Dive Overview:
U.S. financial regulators have flagged the commercial real estate market as a major risk to financial stability in 2024, citing rising vacancy rates, falling office property values, high interest rates and a possible economic slowdown. “Commercial real estate is the largest lending category for nearly half of U.S. banks, and more than a quarter of U.S. banks have large commercial real estate loan portfolios relative to their capital holdings,” the Financial Stability Oversight Council said in its annual report. “The office sector faces the most severe challenges as demand for office space remains weak, particularly in the largest U.S. markets,” the Financial Stability Oversight Council said in a report released Thursday.
Dive Insights:
The work-from-home trend and a sharp rise in borrowing costs since early last year have hit the commercial real estate market, leaving many banks and other financial institutions vulnerable.
Banks had $6 trillion in commercial real estate loans outstanding in the second quarter, about half of the total, according to the FSOC. Delinquency rates on U.S. banks' commercial real estate loans, while “modest,” rose to 0.81% in the second quarter from 0.74% in the same period last year, the FSOC said.
In the Federal Reserve's quarterly Financial Stability Report released in October, three out of four analysts at financial services companies ranked real estate as the top threat to financial stability, up from fourth place in May, tied with inflation.
“The market outlook is challenging with signs of stress emerging in 2023,” FSOC said, referring to the CRE market. “Office vacancy rates in many major U.S. cities are at multi-year highs as many industries transition to hybrid work arrangements in the wake of the COVID-19 pandemic, reducing demand for office space.”
The sharp decline in demand for office space has proven particularly severe in major U.S. cities: In the 20 largest markets, vacancy rates rose to 14.2% in the second quarter of 2022 from 13.2% in the previous quarter, according to FSOC, which is made up of the heads of regulators including the Federal Reserve Board, the U.S. Treasury Department and the Securities and Exchange Commission.
“The decline in real estate demand may take time to stabilize as occupiers navigate remote working decisions and adjust their space needs,” the council said. “A slow recovery for densely populated urban office centres may also reduce the attractiveness of the office properties located there, as well as nearby retail space.”
The drop in yields on the benchmark 10-year Treasury note highlights the challenges that many commercial property owners trying to refinance their loans in 2024 could face.
Over the past three years, yields have risen from 1% to about 4% as the Fed has raised the federal funds rate from near zero to a range of 5.25% to 5.5% in its most aggressive fight against inflation in the past four decades.
“Rising interest rates, higher costs, and possible structural changes in CRE demand have led to heightened concerns about CRE,” the FSOC said. “Loan maturities and lease expirations amid weak demand for office space could put further strain on conditions in the office sector, potentially spreading stress beyond this segment of the CRE market.”