The US commercial real estate sector is at a critical juncture, grappling with significant challenges. Lenders have been grappling with troubled loans, banking on potential intervention from the Federal Reserve that has yet to materialize.

Just before Federal Reserve Chairman Jay Powell announced that benchmark interest rates would hold steady between 5.25% and 5.5%, Colin Simpson, the CFO of Manulife, revealed a substantial 40% write-down in the valuation of their US office investments compared to pre-pandemic levels.

Initially alarming, this write-down could signal a positive shift for investors. Despite the sizable loss, Manulife, a major CRE lender with a portfolio exceeding $30 billion, possesses sufficient resources to weather such setbacks. Moreover, this development underscores a growing trend towards increased transparency within the American commercial real estate market, as lenders become more forthright about the sector’s challenges.

This disclosure from Manulife is both timely and necessary. Amid expectations of rate cuts in the US, property owners and lenders had been caught in a cycle of “extend and pretend,” delaying necessary actions on troubled loans in anticipation of Federal assistance. However, recent indications from the Fed suggest a focus on controlling inflation rather than propping up the property market. Now, the question looms as to how many other industry players will follow Manulife’s lead, finally addressing one of the lingering issues stemming from the excesses of the past decade’s easy credit environment.

The significance of this situation cannot be overstated. Banks, buoyed by the low-interest rate environment during the COVID-19 pandemic, facilitated a surge in inexpensive CRE loans. Post-pandemic, the values of commercial real estate properties have plummeted by an average of 33%, with office buildings experiencing declines of up to 60%, according to Goldman Sachs. Despite this, the financial fallout has been somewhat cushioned by the ongoing extension of troubled loans. For instance, out of the $163 billion in commercial mortgage-backed securities (CMBS) due in 2023, $83.3 billion remains outstanding. Additionally, the sector is grappling with a rise in delinquencies and mounting financial pressure, placing more than 250 of the 4,500 US banks at risk.

In summary, the commercial real estate market is teetering on the edge with $1.3 trillion in distressed debt, largely attributable to low-interest loans during the pandemic. Banks have deferred dealing with $270 billion of this debt until 2024, postponing an inevitable reckoning. Despite improvements in the banking system since the 2008 financial crisis, the current approach of “extend and pretend” casts a shadow over economic growth. The real solution lies in embracing transparency regarding losses and transitioning towards repurposing or demolishing outdated properties. With the Federal Reserve signaling a preference for maintaining higher interest rates, investors must recognize that the era of cheap money has come to an end, necessitating a shift in investment strategies.

Blog by Robert Withers