landlords’ income.
- Credit is likely to be generally less available in the coming year or so.
- The concept of people occupying desks in office buildings five days a week is in question, threatening landlords’ underlying business model.
- While workers may spend more time in the office in the future, no one knows what occupancy levels lenders will assume in their refinancing calculations.
Total U.S. bank assets exceed $23 trillion.
Banks collectively are the biggest real estate lenders, and while we only have rough ranges for the data, they’re estimated to hold about 40% of the $4.5 trillion of CRE mortgages outstanding, or around $1.8 trillion at face value.
Based on these estimates, CRE loans represent approximately 8-9% of the average bank’s assets, a percentage that is significant but not overwhelming.
(Total exposure to CRE may be higher, however, as any investments in commercial mortgage-backed securities have to be considered in addition to banks’ holdings of direct CRE loans.)
However, CRE loans aren’t spread evenly among banks:
- Some banks concentrate on parts of the country where real estate markets were “hotter” and thus could see bigger percentage declines;
- Some loaned against lower-quality properties, which is where the biggest problems are likely to show up;
- Some provided mortgages at higher loan-to-value ratios;
- Some have a higher percentage of their assets in CRE loans.
To this latter point, a recent report from Bank of America indicates that average CRE loan exposure is just 4.5% of total assets at banks with more than $250 billion of assets, while it’s 11.4% at banks with less than $250 billion of assets.
Since banks are so highly levered, with collective equity capital of just $2.2 trillion (roughly 9% of total assets), the estimated amount the average bank has in CRE loans is equal to approximately 100% of its capital.
Thus, losses on CRE mortgages in the average loan book could wipe out an equivalent percentage of the average bank’s capital, leaving the bank undercapitalized.
As the BofA report notes, the average large bank has 50% of its risk-based capital in CRE loans, while for smaller banks that figure is 167%.
Notable defaults on office building mortgages and other CRE loans are highly likely to occur.
Some already have.
(Editor’s note: Since February, Brookfield Corp. has defaulted on US$945 million in office property loans related to at least 14 buildings in Los Angeles and Washington D.C. rather than refinance the debt.)
But that doesn’t necessarily mean the banks involved will suffer losses.
If loans were made at reasonable loan-to-value (LTV) ratios, there could be enough owners’ equity beneath each mortgage to absorb losses before the banks’ loans are jeopardized.
Further, mortgage defaults generally don’t signal the end of the story, but rather the beginning of negotiations between lenders and landlords.
In many cases, the result is likely to be extension of the loan on restructured terms.
No one knows whether banks will suffer losses on their commercial real estate loans, or what the magnitude will be.
But we’re very likely to see mortgage defaults in the headlines, and at a minimum, this may spook lenders, throw sand into the gears of the financing and refinancing processes, and further contribute to a sense of heightened risk.
Developments along these lines certainly have the potential to add to whatever additional distress materializes in the months ahead.
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