Morgan Stanley Analysts See Commercial Real Estate Drop ‘Worse Than The Great Financial Crisis’: BofA Disagrees For 3 Key Reasons

Contrary to Morgan Stanley’s near-apocalyptic tone, with analysts forecasting a “peak-to-trough CRE price decline of up to 40%, worse than the Great Financial Crisis,” Bank of America seems to suggest that commercial real estate will remain stable, while echoing the declining value of the office sector, in a research note published last week.

According to Bank of America analysts, the US commercial real estate market faces two key challenges in our post-pandemic world. The first? High inflation that forced the Federal Reserve to raise interest rates in an attempt to control it. That made it much more expensive to pay off new and past-due commercial real estate mortgage debt. The second challenge, which has already directly affected the office sector, is remote work.

Still, analysts at Bank of America (BofA) argue that those challenges are manageable for 3 key reasons, distancing themselves from the next shoe to drop narrative.

“We examined these challenges in the context of improvements to the commercial mortgage underwriting process in the post-Great Financial Crisis (GFC) era,” the Bank of America analysts wrote. “We conclude that the challenges are real and significant, but, for a number of reasons, they are manageable and do not pose a systemic risk to the US economy.”

Let’s take a look at the 3 key reasons behind BofA’s “manageable” CRE perspective.

1. There are multiple financing tactics for CRE borrowers to avoid defaulting on their debt

Bank of America analysts say 17% of CRE’s debt will mature this year, but expect loan modifications and extensions to become commonplace tactics. That could mean that borrowers who employ such tactics can avoid some of the higher cost caused by the economy’s high interest rates or the potential for default on their debt, directly addressing the first challenge put forward by Bank of America.

Also, along with loan modification, property repurposing has become standard practice in the market, according to analysts. That can serve as another option in the event a borrower’s debt comes due at a higher rate.

2. Office properties, the highest risk sector, are only a small percentage of all CRE loans

“Work from home (WFH) and the broader phenomenon of deurbanization have diminished the need for and intrinsic value of at least one sector of the CRE market, the office sector,” the Bank of America analysts wrote.

There is no doubt that the office sector is facing significant headwinds driven by the work-from-home era that has endured in the post-COVID world. However, rising vacancy rates in the office sector and falling property values ​​are not indicative of the general health of the commercial real estate market.

Bank of America analysts say office properties make up about 23% of CRE loans coming due this year, but that’s just 3.8% of all commercial real estate, which is “a comparatively modest number.” , in your opinion.

3. Post-GFC underwriting improvements mean these loans are less risky

There are two critical parameters within CRE mortgage underwriting, along with trends that have emerged in the aftermath of the Great Financial Crisis (GFC) that may offset the risk ahead, according to Bank of America analysts. Of the two critical parameters, the first is the debt service coverage ratio (DSCR), which measures the borrower’s ability to pay. The second is the loan-to-value (LTV) ratio, which measures two things: the potential for loan recovery if a borrower defaults on their debt, and the borrower’s ability to refinance after maturity.

In the post-GFC era, analysts say they have seen two trends: debt-to-service coverage ratios are substantially higher and loan-to-value ratios are substantially lower. Both trends indicate a shift from the lax underwriting in the pre-GFC era, analysts say.

“The drop in LTV from 70% in 2007 to a low of 52% is significant; Much more capital is required upfront today, which means borrowing is much less risky,” the Bank of America analysts wrote.

Along with improvements in underwriting, sector price growth over the years has led to increased capital that can also serve as a risk buffer, diversification of risk across lender types, and a significant increase in in bank capital after GFC, has led Bank of America’s assessment that the challenges ahead for commercial real estate are manageable.

“We believe the risk of contagion from CRE to the broader economy will be minimal and manageable,” the analysts wrote. “We think there will be a credit crunch, but it is a necessary part of business cycles and will help reduce CRE overcapacity.”