The commercial real estate market may soon collapse. Here's why?

 The commercial real estate market may soon collapse. Here's why

The commercial real estate market is facing a price collapse that rivals the 2008 financial crisis

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Valuations of office and retail real estate could drop as much as 40% from peak to trough this year because high interest rates make it difficult for investors to refinance the looming trillions in debt, according to Lisa Shalit, chief investment officer at Morgan Stanley Wealth Management.

“MS & Co analysts expect a drop in CRE prices from peak to low of as much as 40%, worse than in the Great Financial Crisis,” Shalit wrote in a weekly investment note. More than 50% of the $2.9 trillion in commercial mortgages will need to be renegotiated in the next 24 months when new lending rates are likely to rise by 350 to 450 basis points.

Complicating matters is the fact that small and regional banks are the largest source of credit for the $20 trillion commercial real estate market, holding about 80% of the sector's outstanding debt. Regional banks are at the epicenter of the turmoil within the financial sector, and there are concerns that the turmoil could make lending standards significantly more restrictive.

During a credit crunch, banks raise their lending standards dramatically, making it difficult for businesses or households to obtain loans. Borrowers may have to agree to tougher terms such as higher interest rates as banks try to reduce financial risk on their end.

Banks were already tightening lending standards before the crisis within the industry began. A quarterly survey of loan officers published by the Federal Reserve showed that an increasing number of banks were tightening lending standards and saw demand drop in the last three months of 2022.

Jamie Dimon warns that the banking crisis has increased the odds of a recession. A separate note to Morgan Stanley said "refinancing risks are front and center" for commercial property owners. "The wall of maturity here is front loading. So are the risks associated with it."

Even before the collapse of Silicon Valley Bank and Signature Bank in early March, the commercial real estate market was grappling with a number of challenges, including rising interest rates and declining demand for office space as more companies allow employees to work from home.

The Federal Reserve has raised interest rates nine times from near zero to over 4.75%, and is expected to agree to a tenth rate hike during its next meeting scheduled for May 2-3. It is the biggest jump in borrowing costs since the 1980s.

However, still others are less pessimistic about the future of the commercial real estate market. The headlines about office space are "worse than the reality," said Solita Marcelli, chief investment officer at UBS Global Wealth Management.

"An expected credit crisis due to the high cost of funding for banks may exacerbate their problems," Marsili said in a note. But she added: "We don't think a repeat of the 2008 liquidity crisis is likely - as capital markets were essentially closed to funding."

“In our view, the overall health of the banking system and market liquidity conditions are much better than they were during the [great financial crisis].”

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