The interminably prolonged era of zero-interest-rate “funny money” in 2010-21 produced an unparalleled tsunami of “malinvestment” – investment that was not economically justified in normal conditions – in both the United States and throughout the world. This tottering ziggurat has held up in 2022-23, despite soaring interest rates. But there are signs that, as 2024 begins, asset holders’ ability to prop up their crumbling portfolios is reaching its limits. Providing the Fed and other central banks don’t wimp out too quickly, the collapse of asset prices may finally occur this year. It will be very welcome.
When excess creation of a particular class of assets occurs, trouble generally arrives a few years later. The trigger for that trouble is not normally simply a rise in interest rates and a need to finance outstanding debt; healthy assets generally yield a sufficient margin over their cost of financing that anything but an extreme rise in interest rates (such as occurred in 1979-82, for example) is fairly easily survivable. In the current environment, long-term rates have risen from 1.5% to about 4% on the 10-year Treasury note; only those drunk with their own exuberance will have failed to take into account such a relatively modest rise, which is well within historical experience and probably not enough to bring inflation down permanently.
The problem arises with assets that have developed weaknesses from some other source, in the normal course of economic development. The early 1990s savings and loan crash was caused by those institutions having run long-term cash flow deficits through the rise in interest rates since the 1960s – they suffered the costs of inflation, but received none of the benefits from it, since their borrowers were able to continue enjoying cheap fixed-rate loans in devalued dollars while home values had soared. The dot-coms that crashed after 2000 had structural weaknesses that made it impossible for their revenues to rise to match their expenses – only a few, like Amazon (Nasdaq:AMZN) had underlying operating resilience.
The mortgage banking crash of 2008 related to loans that should not have been made, to borrowers of low credit quality, or more often to borrowers who were “stretching” their credit too far. In many cases these bad loans were then included in securitization “pools” with other loans, poisoning the credit quality of the entire pool. Houses in my non-metropolitan Poughkeepsie street sold for half their 2004 price in 2014; in that circumstance it was unsurprising that the more over-leveraged homeowners with shaky credit were unable to service their debt, leading to multiple foreclosures in the street.
One sector due for an asset price collapse is office property, especially in the big cities, which have their own special problems. This sector was grossly overbuilt on the basis of ultra-cheap credit in the 2010s, with fatuous propaganda about the beauty of living in cramped apartments in big cities luring excessive numbers of new graduates to them and creating a spurious excess demand for office space. Then in 2020, Covid-19 proved to millions of office workers that modern technology enabled them to do much of their work at home, so that they did not need to commute for an hour or so into a cramped, noisy cubicle. In the public sector (Federal and state) an increasing proportion of the whole workforce as the bureaucracies bloat, many workers without great career ambitions have ceased going into the office at all, preferring to “work from home” and cultivate their lifestyle.
This has caused severe indigestion in the office market, as oversupply has affected loan servicing. Most affected are the very new ultra-luxurious “prestige” projects – older buildings can generally reduce rents to attract tenants, while the top end is suffering lack of demand at the nose-bleed rental levels they need to service the debt on their epically expensive construction. Office loan delinquencies hit a 5-year high of 5.28% in November 2023, and there is nowhere for that statistic to go but up, especially if a recession reduces demand further.
$117 billion of office building debt is due for repayment in 2024, according to Mortgage Bankers Association data quoted in the Financial Times, and with refinancing carrying interest rates far above the level of a decade ago, when the debt was taken out, many borrowers will have neither the ability to refinance the debt nor the cash flow to pay it off. Of the 605 buildings with mortgages expiring soon, Moody’s believes that 224 will have trouble refinancing. Austria’s Sigma Corporation has been forced to put the iconic Chrysler Building in New York up for sale, in a market very unlikely to be receptive to a magnificently decorated 1930 gem with office space best suited to the wing-collar and Packard executive patterns of the golden late 1920s.
Even New York’s Seagram building, premier Mies van der Rohe example of 1958’s modernist architecture craze, in 2022 brought in half the rental revenue it had a decade earlier, when the building was last refinanced. (Replacing the world famous Four Seasons restaurant with a lavishly-appointed but sweaty gymnasium may not have helped here – there are some concessions to unpleasant modernity that should be resisted!)
The retail sector is another where there are huge numbers of dead assets, but here the rot was already pervasive before 2020, and much of the overbuilding dates back to the 1990s when every Valley Girl existed for her expensive, glittery trips to the local shopping mall. E-commerce sales represented 15.6% of total retail sales in 2023, a share that had doubled since 2016, boosted by Covid-19 but showing no sign of relapsing since the virus retreated. Some sectors of retailing are more affected by that than others, with supermarkets only marginally affected and mall retailing especially hard hit. With malls more than office buildings, there is a domino effect; once a few large “anchor” stores move out – with J.C. Penney and Sears abandoning many of their large mall spaces in recent years – the mall takes on a ‘spooky’ appearance, with the food service outlets also closing and passenger traffic a fraction of normal. If the mall owner responds to this by scrimping on cleaning and redecoration, as many do, the mall is doomed. Unlike with most office buildings, no amount of refinancing generosity can then make it viable.
Residential real estate ought to offer relief – after all, the sector had a severe downturn only a decade ago, and population increase has continued at a rapid rate, mostly from immigration. The problem here is that most illegal immigrants cannot afford the condominiums that represent most new construction. In the suburbs and exurbs, Blackrock has provided much support for the market in the downturn, buying up houses in foreclosure and using their access to ultra-cheap finance to turn them into rentals. This game is damaged severely by rising interest rates; it is also damaged by Millennials and Gen-Z wanting to buy when they can and Blackrock not having the best of reputations as a landlord – one cannot help believing that a crash is coming though it may be delayed.
It is in the big cities where a crash is most likely and most immediate. Inflated to infinity by the blather about “world cities” and overbuilt like crazy at the top end, the mystique of big city real estate has gone, if only because the cities have changed. Abominable leftist management has made them much more unsafe, while abominable leftist taxation has vastly increased the costs of living there. Consequently, there is a general exodus of the upper middle classes, who support the real estate market, and an influx of down-and-outs and illegal immigrants, who impose costs, financial and social upon it. Mayor Mike Bloomberg called New York a “luxury city.” – well, Bloomberg has been gone for a decade now, and New York, although still an unaffordable luxury, is a luxury slum from which many are fleeing. The same is true of San Francisco, Los Angeles, Chicago and the other cities that were touted as the world’s most elite places to live. Crime in New York is no higher (yet) than it was in the late 1970s, when I first lived there, but in the late 1970s I could run a lot faster than I can today!
Finally, there is private equity, where rising interest rates have destabilized financing calculations that were generally over-optimistic in the first place. In 2023, private equity financiers have been able to plug holes in their portfolio, using the large amounts of money they raised in the happy days of 2021, but the holes in the portfolio are getting bigger and more prevalent, and the extra cash is running out. We can thus expect this sector also to be a source of defaults and aggressive restructurings, with consequent loss of jobs and economic well-being.
Will it happen in 2024? Who knows. Some of the potential default sectors seem somewhat more distant than others. But if one starts cracking badly, the loss of confidence in the lending markets will affect all the others. So, my guess is that 2024 and 2025 will see some serious erosions of value, with defaults and investor misery inevitably following.
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)