More than $900 billion in loans secured by office buildings, retail centers, hotels, warehouses and more are coming due this year, and analysts who track commercial real estate are already worried that this part of the economy could soon threaten the finances of local banks and municipalities.
That huge amount of loans — roughly 20% of the nation's commercial real estate loans — comes due this year, but it comes on the heels of a disastrous 2023 that saw a short-term deferral of hundreds of billions of dollars in approaching loan maturities, and experts are warning that 2024 may not be any better.
The near collapse of New York Community Bancorp earlier this month, leading to its rescue with $1 billion in new investment led by former Treasury Secretary Steven Mnuchin’s private equity firm, rekindled concerns about regional banks since two failed banks in the spring of 2023. Mid-sized banks underwrite a lot of commercial real estate loans, which could have a knock-on effect in the financial sector if developers and property owners struggle to make repayments.
“There will be challenges,” said Matt Reidy, director of commercial real estate economics at Moody's. “It could be a lot like last year.”
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The office market could see the most serious problems. For example, there is more than $17 billion in commercial mortgage-backed securities (CMBS) office loans maturing in the next 12 months, double the amount in 2023. Moody's estimates that 75% of those have certain characteristics that could make them difficult to refinance. These could include properties with canceled leases, vacant buildings and other cash-flow issues.
From there, options for borrowers range from less than ideal to desperate. In many cases, borrowers took out lower-interest loans before inflation soared and interest rates soared. If companies refinanced now, they would likely incur higher borrowing costs on top of their existing problems. Otherwise, borrowers will try to push maturities further into the future or face defaulting altogether.
This year promises some improvement: Office loan paydowns were 48% in January and February, several notches above the overall 2023 performance of 35%, according to Moody's data. And not all real estate types are in as dire a situation as office. Hotels, for example, have generally performed much better since recovering from the pandemic. Industrial real estate also finished last year strong.
But economists stress it's too early to draw any big conclusions about whether rising repayment rates will continue or whether more bad news is yet to come. Based on a portfolio of loans maturing this year, Moody's is still keeping an eye on roughly $10 billion in troubled CMBS office loans. If all of those loans default, the CMBS office loan delinquency rate could rise to more than 13% from the current 6.2%. That would be problematic for banks that hold the loans (especially if their portfolios are heavily weighted toward the office market) and for downtowns that are already struggling to attract new tenants.
Ronnie Hendry, chief product officer at analytics firm Trepp, said early signs should surface soon, even if it will take several more months to get a full picture.
“Can they extend it or modify it? Can they refinance it?,” Hendry said. “If that doesn't happen and they're holding off, that could have a negative impact on properties that are still out through 2024.”
Overall, the United States has made a remarkable comeback since the pandemic upended every aspect of the economy and daily life: Growth has remained strong, the job market remains tight, and the Federal Reserve's aggressive efforts to raise interest rates and curb inflation have prevented the recession that seemed all but certain.
But the dangers associated with commercial real estate, especially offices, still loom. Buildings across the country remain empty as companies rethink their need for in-person space, settling for smaller spaces or shifting to fully remote work. Restaurants in major downtown areas remain closed, lamenting vacant weekdays and vacant weekends. Some economists worry about a kind of “vicious circle” in which empty buildings here and there would be even more dire for city budgets that rely heavily on property and wage taxes.
Ultimately, the danger comes from individual banks and borrowers themselves, many of whom are using “extension and cheating” tactics to get through these difficult times.
A first step that became popular after the Great Recession was to extend the term of the loan and keep the payments and interest rate on the same schedule, rather than refinancing or paying off. This allows the borrower and the bank to “pretend” that the loan is still worth what it was and hasn't gone down in value. That means the bank doesn't have to write down a loan that's worth less than when it was originally extended.
The workaround gained traction after the Great Recession, when the Fed cut interest rates and kept them low to stimulate the economy. At the time, this meant that struggling borrowers could refinance their loans and get lower rates than they were paying before.
But over the past two years, interest rates have been moving in the opposite direction, as the Fed has tried to raise borrowing costs to keep up with soaring inflation, ultimately driving interest rates to their highest levels in 23 years. While the central bank is expected to cut rates multiple times this year, these moves are unlikely to significantly lower borrowing costs. And ultimately, lenders and borrowers may be faced with the harsh reality that they can't “pretend” that properties and loans aren't falling in value.
Hendry said the strategy of extending and showing off may be the wrong treatment at this point.
“There's a revisionist view of why it worked, so people are supporting it now,” Hendry said. “If enough lenders expand lending and the market doesn't improve, it could have a really devastating impact.”
One sign of the problem is that some buildings are already selling at big losses. Commercial real estate prices fell 5.3 percent last year, according to Trepp data. In central Washington, a building that sold for $100 million in 2018 sold for just $36 million in December. In suburban Boston, an office building that sold for $43 million six years ago just sold for $6 million.
Overall, this gloomy picture has policymakers and economists keeping a close eye on small and mid-size banks (lenders with less than $250 billion in assets). These banks hold about 80% of all commercial mortgages, according to Goldman Sachs estimates. Scrutiny was heightened last year by the sudden collapse of two regional banks, Silicon Valley Bank and Signature Bank, although commercial real estate loans were not the primary cause. The collapses caused a brief but significant panic throughout the financial system and prompted an emergency government response.
NYCB then ended up buying most of Signature's assets, which exacerbated an existing problem: Many of the bank's assets are concentrated in rent-controlled apartments and offices, which made cash flow even tighter at a time when people were still working from home and landlords couldn't keep up with market rents.
Still, regulatory experts say they're confident commercial real estate isn't on the brink of collapse or putting the entire financial system at risk. They argue the risks are well understood and banks are aware of the loans on their books. Even if there are a wave of defaults in 2024, the results may be more like a rising puddle than a sudden tsunami.
Meanwhile, the Fed sees the possibility of large losses in commercial real estate as a financial stability risk. The central bank also uses significant declines in commercial real estate prices as part of its regular tests of the banking system's resilience to large shocks and stressors.
“We have identified banks that have high concentrations in commercial real estate, particularly office, retail and others that have been hit hard,” Fed Chairman Jerome H. Powell told lawmakers earlier this month. “This is something we'll be dealing with for years to come. Bank failures will happen, but they won't be the big banks.”