Bracing for Impact. The Looming Storm in Commercial Real Estate Threatens the U.S. Banking Sector.

The global commercial real estate (CRE) sector faces immense pressure as interest rates remain high worldwide. Nowhere is this more evident or significant than in the United States, home to the world’s largest commercial property market. With a massive wave of property debt reaching maturity over the next three years, concerns are growing that the US banking sector could be vulnerable to another major crisis if default rates on CRE loans rise to unsustainable levels.

CRE loans, comprising about a quarter of the average lender’s assets and totaling a staggering $2.7 trillion in aggregate bank assets, represent a significant portion of the US banking system in 2024. Many of these loans were issued at historically low rates during the previous decade’s low-interest environment. However, borrowers now face the challenge of repaying their CRE loans at today’s considerably higher rates, placing immense strain on American lenders as they strive to avoid selling loans at substantial discounts.

Additionally, factors such as a slowing economy and a notable preference for remote and hybrid work arrangements post-pandemic have exacerbated distress within the US CRE market. These trends have also led to considerable pessimism regarding US commercial property prices. According to the Commercial Property Price Index (CPPI) by Green Street, US commercial property prices have declined by 7 percent over the past year and by 21 percent since their peak in March 2022.

The total value of delinquent loans tied to commercial properties such as malls, offices, and industrial units reached $24.3 billion last year, more than double the amount registered in 2022. Moreover, over $38 billion worth of US office buildings are now at risk of defaults, foreclosures, or other distress, marking the highest amount since late 2012. The Mortgage Bankers Association’s (MBA) survey indicates that $929 billion of outstanding commercial mortgages will mature in 2024, a 28-percent increase from the previous year.

The stress on the banking sector is evident, with filings from the Federal Deposit Insurance Corporation (FDIC) revealing that US banks hold lower reserves for delinquent commercial real estate loans compared to a year ago. The reserves at major banks, including JPMorgan Chase, Bank of America (BofA), Wells Fargo, Citigroup, Goldman Sachs, and Morgan Stanley, have declined, leaving them potentially vulnerable if delinquent CRE loans escalate to defaults.

While major banks may manage the situation at current levels, smaller and regional US lenders face higher risks due to their significant exposure to CRE loans. S&P Global Ratings warned that regional lenders could experience deteriorating asset quality and performance due to stresses in CRE markets. Additionally, a study by consulting firm Klaros Group revealed that numerous smaller lenders, facing threats from CRE loans and potential losses tied to higher interest rates, are under stress.

Already, casualties are emerging, with some institutions experiencing substantial losses on CRE loans, leading to downgrades and bankruptcy filings. Despite some commercial borrowers taking steps to avoid bankruptcy, the outlook remains concerning, with expectations of further stresses and failures in the US banking sector in the coming months and years.

A working paper published by the National Bureau of Economic Research (NBER) highlights the vulnerabilities of US banks to distress from CRE loans amidst monetary tightening. The paper warns of potential increases in insolvency risks for a substantial number of US banks, particularly under scenarios of rising default rates.

The prevailing high-rate environment makes refinancing loans expensive for CRE borrowers, further complicating the situation. Regulatory supervisors are closely monitoring banks’ CRE lending activities, emphasizing the importance of risk measurement, mitigation, and appropriate provisioning.

Despite known risks, US commercial banks continue to accumulate CRE loans on their balance sheets, indicating a sustained upward trend in CRE lending activity.