“We've seen a change, probably a permanent change, in how we use space,” said Andrew Metrick, a professor at the Yale School of Management. Swipe-card data shows that the number of people going in and out of offices is about half what it was before the pandemic. “As long as this situation continues, we're not going to be able to sustain the same amount of commercial real estate we've had,” he explained, adding that he expects valuations for office buildings to fall by about 30%.
Compared to mortgages, commercial loans have much shorter terms and usually end with a balloon payment of the property's residual value. Few owners can repay the full amount, so refinancing is common. Over the next four years, about two-thirds of commercial office real estate will need to refinance. When low valuations combine with significantly higher interest rates, “the math just doesn't work,” Metrick warned. Losses occur on all sides.
“The bottom line is that it's going to be a very difficult environment to get financing from financial institutions that normally make these loans,” Metrick, the Janet L. Yellen Professor of Finance and Management and director of the Yale University Financial Stability Program, said in a speech at the Yale Alumni Association of Real Estate Conference on Oct. 27.
Historically, every percentage point increase in the Fed's policy rate reduces bank capital by 1 percent. A 5 percent reduction in bank capital would put many banks in trouble.
One reason it will be so difficult is the collapse of Silicon Valley Bank in early 2023. SVB was a consumer-focused bank, but the spike in interest rates that was the main cause of its collapse also stressed other smaller banks. “Everybody who got scared of Silicon Valley Bank started running to the biggest banks,” he said.
Smaller banks have been forced to either endure capital outflows as customers abandon them or pay more interest to depositors. “Banks are facing pressure on their profitability and they're taking a hit in terms of assets,” Metrick said.
The collapse of Silicon Valley Bank, followed by Signature Bank and First Republic Bank, means that by all technical definitions, a banking crisis occurred in 2023. It wasn't a terrible crisis, but “it occurred outside of a recession, which is really, really unusual,” Metrick said. It was driven not by bank credit losses but by rising interest rates as the Federal Reserve tried to end inflation. “Interest rates have never gone from zero to 5% in the U.S.,” he added. “There have been bigger increases in interest rates, but they started from a higher base.”
“Historically, for every percentage point increase in the Fed's policy rate, banks lose 1 percent of their capital over the next eight quarters,” Metrick said. That's a trade-off policymakers are willing to make to cool the economy, but he warned that “if banks lost 5 percent of their capital, a lot of them would be in trouble.”
Banks, recognizing past patterns, are getting nervous. As a result, they will be cautious about lending to commercial property owners as interest rates remain elevated. “We pretty much know restructuring is coming,” Metrick explained.
The situation is exacerbated by the fact that commercial real estate is dominated not by the big banks, but by regional and community banks: “The banking system has about $3 trillion in commercial real estate on its balance sheets,” Metrick notes. “About two-thirds of that is held by banks outside the top 25.”
Again, the bulk of commercial loans generally remain on banks' balance sheets, as opposed to mortgages that are packaged and resold to investors. So far, the loans have continued to perform largely well because interest rates are so low, and the drop in real estate valuations is only hypothetical.
That could pave the way for a promising future. “If we can avoid a recession and have a soft landing, banks will recover,” Metrick said. “Previous downturns in commercial real estate have been slow,” he explained. “After the GFC, we had 10 years to sort out a lot of the problems.” Because the problems take a long time to sort out and span thousands of banks, “we're not going to suddenly have a system-wide collapse like Lehman Brothers did.”
“I study financial crises, so I try to think, 'What could go wrong?'” Metrick said.
In this case, he's worried that a soft landing won't work. “What happens if we actually have a recession and we start to see cyclical negative effects on bank balance sheets?” Metrick asked. “That's the real concern.” He believes the likelihood of a recession is decreasing, but added, “We're definitely not out of the woods. There are a lot of people looking at recessionary indicators and saying, 'I still think a recession is going to happen.'”
If that happens, the painful and lengthy process of dealing with commercial property losses could quickly become urgent. “That would make things a lot worse,” Metrick said.
Rules put in place since the last recession could be the trigger. Previously, banks didn't adjust the expected value of loans on their balance sheets as long as payments were made on time. But in 2016, the Financial Accounting Standards Board introduced a new accounting rule, Current Expected Capital Losses (CECL), for how banks should set aside reserves for expected losses on existing loans.
“Think about commercial real estate loans that are coming up for refinancing,” he said. Those loans had 1% interest rates, but rates are now closer to 7%. And the buildings have fallen in value significantly. In many of these cases, the question is how to split the losses. “The new rules require banks to really think about the likelihood that they'll be repaid in the future, even if they're still in place,” Metrick said. But banks haven't built up much reserve for losses under CECL.
What seemed like a slowly developing recession suddenly materializes as a catastrophe of expectations that everyone must account for on their balance sheets at the same time.
“Here's my nightmare scenario,” Metrick said. “All of this is run by accountants, not regulators. So imagine for a second that the Silicon Valley Bank of Commercial Real Estate suddenly collapses, with a congressional investigation coming immediately after.”
The investigation found that banks had not made sufficient reserves for losses on commercial loans and had not warned shareholders. As a result, Metrick said, “Next quarter, accountants around the world will be saying to banks, 'I'm not to blame if you go bankrupt.' They'll get very tough on CECL. And what looked like a slow-moving recession will suddenly materialize as a catastrophe of expectations that every bank will have to put on their balance sheets at the same time.”
Suddenly, 500 banks were on paper insolvent. “That's a nightmare scenario, and there's a risk that it will happen as long as interest rates remain high,” Metrick warned. Without the further pressures of a recession, the problem is likely to be resolved slowly, but Metrick concluded: “I don't want to scare you, but you should be a little scared, just as I am a little scared.”