About $929 billion in commercial real estate loans are coming due in 2024. About 14% of CRE loans and 44% of office loans appear to be in distress. Recent studies have warned that if defaults were to spike to 10%, the risk of bank failures would become widespread.
Experts have warned that the struggling U.S. commercial real estate market could trigger a new banking crisis if default rates on commercial mortgages spike.
About $929 billion in commercial mortgages held by lenders and investors are due to mature in 2024, according to the most recent data from the Mortgage Bankers Association, or 20% of the $4.7 trillion in total outstanding debt.
Meanwhile, rising interest rates have caused commercial real estate (CRE) asset values to fall across the board, with office buildings being hit particularly hard by the enduring popularity of remote and hybrid working.
Alarmingly, about 14% of all CRE loans and 44% of office loans are in “below value” status, meaning the current value of the property is less than the loan balance, according to a recent working paper from the National Bureau of Economic Research.
“If nothing changes – if interest rates stay high and property values don't rise – we see the potential for defaults on par with, and possibly even higher than, the Great Recession,” co-author Tomasz Piskorski, a professor at Columbia Business School, told DailyMail.com.
Traditional banks hold roughly half of the $929 billion in commercial mortgages maturing this year, up 28% from the $728 billion maturing in 2023. 180 Grand Avenue in Oakland, California (above) was sold for $119 million in 2017, but the loan is now listed as “non-performing” and control of the building is for sale.
If default rates on CRE loans were to spike to 10%, the study estimates that the market value of the assets of 231 U.S. banks with total assets of $1 trillion would fall below the value of customer deposits.
Such a situation could trigger panicked customers to withdraw uninsured deposits in a rapid bank run similar to the one that caused the collapse of Silicon Valley Bank last year.
“There are dozens, maybe hundreds, of banks that are on the edge of being solvent because of high interest rates, so further problems in commercial real estate put them in the group of banks that could be caught up in a depositor run,” Piskorski said in a Zoom interview this week.
“This is a tailspin that could cause real problems for a lot of banks, especially smaller and mid-sized ones,” he added.
Piskorski said he and his co-authors believe it's “quite likely” that commercial mortgage default rates will reach 10 percent or more, given the current rate of underwater loans.
Unlike mortgages, where you pay off the principal over time, most CRE loans are interest-only, meaning you must pay them off in full or refinance them when they mature.
Many of the outstanding CRE loans were issued when interest rates were low, so even properties that are still current on their mortgage payments may have a hard time finding a bank willing to refinance, and some may struggle to make payments even if interest rates rise.
Shark Tank star Kevin O'Leary is advising consumers to avoid small regional banks and keep their money with large national banks that are “too big to fail.”
“Community banks are doomed,” he wrote in a recent column for DailyMail.com. “Start moving your money now.”
Others worry that a possible banking crisis could spread and threaten the entire financial system.
A recent report from a financial regulator established after the Great Recession listed the commercial real estate market as the No. 1 financial risk to the U.S. economy.
“If losses from CRE loan portfolios accumulate, they could spill over into the broader financial system,” the Financial Stability Oversight Council's annual report said.
The FSOC warned of the possibility of a “downward spiral of CRE valuations” in which sales of financially distressed properties could flood the market, lowering the market value of nearby properties.
Such a downward spiral could lead to other commercial mortgage defaults, higher default rates and even reduced property tax revenues for local governments.
Why are commercial real estate values declining?
Overall, U.S. commercial property values have fallen 21% since their most recent peak in March 2022, when interest rates began to rise, according to real estate consulting firm Green Street.
Office space saw the steepest decline, falling 35% in value from its peak, but the declines affected everything from apartments and shopping malls to medical facilities and self-storage facilities.
Dylan Burzynski, analyst and head of office sector research at Green Street, told DailyMail.com that the 35% drop in values reflected trends in the top-quality “Class A” office sector, with lower-tier properties down more than 60% from pre-pandemic levels.
“The office sector is facing a lot of headwinds,” Burzynski said, citing a shift to remote work, a general economic slowdown and layoffs, and tightening debt capital markets as factors that are driving down office values.
Four years on, remote and hybrid work arrangements remain popular among white-collar workers due to the convenience and significant savings in time and costs associated with commuting.
U.S. office vacancy rates hit a 40-year high of 19.6% last month, according to Moody's Analytics. U.S. commercial real estate prices have fallen 21% since their most recent peak in March 2022, when interest rates began to rise, according to Green Street. A storefront building on New York's Third Avenue reads, “Retail Space for Lease.” Asset values of all types of commercial real estate have fallen over the past two years.
That has sent office vacancy rates to record highs: U.S. office vacancy rates hit 19.6% last month, the highest since at least 1979, when Moody's records began, according to Moody's Analytics.
While property values in the office sector have been hit the hardest, experts say remote working could have a “negative ripple effect” on other commercial property.
Urban retailers are facing pressure as fewer people commute to work, apartment complexes may see a drop in demand as people no longer need to live close to their offices, and hotels are under threat from a drop in business travel.
Piskorski exclusively revealed to DailyMail.com the results of an unpublished study which shows that 12 percent of multifamily mortgages are currently below the value of the collateral.
Meanwhile, the Federal Reserve's interest rate hikes have weighed heavily on commercial real estate values overall due to higher borrowing costs and reduced demand from potential buyers.
“Interest rates reduce the value of bank assets, but they also reduce the value of commercial buildings,” Piskorski said.
“Many of these commercial buildings have long-term leases, so when interest rates rise, the value of the cash flows from these buildings goes down,” he explained.
“Yes, offices are by far the worst sector, but even if there were no office loans that doesn't absolve banks of responsibility,” he added.
Why do rising commercial mortgage defaults put banks at risk?
Traditional banks hold roughly half of the $929 billion in commercial mortgages maturing this year, up 28% from the $728 billion maturing in 2023, according to MBA data.
A description of the current solvency risks facing banks
1. Rising interest rates over the past two years have reduced the market value of U.S. bank assets by about $2 trillion.
2. This has left dozens, possibly hundreds, of small banks in danger of having assets worth less than their liabilities to depositors.
3. A 10% default rate on CRE loans would wipe an additional $80 billion in value off bank balance sheets.
4. While this figure is small relative to banks' total assets, for about 231 banks, the lender could technically fail.
5. 231 banks would be at risk of failure if they faced a run on them by uninsured depositors trying to move their deposits.
Source: Jiang et al. (2023)
According to the NBER study, CRE loans make up about a quarter of the average bank's assets, with total bank assets amounting to about $2.7 trillion.
The study found that even if default rates on CRE loans had soared to 10% in early 2022, when interest rates were still low, all U.S. banks would have been able to absorb the shock without risk of failure.
But the study found that the Fed's interest rate increase to 5.33% from near zero two years ago has reduced the total market value of assets held by U.S. banks by about $2 trillion.
The authors argue that many banks have not adequately adjusted their portfolios to manage risk, and warn that hundreds of lenders could face bankruptcy if default rates on CRE loans spike to 10 percent.
These banks could face failure if customers with deposits exceeding $250,000, the maximum amount insured by the FDIC, try to move uninsured deposits.
“What our research shows is that hundreds of banks could fail if uninsured depositors withdraw their money,” Piskorski said.
“There's a good equilibrium that can only be achieved if they don't do that, and for that good equilibrium to occur, uninsured depositors need to have confidence in the banking system, and that's what regulators are trying to instill,” he added.
While a default rate of 10 percent or more is by no means a certainty, Piskorski and his co-authors believe it is quite possible, given the high percentage of commercial mortgages that are already insolvent.
The commercial mortgage delinquency rate, a leading indicator of defaults, rose to 3.2% in December from 2.7% the previous quarter, according to the MBA.
If defaults surge, those most at risk of failure will be smaller, regional financial institutions with a larger share of commercial real estate loans on their balance sheets.
Large banks such as JPMorgan, Bank of America and Citigroup are unlikely to be at risk because commercial mortgages make up only a small portion of their balance sheets.
Small banks account for roughly 70% of all CRE loans outstanding, according to Apollo research.
Commercial buildings across the country are struggling to find tenants even as landlords grapple with rising interest rates. Delinquency rates on commercial mortgages, a leading indicator of default, rose last year but so far remain well below levels seen during the Great Recession, when they approached 10 percent.
Among small and mid-sized banks with large CRE loan portfolios, lenders with a large share of uninsured deposits would be most vulnerable to a bank run.
New York Community Bancorp's recent troubles have sounded a wake-up call for the industry: The bank posted an unexpected loss in the fourth quarter due to loans tied to the troubled commercial real estate sector.
Since reporting an increase in its bad loan reserves and cutting its dividend on Jan. 31, NYCB's market capitalization has fallen by nearly $4 billion, or about 50%,.
Still, some observers expect the banking system to weather rising CRE loan defaults without widespread failures.
Morningstar DBRS analysts expected the CRE industry's woes to weigh on U.S. bank results, but they expect losses to spread as lenders process maturing loans, a process that could last for years.
“Some of these loans are in the right position and will be refinanced, some will be extended and some will become non-performing,” the ratings agency said in a recent report.