Commercial real estate market participants are closely following reports of a potential deal between President Joe Biden and the House of Representatives to raise the US debt ceiling – and avoid a potentially catastrophic default on US sovereign debt – ahead of a June 1 deadline.
A positive outcome would provide a critical boost for the global economy – and the US commercial real estate market, which anticipates a protracted period of inactivity, higher interest rates and a steep drop in foreign investment should the US fail to come to an agreement to extend the debt ceiling.
Published reports on May 25 indicate key sticking points between the White House and the House of Representatives over spending are closer to being resolved, which would allow for a two-year extension of the debt ceiling.
Not out of the woods yet
Arthur Jones, senior director of real estate research at Des Moines, Iowa-based Principal Asset Management, outlined three potential scenarios should negotiations fail.
In the first scenario, the debt ceiling is not raised in a timely manner – and the US could default on some of its debt obligations on a short-term basis. There is another scenario in which the debt ceiling is raised and significant cuts are made to Federal programs. A worst scenario would include a prolonged credit breach, Jones wrote.
“Under each of these scenarios, Treasury rates would spike before declining due to an ensuing recession,” Jones wrote in a research note this week. “Increases in long-term Treasury bond yields would potentially push borrowing costs higher over the longer-term. In the shorter term, [credit] spreads would almost certainly widen, pushing the cost of capital higher, which will disrupt the transaction market.”
The potential for a continued impasse is being taken extremely seriously by the markets, with New York-based agency Fitch Ratings and Toronto-based DBRS Morningstar putting the US’ AAA long-term foreign-currency issuer default rating on negative watch earlier this week.
Bert Haboucha, principal of Los Angeles-based Atlas Capital Advisors, believes the impact of a continued impasse will be swift and harsh on the commercial real estate market. “Materials for anybody who is in the middle of construction, [or] who is looking for a construction loan anywhere in the US, [it’s] probably going to be a lot more difficult, a lot more expensive, and at a lower loan-to-value ratios than several days ago.”
As news of a potential agreement trickles out of Washington, there is a sense the US has so far been able to negotiate increases in the debt ceiling 78 times since 1960 and will do so again this week. Still, the federal government continues to make contingency plans.
“[The] Treasury [Department] has both explicitly and implicitly signaled that they have a plan to prioritize payments, and I’m sure that the number one priority throughout this entire process [will be] prioritizing payment of the US debt,” said Rick Jones, partner of Philadelphia-based Dechert Global Finance.
“It’s almost too big to even worry about,” Jones said, adding the sentiment on the real estate markets has been “captivated, while pretending not to be.” He continued: “We’re afraid if we admit this is a monumental event, it might pull forward the negative consequences of an actual default ahead of time.”
Dechert’s Jones identified another potential risk in the event an agreement is not reached, citing the “material adverse change clauses” in commercial real estate transactions which stipulate that if the capital markets are disrupted by uncontrollable factors, a party’s performance might be excused, delayed, or reduced either completely or partially.
Though the possibility of invoking the MAC clause is similarly low for both lenders and borrowers, Dechert’s Jones suggested market actors “look at financial circumstances change provisions in their deal documents to see if there’s any potential exposure for someone to step away from their obligations because of it.”
A likely outcome of the ongoing negotiation is spending cuts for many discretionary programs, although a May 25 article in The New York Times stated any cuts could not affect the military or veterans.
Spending cuts, however, could trickle down to commercial real estate. Though fundamentals have been generally healthy except for outliers like the office and retail sectors, a recession triggered by severe government spending cuts would undermine the economy’s ability to see a so-called soft landing, Principal’s Jones explained.
“We would likely see declining NOI across most major property types,” he said, adding that it could take longer for commercial real estate’s occupancy levels and values to fully recover.
Banking sector impact
A debt ceiling deal is also important for the health of the US banking sector, which has experienced substantial volatility since March.
“The banking system holds a massive amount of government debt. If the government debts were not paid, the value of those securities would presumably drop, causing bank balance sheets to be further impaired,” Dechert’s Jones said.
In addition, banks under pressure could end up unloading or reducing their riskiest assets, including commercial real estate loan books, according to FDIC regulation. According to Haboucha, banks would still lend into commercial real estate, but would require lower loan-to-value ratios and charge higher fees. Sponsors would also have to put more equity into deals, he added.
Finally, a default would mean a deteriorating global perception of the US credit profile, which could have a knock-on effect on commercial real estate investing.
“Many of the underlying investors [behind] the biggest office buildings in [the] US are usually foreign entities, whether it’s a sovereign fund in Singapore, or a Chinese investment company, or a European Investment Company. So, when you have these essentially foreign companies looking at real estate in the US and [if they] think it’s riskier than they anticipated, they’re going to be out of the market for a while,” Haboucha said.