"A 10% loss on CRE loans would leave more than 100 mostly small and midsize banks, representing nearly $700B in assets, undercapitalized. A 20% loss would render over 900 banks undercapitalized, including some larger banks."
U.S. banks face a reckoning: Over the next two years, more than $1 trillion in commercial real estate (CRE) loans will come due, according to The Conference Board calculations using MSCI Real Assets data. Institutions with the most concentrated exposures, insufficient capital cushions, and limited lifelines from larger institutions or regulators face significant losses.
The damage could metastasize into a full-blown financial crisis if scores or even hundreds of small- and midsize commercial banks fail simultaneously. A worst-case scenario might include contagion to other economies and banking deserts across the U.S.
As the Federal Reserve keeps interest rates elevated and CRE risks worsen with falling property values, businesses will continue to experience restrictive financing conditions. Executives can nonetheless take steps to potentially mitigate the fallout — including examining banking relationships, extending debt maturities, and securing adequate working capital. How Did We Get Here?
The risks of U.S. commercial banks being overexposed to CRE have intensified as the global pandemic upended long-held economic assumptions: perpetually subdued inflation, low interest rates, and in-office work.
Exacerbating the situation are CRE management costs — including insurance premiums, labor, and energy prices — which have skyrocketed. An aging U.S. population is fueling labor shortages, forcing wages higher as firms aim to attract and retain talent. What’s more, natural disasters are increasing property insurance premiums, and dated electricity grids and the uneven energy transition are raising building power costs. There’s Trouble Brewing
Hundreds of banks hold an outsized amount of CRE loans on their books relative to capital. Small banks (assets of $100 million to $1 billion) and midsize banks (assets of $1 billion to $10 billion) have CRE loan values far exceeding risk-based capital levels at 158% and 228%, respectively, according to The Conference Board calculations using FDIC Institutional Financial Reports data. This is compared to 142% for large banks (assets of $10 billion to $250 billion) and 56% for the largest banks (assets greater than $250 billion). The smallest banks (assets less than $100 million) issue few of such loans.
As CRE property values fall and the debt service on associated loans accumulates, borrowers are becoming delinquent or defaulting. The portion of these loans that are nonperforming more than doubled — from 0.54% to 1.25% — over the six quarters from the Q3 2022 cycle low, according to data compiled from BankRegData.com and the FDIC. Compare this with the just 0.87% rate six quarters after the cycle low, in the second quarter of 2006, which preceded the 2008–09 Great Recession.
However, only the largest banks are reporting increases in nonperforming loans and charge-offs (i.e., losses). Reported CRE loan delinquencies exceeding 90 days have surged from under 1% in mid-2022 to 3% in early 2024 for the largest banks, while delinquency reports for all other banks remain near 1%, according to The Conference Board calculations using FDIC Institutional Financial Reports data. (By comparison, delinquency rates reached 5% in 2010 in the wake of the 2008–09 Great Recession.)
Meanwhile, CRE loan losses for the largest banks spiked to 0.6% in early 2024, while other banks are reporting virtually zero losses. By comparison, such losses topped 1.4% in 2010.
The reason for the different behaviors is that the biggest banks face greater regulatory scrutiny and are required to maintain larger capital cushions, prompting swifter realization and write-offs of souring loans. Smaller and midsize financial institutions — many of them regional and community banks — are evidently not marking down CRE loan losses but may be managing stresses differently.
These institution
s are likely engaging in “extend and pretend” behaviors that lengthen loan maturities with the hope that property valuations will recover in the future. They also may be seeking to widen capital buffers through M&As with similarly sized or larger financial institutions. What Could Trigger a CRE Crisis?
Multiple troubled banks simultaneously raising equity capital would prove challenging and potentially destabilizing for the U.S. banking system. Any hint of doing so could cause massive depositor flight (i.e., bank runs), creating a redux of the March 2023 panic across global financial markets when only three U.S. banks came under pressure. Digital banking has accelerated the speed at which these runs might occur.
The clock is ticking for banks delaying recognition of CRE loan losses, and the timing of the financial market fallout — potentially starting later this year — could be during a vulnerable period for the economy. The Conference Board expects that U.S. real GDP growth may be weaker, the unemployment rate slightly higher, and interest rates still near multi-decade peaks, when a cascade of banks begin reporting losses.
Other CRE crisis triggers could include a U.S. recession; interest rates that stay higher longer than expected; and/or financial market upheaval from a fiscal crisis (e.g., the looming January 2025 debt ceiling) prompting investors to demand greater credit risk compensation in the form of higher yields. The Potential Fallout
As these loan losses begin to mount, an increasing number of banks — mostly regional and community banks — risk having insufficient capital cushions. A 10% loss on CRE loans would leave more than 100 mostly small and midsize banks, representing nearly $700 billion in assets, undercapitalized. A 20% loss would render over 900 banks undercapitalized, including some larger banks.
The quality of banks’ real estate assets will heavily influence the extent of such losses. Banks with exposure to Class A properties are likely to fare better due to the fewer vacancies. Older, lower-quality Class C properties in harder-hit metro areas may experience more vacancies given increased demand for newer and refurbished Class A buildings. With few properties changing hands, it is difficult for assessors to assign property values, only complicating loan loss estimates.
It’s unlikely that the Fed, FDIC, and a consortium of the largest banks can rescue hundreds of compromised commercial banks at once. The largest and best-capitalized banks might be reluctant to acquire the assets of smaller financial institutions with sizable CRE losses, especially if there are few operational or geographic synergies, while regulators may choose not to step in.
Fed officials have indicated that a CRE crisis will probably lead to bank failures. Multiple, simultaneous bank failures could be catastrophic for the financial system. Nonetheless, policymakers and regulators may be wary that Federal Reserve and FDIC liquidity injections might encourage excessive bank risk-taking in the future, justifying a more cautious approach. The Depth, Breadth, and Duration of a Crisis
Pandemic-accelerated troubles in the CRE market may take more than a decade to resolve.
Increasing office space vacancies linked to remote and hybrid work could extend price declines and deepen losses for lenders in this space. Most empty or underutilized office space is too costly to convert to residential or other uses and will require deeper price concessions. As leases can stretch to 10 years before they are due for renewal, it may take years for the office space market to clear.
Notably, the sharp rise in interest rates has caused all commercial property subtypes, not just offices, to lose value. Indeed, commercial property prices have already fallen by 21% from their mid-2022 peak, according to Green Street, a CRE analytics firm, and could ultimately decline by 35%. Hardening Companies for a CRE Storm
Corporations should prepare for an extended period of tight lending standards, elevated borrowing costs, and possible market liquidity shortages, as banks work to resolve CRE challenges. Prudent corporate managers should extend their debt maturities and add a cash liquidity buffer — now.
Even if the Fed creates a new liquidity facility to relieve CRE-induced stress on the financial system, yield spreads on corporate debt would likely widen, raising the cost of capital. Liquidity may also become scarce, especially as banks discover CRE loan impairments and recognize losses.
Companies should maintain a diverse set of readily accessible financial instruments with characteristics suitable for each individual firm. And they must constantly measure and keep adequate levels of liquidity for all asset classes in their possession and dedicate internal staff to executing these operations.
Firms must have multiple sources of liquidity, in case financial market liquidity dries up or their primary financial institution folds. Companies should review all banking relationships and be aware of the terms and limits associated with any liquidity drawdowns from their credit lines. Firms with deposit accounts at banks with high CRE loan concentrations should be especially mindful of liquidity requirements and FDIC deposit insurance limits.
Importantly, corporate managers should know of any provisions allowing their financial institutions to transfer depositor assets to third parties for management. In such cases, executives should be aware of the safeguards their banks have in place should third-party asset managers come under duress.
Finally, companies should monitor liquidity risk exposure of key counterparties, including subsidiaries, suppliers, customers with credit lines, creditors, and debtors. While expensive, such measures may mean the difference between survival and extinction when the commercial real estate reckoning comes.
