A decline in demand for office space in the commercial real estate market could lead to bank failures in parts of the country, according to two financial experts from Florida Atlantic University.
A decline in demand for office space in the commercial real estate market could lead to bank failures in parts of the country, according to two financial experts from Florida Atlantic University.
A combination of rising interest rates, high office vacancies due to remote work and declining returns on investment in these buildings is exposing the fragility of the banking system as hundreds of billions of dollars in commercial real estate loans come due.
“There's a fundamental downward trend in demand for office space. During the pandemic, people started working from home instead of going to the office, and four years later, that's still the case,” said Dr. Rebel A. Cole, Lynn Eminent Scholar and professor of finance in the FAU College of Business. “This is problematic for the banking system because it puts a lot of banks at great risk.”
Cole's analysis of the latest bank regulatory data for Q4 2023 shows that among banks of all sizes, 1,522 of 4,641 U.S. banks have total exposure to commercial real estate (the ratio of the amount of CRE to the amount of capital) of more than 300%, while 732 have exposure above 400%, 320 have exposure above 500%, and 113 have exposure above 600%.
“Inflation has not fallen as quickly as the Fed hoped, which should lead the Fed to become more hawkish,” said Dr. Ken H. Johnson, a real estate economist at FAU's School of Business. “The worsening interest rate environment and falling rents are impacting the value of commercial office space, worrying banks and banking regulators.”
Experts agree that some banks may fail, especially in areas like the Northeast and California, where many offices are empty due to remote work. Bank failures are less likely in the Sunbelt states (Colorado, Florida, Utah) because of the demand for office space as workers and businesses migrate to these areas.
Johnson said these potential closures would be kept to a minimum and should not put undue strain on the banking system as banks try to close deals with investors.
“There appears to be a lot of equity in these buildings, so there's a lot of investment capital coming in and wanting to buy equity. Banks have an opportunity to put together deals where the owners can simply hand over the keys to the buildings,” Johnson said. “The chances of a major financial crisis like we had 16 years ago are very low.”
For Cole, it's hard to quantify how big the impact would be, but another major bank failure in the next 12 months or so could cause panic in the system.
“This is a very serious thing that's never going to go away,” he said. “Rising mortgage rates impact all real estate, including both commercial and residential mortgages. There's a growing concern that as interest payments rise, these properties will no longer be cash flow positive. As owners exit these buildings, it will result in sales of similar properties at significant discounts, causing appraisers to devalue other properties that are cash flow positive.”
-FAU-