How is the commercial real estate and consumer crisis unfolding?

Although Viet Hustler had warned beforehand, last week a series of events in the Real Estate (RE) market and US consumer savings data provided an even clearer warning:

But behind these 2 minor crises lies the risk of 2 larger crises for the US economy: Banking crisis and Economic recession. 

Following the stream of last week's economic and financial events, Viet Hustler's weekend Macroeconomic article will provide a systematic view of the data and events in the US commercial real estate market and household savings activities. 

Through that, Viet Hustler also provides personal opinions on the possibility of a banking crisis and economic recession in 2024.

Disclaimer: Some of the following opinions are entirely the personal views of the author group, may not be accurate, especially not investment advice! Therefore, Viet Hustler is not responsible for any investment decisions of readers based on this article.

Commercial real estate crisis: warning of potential banking crisis (banking crisis)

• If a few months ago, the Chinese real estate market was still the main risk of concern for managers of large investment funds…

• … then currently US commercial real estate has “risen” to become the biggest concern among credit system risks (chart below).

• This is what Viet Hustler predicted 6 months ago:

  • Related articles: What else awaits the economy after the early-year crises (end of the article).

• Above all, remote or hybrid work policies + office staff layoffs by businesses + high borrowing interest rates are the 3 main causes leading to difficulties for office building owners.

There have been many events reflecting the difficulties the commercial real estate market is facing (although hard data is not abundant), including:

• Back in September 2023: a 6-story office building in Manhattan was sold for USD 16.5 million – only 25% of the construction and development costs previously incurred by the owner (about USD 90 million in 2019).

  

• Early October: Rite Aid Corp. announced the closure of a series of stores across a total of 154 locations – causing damage to landlords. 

  

  • Among them, 12 large spaces in shopping centers owned by real estate investment trusts (REIT), causing significant damage to these funds.

    

• The collapse of We-Work sounds the alarm for the commercial real estate market.

• Office buildings in New York are being converted into rental apartment buildings.

  

• Early last week: Deutsche Bank announced it will record a loss of -USD 350 million from the office building in New York that they acquired in 2014…

  • … after the main tenant, Bank of America, left, causing the occupancy rate of this office building to drop to only 31%.

  

• Mid-week: Draper & Kramer (veteran commercial real estate developer in Chicago) sold a high-rise apartment complex with 275 new units in South Loop - Chicago, for only USD 59 million.  

  • Previously, in 2020, Draper & Kramer borrowed USD 69 million to build this apartment complex.

  • This event marks the possibility that the commercial real estate crisis has spread to residential real estate.

  

• Currently, the market value of the real estate sector is accounting for an increasingly smaller proportion in the S&P500 index (currently only under 5%).

  

The data in the chart below is quite old but also shows the reality that: 

• Commercial real estate loans (CRE) declined at the beginning of this year as mortgage rates rose sharply – but this is not the key point.

• The key point is the number of commercial real estate loan contracts executed in 2021 (and prior periods) was too high – these loans were all locked in at low interest rates.

  

• This creates difficulties for current banks, as their borrowing rates have risen high but they only receive extremely low returns from old investments.

The burden of the commercial real estate crisis, particularly, is placed on the shoulders of regional banks (regional banks):

• …as they hold >70% of the value of commercial real estate loan contracts:

• While they are also the most heavily affected by the bank-run issue following the collapse of SVB.

  • Deposit amounts are declining at small banks, with people transferring deposits to large banks or money market funds (MMF).

    

  • FYI: Last week, small banks saw deposit outflows - USD 3.3 billion…

    – forcing the Fed to increase the total term funding facility for commercial banks (BTFP) to a record level: USD 114 billion.

    

What must come will come, delinquent debt on commercial real estate loans in the banking system has reached the highest level in 10 years.

It's only a matter of time before a systemic crisis at small banks occurs following the real estate crisis in the US!

Recession or no recession? Signs from excess savings of US households.

• Consumer spending is the key variable affecting the current recession risk, which has been emphasized many times by Viet Hustler through articles on markets and macroeconomics.

  (As consumer growth accounts for up to 68% of current US economic growth).

• Related articles: Risk of recession returning through recent economic fluctuations

However, the latest data on household excess savings is sending a clear message:

• The cumulative amount of excess savings in households has decreased significantly compared to the peak in 2021.

• However, there is still an amount of excess savings (~433 billion USD) remaining in households from the 2020-2021 QE economic stimulus period.

  

  • Note, excess saving differs from normal saving in that: excess saving is unwanted savings or not part of people's savings plans (usually due to an economic shock that gives them extra money or money they can't spend, e.g.: Covid-19…)

    (FYI: Cleveland Fed's research on Excess Savings)

  • Therefore, as long as excess saving remains, people still have money to spend, the economy won't enter recession but inflation will be harder to reduce (due to high consumer demand).

Why is excess saving important in economic growth or recession?

Due to high excess savings during the Covid period, the impact of this interest rate hiking cycle on GDP growth has a much longer lag than previous cycles.

• For other cycles: investments in housing and production activities immediately declined from the early stage after the Fed raised rates…… indicating faster contraction in economic investment activity.

  • But in this cycle: housing and production investment activities remained strong in the early stage – due to still high demand (people still have money), 

• These economic activities have only truly declined recently.Image

  • Image   

  

• – the reason is also because people still have excess saving, and market yields are quite high for investment.

• Alongside declining investments in housing (due to high mortgage rates), people's investments in non-housing assets are increasing rapidly (chart on the right).

  • – the reason is also because people still have excess saving, and market returns are quite high for investment. 

  

However, excess savings are gradually depleting …

• Excess savings are being eroded at a slower rate than previously predicted by the San Francisco Fed (chart below). But this amount of excess savings will certainly end soon (analysis below) -- this also creates 2 opposing effects:

  • Inflation may soon fall back to the Fed's 2% target.

  • But the likelihood of the economy entering a recession will also increase as the strong consumer buffer from Americans gradually disappears.

• Moreover, the New York Fed warns that the “financial resilience” of US households is declining: 

  • … when only 65.8% of households are able to pay if an unexpected USD 2000 expense hits — the lowest payment rate ever.

    

Therefore, even though excess savings have delayed the impact of this interest rate hiking cycle on GDP, this impact is still approaching, and could become more severe due to the sudden consumer adjustment shock from the people …

(when people who are spending strongly suddenly stop spending). 

• Indeed, consumption will soon slow down due to 3 reasons:

  • (1) Real disposable income has fallen below the pre-Covid trend (chart below - left side).

  • (2) Prediction that excess savings will be depleted by the end of Q1/2024 (chart below - right side).

    

  • (3) Even the use of credit loans to finance consumer spending is gradually disappearing (people will not borrow more debt to consume…)

    • , consumer credit growth in the last 3 months has dropped to 1%, 

    • the Y/Y growth figure is also only 3.5% (lower than the 5% average).

      

=> We should still prepare for the worst-case scenario that a recession will occur soon.

• If previously, the economy's leading indicators said that a recession “is about to happen”… now coincident indicators (indicators reflecting the current economic situation simultaneously) indicate that the recession is already near.

  • Philly Fed collects data for the monthly Coincident Indicator of 50 US states to track ongoing economic activities. 

  • Among them, the coincident diffusion index (coincident diffusion index – CDI) = % of states facing recessionary levels of economic activity, is also published.

  • Currently, only about 25% of state economies are still growing month-over-month (M/M).

  • But compared to 3 months ago, about -25% of US states are facing declines in economic activity.

    

CONCLUSION

Hard data (official statistical data) on the crises in the commercial real estate market is still not abundant (or not yet compiled/published clearly). However, recent events reflect that businesses in the real estate sector have deeply felt the difficulties brought by this invisible crisis. 

From Deutsch Bank to Draper & Kramer (not to mention other small businesses), from New York City to Chicago, all share the story of losses for real estate investment businesses — due to rising borrowing rates while vacancy rates in buildings are increasing.

The spillover effects from the commercial real estate sector to the system of small banks (regional banks) are too clear.

• This group of banks, still heavily affected by the worsening trend of bank runs, now have to bear losses from commercial real estate loans at low interest rates from many years ago.

• Not to mention that overdue commercial real estate debts are increasingly rising.

• It's only a matter of time before we clearly see the crisis hitting this group of banks.

Besides the banking sector, the US economy has another important variable, which is the depletion of excess savings among the populace from the Covid period. Over the past more than 1 year, this amount of money has been the backing buffer for US economic growth. However, the latest data shows that the decline rate of excess savings is going quite fast. And it is expected that by Q1/2024, people will use up the excess savings. That could also be the time when recession hits the US economy!