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Samantha Burns, International Banker
The global commercial real estate (CRE) sector is currently under severe pressure as interest rates remain high in many parts of the world. Nowhere is this more pronounced or systemically important than in the United States, home to the world's largest commercial real estate market. With real estate debt maturing over the next three years, there is growing speculation that the U.S. banking sector could again slip into a major crisis if default rates on CRE loans rise to unmanageable levels.
CRE loans represent roughly a quarter of the average lender's assets and a staggering $2.7 trillion of banks' total assets, and will represent a significant portion of the entire U.S. banking system by 2024. And because many of these loans were issued at rock-bottom interest rates during the low interest rate environment of the past decade, the challenge of borrowers repaying CRE loans at today's significantly higher interest rates poses significant strain on U.S. lenders seeking to avoid selling loans at deeply discounted prices.
And to make matters worse for CRE lenders, factors such as the economic slowdown and a strong preference for remote and hybrid work in the wake of the pandemic are not only adding to the sharp rise in distress in the U.S. CRE market, but are also quite bearish for U.S. commercial real estate prices. According to Green Street's Commercial Property Price Index (CPPI), which tracks the prices at which U.S. institutional CRE deals are currently being negotiated and signed, commercial real estate prices have fallen 7% over the past year and are down 21% from their March 2022 peak.
It is not surprising that the total amount of delinquent loans related to commercial real estate such as shopping malls, offices and industrial units was estimated at $24.3 billion last year, more than double the $11.2 billion in 2022. Meanwhile, more than $38 billion in U.S. office buildings are currently in default, foreclosure or other forms of distress, according to data firm MSCI, the highest amount since the fourth quarter of 2012. And the Mortgage Bankers Association's (MBA) 2023 Commercial Real Estate/Multi-Family Mortgage Maturity Volume Study, released in mid-February, found that of the $4.7 trillion in outstanding commercial mortgages held by lenders and investors, 20% ($929 billion) will mature in 2024, up 28% from the $729 billion maturing in 2023.
The stress these staggering figures are putting on the banking industry is now raising serious concerns. For example, as the Financial Times reported in February, Federal Deposit Insurance Corporation (FDIC) filings showed that U.S. banks now hold $1.40 in reserves for every dollar of delinquent commercial real estate loans, down significantly from the $2.20 recorded a year ago and the lowest level in more than seven years.
Additionally, the average reserves at JPMorgan Chase, Bank of America (BofA), Wells Fargo, Citigroup, Goldman Sachs, and Morgan Stanley fell from $1.60 to $0.90 for every dollar of commercial real estate debt that borrowers are 30 days or more past due. This means that delinquent CRE loans at the six largest US banks have tripled to $9.3 billion over the past year and now exceed the amount of reserves these banks are holding to cover them, which could pose a huge problem if these loans default.
Many believe the situation is manageable at current levels for large banks. Wells Fargo, for example, recently confirmed that its CRE loan burden is primarily confined to the office sector and that it has built up enough reserves to absorb charge-offs after major construction. But with CRE making up about 11% of the average loan portfolio for large US banks, while that percentage jumps to 21.6% for smaller banks, smaller and regional US lenders face higher charge-off risk and could be in more serious trouble.
Indeed, S&P Global Ratings warned in late March that the asset quality and performance of regional financial institutions could be hurt by stress in the CRE market, with loan modifications and rising loan maturities “potentially harbingers of weakening asset quality and performance.” The credit rating agency lowered its outlooks for five regional banks — First Commonwealth Financial (FCF), M&T Bank, Synovus Financial, Trustmark and Valley National Bancorp — because the five banks “have among the highest exposure” to CRE loans among the banks it rates.
Moreover, a recent analysis of nearly 4,000 U.S. banks by consulting firm Claros Group found that 282 of them, mostly small institutions with less than $10 billion in assets, face two distinct threats: commercial real estate loans and potential losses from rising interest rates. “Most of these banks are not insolvent or close to insolvent. They're just stressed,” Brian Graham, co-founder and partner at Claros Group, told CNBC. “So you'll see fewer bank failures, but that doesn't mean that communities and customers won't be hurt by that stress.”
Already, casualties are beginning to be felt. New York Community Bancorp suffered huge losses on commercial real estate loans that wiped out nearly $6 billion in its market capitalization. It reported a $2.7 billion loss in the fourth quarter of 2023 and was downgraded to “junk” by Moody’s. And Pennsylvania Real Estate Investment Trust (PREIT) warned in November that it couldn’t meet its debt repayments of about $1.1 billion, filing for Chapter 11 bankruptcy protection a month later for the second time since 2020. But some commercial borrowers are taking steps to avoid or exit bankruptcy. To its credit, the owner and operator of shopping mall retail space emerged from bankruptcy in early April with a comprehensive restructuring that removed $835 million in debt from its balance sheet.
Nonetheless, these deteriorations are a sign of things to come, and further stresses and failures are expected in the coming months and years, and it is entirely possible that the US banking sector could slip into a new crisis. A working paper published in February by the National Bureau of Economic Research (NBER) analyzed the risk of US banks suffering distress from CRE loans during the Federal Reserve's tightening cycle that begins in early 2022. It found that following the recent decline in real estate values due to rising interest rates and the increased adoption of hybrid work arrangements, about 14% of all loans and 44% of office loans have “negative equity,” meaning that the current property value is lower than the loan balance. If interest rates remain high and property values do not recover, loan default rates could reach or exceed levels seen during the 2007-2009 Global Financial Crisis (GFC).
Depending on the scale of defaults that occur, banking sector stress could ultimately trigger a wave of lender failures. For example, if the default rate on CRE loans was 10%, U.S. banks would suffer total losses of about $80 billion, the paper argues, but if default rates rose to a worse 20%, total losses could reach $160 billion. The NBER paper also notes that about a third of all loans and “a large portion of office loans” could face substantial cash flow problems and refinancing challenges as aggressive monetary tightening and large increases in credit spreads have more than doubled the cost of debt.
“If such CRE loan defaults were to materialize in early 2022 when interest rates are low, no banks would fail even in the most pessimistic scenario,” the paper states. “However, we find that the large decline in bank asset values following the 2022 monetary tightening significantly reduced banks' ability to withstand adverse credit events.” As such, the authors warn that the risk of failure of a “substantial” number of U.S. banks increases, with an estimated 231 additional banks with $1 trillion in total assets whose mark-to-market (MTM) asset values fall below the par value of all non-equity debt in a 10% CRE loan default scenario. In a 20% default scenario, that number rises to 482 banks with $1.4 trillion in total assets.
Additionally, the continued high interest rate environment means refinancing costs remain high for CRE borrowers, and those costs will rise as many banks seek to reduce their overall CRE loan exposure. The FDIC's 2023 Annual Report notes that “banks have tightened their underwriting standards for a variety of consumer and commercial loans over the past year and may continue to do so this year.”
Federal Reserve Vice Chairman for Supervision Michael S. Barr, in a February 16 speech, also confirmed that regulators are looking at banks' CRE loans in a variety of ways, including “how banks measure and monitor their risks, what steps they are taking to mitigate the risk of losses on CRE loans, how they report risks to their boards and senior management, and whether they are setting aside adequate reserves and have sufficient capital to mitigate future CRE loan losses.”
As the following chart from the Federal Reserve Bank of St. Louis shows, U.S. commercial banks continue to pile large amounts of CRE loans onto their balance sheets, with the latest figure for March reaching a staggering $2.985 trillion. This is up 0.34% from the previous month and 3% from a year ago, suggesting that a long-term upward trend is continuing despite widely-publicized risks emanating from the commercial real estate sector.
Last June, the FDIC, along with the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System, and the National Credit Union Administration (NCUA), issued the “Interagency Policy Statement on Prudent Commercial Real Estate Loan Adjustments and Adjustments,” a “principles-based resource for financial institutions to consider when engaging with borrowers experiencing financial difficulties.”