The decline of commercial real estate is complicated: Not only will landlords lose money as leases are cancelled or expire, but the banking industry could also take a hit as buildings sit empty and lose value.
Indeed, Federal Reserve Chairman Jerome Powell is concerned that the struggling commercial real estate market is only just beginning to affect banks.
“This seems like something we're going to be dealing with for years,” he said in an interview on CBS' 60 Minutes on Sunday, adding that “this is a pretty big problem,” but that it's a “manageable problem” that will likely affect smaller and regional banks.
But this is the second time in the past year that Powell has warned about the impact of the commercial real estate sector on smaller regional banks. In June 2023, months after Powell took the extraordinary step of trying to prevent a ripple effect on banks after the collapse of Silicon Valley Bank, then the second-largest bank in U.S. history, he said he was focusing on commercial real estate and its impact on the banking system.
“If diversification goes well, the system could have losses. We expect there will be losses, but there are concentrated banks and those banks are going to have bigger losses,” Powell told reporters. “So we're very aware of that and we're watching it very closely.”
Office space issues
The pandemic has forced many companies, large and small, to adopt fully remote or hybrid work models and drastically reduce their office space, with Fannie Mae and Wells Fargo both recently offloading hundreds of thousands of square feet of office space in Washington, D.C., and Raleigh, North Carolina, respectively.
It's just one example of a commercial real estate sector in disarray: Unused office space could reach 1 billion square feet by the early 2020s, according to data from Cushman & Wakefield, and the situation is likely to get worse as loans come due and more leases expire.
“Current weakness in CRE property performance is concentrated in office properties, particularly with properties nearing loan maturities and high lease rollovers,” Kevin Fagan, head of CRE economic analysis at Moody's Analytics, told Fortune. “With roughly $325 billion in loans maturing, some loans will have trouble refinancing in a high interest rate environment, potentially slowing demand for CRE space.”
Many commercial real estate developers and investors borrowed heavily when interest rates were low after the 2009 global financial crisis, but those loans have long maturities of 10 to 20 years and come due in the next year or so, says Michael Immerman, an assistant professor of banking and risk management at the Paul Merage School of Business at the University of California, Irvine.
“Some of these loans are coming from large banks. [such as] JP Morgan, Bank of America, Wells Fargo, [and] “Citi, many of which are regional banking businesses,” Immerman told Fortune, “which is why I remain very concerned about the crisis in the regional banking industry.”
Does the downfall of CRE mean doom for all banks?
On this point, economists, bank executives and real estate experts disagree. Seamus Nally, CEO of property management software company Turbo Tenant, says the commercial real estate market “has a huge impact on banks, especially regional banks.” That's because homeowners and local businesses tend to look to smaller banks for loans rather than financial institutions, “so the ups and downs of the real estate market have a much bigger impact on smaller banks.”
He expects “some” local banks will start closing this year, but not in large numbers.
“The real estate market has been very tough for the last few years and is only expected to ease a little bit this year,” Nally said. “We may see larger banks start acquiring smaller banks that can't keep up with the market.”
But Grant Cardon, founder and CEO of real estate investment firm Cardon Capital, said the Fed is “hiding” how many problems exist around regional and commercial banks, which will “spread to hundreds of banks across the country, further reducing the number of choices Americans have for local banking.”
“Banking is undergoing disruption at the fastest pace in the country's history,” Cardone told Fortune magazine. “As Americans place their trust in online banking, regional banks and national chains like Wells Fargo, Bank of America and Citi, which have tens of thousands of branches across the country, will become obsolete, further negatively impacting commercial real estate values.”
Will we see as many bank failures as we did during the 2008 global financial crisis?
While Cardone is more pessimistic about the prospects for bank closures and a decline in commercial real estate, Powell has a less bleak outlook.
“This doesn't seem to be signaling the kind of crisis we've seen sometimes in the past, for example the global financial crisis,” he told 60 Minutes in an interview. “So we're certainly going to see some banks disappear through closures and mergers,” but he thinks it will be smaller banks that suffer the losses.
“This is a long-term change in downtown real estate usage,” Powell said. “It will result in losses for owners and lenders, but it should be manageable.”
Tom Collins, national commercial banking director at consulting firm West Monroe Partners, agrees that some commercial real estate will default, but it won't be the hundreds that Cardone predicts, and he doesn't foresee a repeat of 2008 “unless something big changes.”
“Regional banks are certainly at the epicenter of the issues related to the commercial real estate market, but larger banks could also be affected,” Collins told Fortune. “There are alarm bells ringing for regional banks regarding the commercial real estate sector, but I don't think it's time to panic.”
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