REIT and Non-Bank Commercial Real Estate Issues Could Shake Our Financial Foundation
Our latest article on bank safety: REIT and Non-Bank Commercial Real Estate Issues Could Shake Our Financial Foundation
Last week, the Financial Stability Board (FSB), an international body that monitors and makes recommendations about the global financial system, published a report analyzing vulnerabilities in non-bank commercial real estate (CRE) investors. A key focus was the complex interlinkages between banks and non-bank CRE investors, which amplify the potential for spillovers from CRE market shocks.
According to the FSB, global CRE financing (equity and debt) is estimated at over $12 trillion, with the United States accounting for $6 trillion. This makes the report especially relevant for U.S. banks and the broader financial system.
The report identifies three major vulnerabilities in non-bank CRE investors:
- Liquidity mismatches: Some open-ended property funds face significant liquidity mismatches, making them vulnerable to runs.
- High leverage: Elevated financial leverage in some REITs and property funds could lead to forced deleveraging if property values decline or debt cannot be refinanced, propagating stress across the CRE market.
- Illiquidity and pricing risks: The CRE market’s illiquidity makes asset and collateral pricing difficult, especially during stress. Infrequent valuations and lenders’ "extend and pretend" practices can delay loss recognition, causing abrupt losses in prolonged downturns. Enhanced transparency and incorporating valuation uncertainty into risk management could mitigate this.
While this report is also relevant for REIT investors (as the FSB warns many could face bankruptcy due to liquidity issues), the interlinkages and spillovers to banks are more critical for our focus.
Despite recent increases in CRE-related NPLs, no major systemic issues have emerged. As highlighted in our previous articles, U.S. banks widely employ "extend and pretend" strategies. The New York Fed explicitly states: "U.S. banks are extending impaired CRE mortgages to avoid writing off capital, leading to credit misallocation and a buildup of financial fragility." This creates a "maturity wall" peaking between late 2025 and 2027 – a major financial stability risk. But direct CRE lending is only one part of U.S. banks’ exposure to CRE.
The FSB also notes banks (especially larger ones) provide unsecured off-balance-sheet credit lines to non-bank CRE investors. These are difficult to measure, even for regulators. REITs utilize these lines more heavily during stress than other intermediaries. The "extend and pretend" approach also applies to bank term loans for REITs.
Banks, especially large U.S. institutions, are further exposed via:
- CMBS investments (the U.S. CMBS market is ~$636B as of Q2 2024 vs. €29B in Europe),
- Warehouse lines to CMBS issuers,
- Holdings of REIT and property fund shares.
Notably, ~45% of U.S. CMBS deals focus on distressed office and retail segments.
Finally, interlinkages exist through exposures to property developers.
Thus, U.S. banks face CRE exposure through:
- Direct CRE lending,
- Off-balance-sheet credit lines to non-bank CRE investors,
- CMBS holdings and financing,
- Lending/exposures to property developers.
Total U.S. bank exposure exceeds $5 trillion – over 200% of the sector’s aggregate equity. (Discussed in prior articles.)
The FSB concludes that while REITs/non-bank CRE investors face significant issues (potentially leading to major problems for them), these may not pose standalone systemic risks in all jurisdictions. However, they could amplify and transmit shocks to banks. U.S. banks are especially vulnerable given their massive exposures.
Followers of our banking work will recognize these issues. Nevertheless, it is significant to see this warning from the world's leading international financial body.
Bottom line
Believe it or not, there are more major issues on the larger bank balance sheets as compared to smaller banks, which we have covered in past articles. Moreover, consider that there was one major issue which caused the GFC back in 2008, whereas today, we currently have many more large issues on bank balance sheets. These risk factors include major issues in commercial real estate, rising risks in consumer debt (approaching 2007 levels), underwater long-term securities, over-the-counter derivatives, and high-risk shadow banking (the lending for which has exploded). So, in our opinion, the current banking environment presents even greater risks than what we have seen during the 2008 GFC.
Almost all the banks that we have recommended to our clients are community banks, which do not have any of the issues we have been outlining over the last several years. Of course, we're not saying that all community banks are good. There are a lot of small community banks that are much weaker than larger banks. That’s why it's absolutely imperative to engage in a thorough due diligence to find a safer bank for your hard-earned money. And what we have found is that there are still some very solid and safe community banks with conservative business models.
So, I want to take this opportunity to remind you that we have reviewed many larger banks in our public articles. But I must warn you: The substance of that analysis is not looking too good for the future of the larger banks in the United States, and you can read about them in the prior articles we have written.
Moreover, if you believe that the banking issues have been addressed, I think that New York Community Bank is reminding us that we have likely only seen the tip of the iceberg. We were also able to identify the exact reasons in a public article which caused SVB to fail. And I can assure you that they have not been resolved. It's now only a matter of time before the rest of the market begins to take notice. By then, it will likely be too late for many bank deposit holders.
At the end of the day, we're speaking of protecting your hard-earned money. Therefore, it behooves you to engage in due diligence regarding the banks which currently house your money.
You have a responsibility to yourself and your family to make sure your money resides in only the safest of institutions. And if you're relying on the FDIC, I suggest you read our prior articles, which outline why such reliance will not be as prudent as you may believe in the coming years, with one of the main reasons being the banking industry’s desired move towards bail-ins. (And, if you do not know what a bail-in is, I suggest you read our prior articles.)
It's time for you to do a deep dive on the banks that house your hard-earned money in order to determine whether your bank is truly solid or not. Review our due diligence methodology here.