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The commercial real estate sector’s struggles are threatening to spread. Regional and community banks, the primary lenders to commercial real estate borrowers, face a sustained period of deep losses on problematic commercial real estate loans, potentially reaching hundreds of billions of dollars.
This could lead to a string of bank failures as commercial real estate price declines deepen and loans come due this year and next. Structurally weak demand for office properties, along with a prolonged period of high interest rates, pose potentially insurmountable headwinds for the entire commercial real estate market.
Small and mid-sized banks need to start addressing the problem now or face a potentially existential crisis. The risk in the office market is not evenly distributed. New and renovated trophy office buildings in prime locations are in great shape, with low vacancies, strong tenant demand and rent growth. But these towers don’t represent most of the office stock in major cities.
The older class B and C buildings are struggling with tenant flight, higher operational costs, record-high vacancy rates, and downward pressure on rents. These are the buildings that are forcing banks to reevaluate loan terms, shed assets, or take the keys.
In New York City, remote and hybrid work are the new norm, even if some large tech and financial companies have publicly announced plans to curtail workplace flexibility. Labor markets are tight, and with companies eager to retain talent, CEOs are disinclined to force workers back to the office.
Kastle’s “Back-to-Work” Barometer tracks employee card swipes in major metro areas. It shows New York City office workers’ return rate plateauing at about 50% of pre-pandemic activity. The office vacancy rate for Manhattan clocked in at 23.4% in the first quarter of 2024, nearly twice the historical average of 12.7%, according to the real estate firm Cushman & Wakefield.
Companies have a choice: Either lower their real estate expenditures by reducing square footage or draw their employees back to the office by upgrading the experience there—at a similar or higher price per square foot. Most firms face higher operating costs and so are looking for ways to economize on office space. However, this process takes time: The average lease term for Class A properties in Manhattan is roughly 10 years, so many tenants are locked in.
But what might be a smart financial decision for a company, complicates an already difficult situation for property managers, bank lenders, and the broader commercial real estate market. They face sharply higher borrowing costs due to the recent interest rate increases and rise in long-term bond yields.
Those borrowing costs don’t appear likely to come down soon: The Fed has pushed back rate cut expectations and is steadily reducing its balance sheet, lifting its thumb off long-term interest rates. Real estate crises since the 1980s eventually resolved with the help of structurally lower interest rates. Not this time. Some property owners are converting class B/C office towers to residential, but the vast majority of properties are either unsuitable or uneconomical.
Neither development—weak office-property demand and higher interest rates—is a surprise. Still, the paucity of regional and community banks that have lifted commercial real estate loan delinquencies and charge-offs is shocking. These same banks have also done little to lift allowances for future loan losses.
The largest banks already started recognizing higher CRE losses, but they’re not the core of the problem given their diversified lending businesses and strong capital cushions. It’s the smaller banks with greater exposure to commercial real estate that face a “trainwreckoning.”
This doesn’t mean that a full-blown financial system outage—something akin to the 2007-09 global financial crisis—is on the horizon. Some banks will fail, others will muddle through.
Companies should prepare for an extended period of tight lending standards and elevated borrowing costs, as banks come to terms with their commercial real estate problems’ severity. Insufficient liquidity is a danger and risk for all when banks raise charge-offs and recognize problem loans. Prudent corporate managers extend their debts’ maturities and add a cash liquidity buffer before the storm.
While expensive, such measures can mean survival. Some companies will even be able to take advantage of the adverse markets while others are scrambling to survive.
The factors separating the financial institutions that weather this storm are how quickly they reckon with it and their exposure. It is already too late for banks with concentrated exposures that haven’t made the necessary provisions, but others can still act.
Kurt Reiman is a senior economist at The Conference Board, a non-profit research organization at the intersection of business performance and societal advancement.
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Kurt Reiman , 2024-05-16 18:03:04
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