Commercial real estate is in trouble. There are several reasons why.
First, higher interest rates put pressure on commercial real estate operators who financed their acquisitions with debt at historically high property values and low interest rates. Many of these loans mature in the next couple of years and may have to be refinanced at much higher rates potentially resulting in maturity default.
Second, recent technology-sector layoffs and a potential U.S. recession could lead to a significant decline in the demand for commercial properties, adversely affecting their valuation.
Finally, the shift in workplace culture to more hybrid and remote styles is putting significant pressure on office properties, which constitute a sizeable share of all commercial real estate. As of July 2023, just half of U.S. workers had returned to the office on an average day relative to pre-pandemic levels.
The signs of commercial real estate distress are already visible, especially in the office sector. In the first quarter of 2023, the office vacancy rate reached 18.6%, 5.5% higher than it did in first quarter 2020 when the pandemic began. This is a larger trough-to-peak increase than the 4.6% increase during the Great Recession.
The shares of real estate holding companies (REITs) focused on the office sector declined by about 60% since the beginning of pandemic, implying more than 30% decline in the value of their office buildings. While the overall delinquency rate on commercial mortgages is still relatively low, it has been quickly rising, especially in the office sector. Several deep-pocketed investors including PIMCO and Blackstone recently defaulted on their office loans.
But how big of a threat is the commercial real estate decline? The subprime mortgage crisis that started in 2007 eventually launched the 2008 Great Recession. Many economists aren’t yet seeing the ties between empty office buildings and the future of U.S. banks.
My new research with Erica Jiang, Gregor Matvos, and Amit Seru explores bank-level data to assess the commercial real-estate distress risk for each of 4,844 of U.S. banks — accounting for about $24 trillion of assets in the aggregate. As I explain below, the news is mixed: the risk is not as big as sometimes portrayed, but is real.
Commercial real estate (CRE) loans are an important portion of bank assets, accounting for about a quarter of assets for an average bank and $2.7 trillion of bank assets in the aggregate. Most of these loans are held by smaller- and midsize banks. So, banks indeed have a very significant exposure to commercial real estate loans.
To assess the banks’ ability to withstand the CRE credit distress, we consider a range of CRE stress-test scenarios ranging from 10% to 20% of commercial real estate loans defaulting at each U.S. bank. We assume that in the case of a default the banks can recover about 70% of outstanding face value of their loans, which is in line with the historical data. Notably, delinquencies on bank-held commercial real estate loans reached almost 10% during the Great Recession.
“ The good news: direct losses to banks from commercial real estate have not been not that large. The bad news: interest rates are high.”
The good news is that direct losses to banks due to CRE distress are not that large. At a 10% to 20% default rate, the direct losses on banks’ CRE loans relative to their book value amount to about $80 to $160 billion. If CRE distress would manifest itself early in 2022 when interest rates were low, not a single bank would fail, even under our most pessimistic scenario. This is because the losses due to CRE distress are less than 10% of aggregate book value of equity in the banking system — which was about $2.3 trillion at the beginning of 2022 — and banks were sufficiently capitalized to withstand them.
The bad news is that we are in 2023, and interest rates are much higher. Banks engage in maturity transformation: they finance long maturity assets with short-term liabilities — deposits. Banks operate with high financial leverage, with a typical bank funding itself with 90% of debt, consisting of mostly deposits. As interest rates rise, the value of a bank’s assets can decline, leading to bank fragility and insolvency risk.
Read: The $1 trillion ‘wall of worry’ for commercial real estate that spirals through 2027
As we show in our other related work, following recent monetary tightening the U.S. banking system’s market value of assets is about $2.2 trillion lower than suggested by their book-value accounting for loan portfolios held to maturity. Consequently, about half of U.S. banks (2,315) with $11 trillion of assets have a lower value of their assets compared to the face value of their debt liabilities.
This does not mean that half of U.S. banks are insolvent. Banks primarily fund themselves with deposits so they could survive these asset value declines if they can pay low rates on their deposits and their depositors do not flee.
“ If there is a widespread run by uninsured depositors, more than 1,600 banks could fail. ”
However, about half of deposits are uninsured, accounting for about $9 trillion of bank funding in the aggregate. Unlike insured depositors, uninsured depositors stand to lose a part of their deposits if the bank fails, potentially giving them incentives to run in response to the decline in bank assets values following an increase interest rates.
We show that if half of uninsured depositors would withdraw their money, 186 banks would fail. If there is a widespread run by uninsured depositors, more than 1,600 banks could fail with aggregate assets of close to $5 trillion. In sum, higher interest rates combined with high leverage has made the U.S. banking system extremely fragile and eroded the banks’ ability to deal with credit distress.
The commercial real-estate distress would add up to an additional $160 billion of losses and a $2.2 trillion decline in the value of bank assets due to higher rates. While losses due to commercial real estate distress are an order of magnitude smaller than the decline in bank asset values associated with a recent rise of interest rates, they would impact a sizable set of banks.
Due to these losses, up to 580 additional banks with aggregate assets of $1.2 trillion would have their mark-to-market value of assets below the face value of all their non-equity liabilities. If half of uninsured depositors decide to withdraw, the losses due to CRE distress would result in up to 58 smaller regional banks becoming insolvent in addition to 186 banks that would become insolvent just due to higher rates.
Importantly, the news about commercial real estate default and banking losses could be a trigger for a widespread run on the banking system by uninsured depositors, unraveling a fragile equilibrium in the banking system. Moreover, commercial real estate distress could also lead to a credit crunch adversely affecting the U.S. economy and increasing recession risk.
“ A near-term solution: a market-based recapitalization of the U.S. banking system.”
What can be done? As long as interest rates remain elevated, the U.S. banking system will face a prolonged period of significant insolvency risk. In the near term, the creation of the Bank Term Funding Program in March 2023 together with other policy responses to the recent banking vulnerabilities may put a pause on the crisis and reduce the risk of acute deposit runs across the banking system.
However, these are temporary measures that do not really address the fundamental insolvency risk, which our analysis indicates could involve hundreds of banks.
A near-term solution is a market-based recapitalization of the U.S. banking system. Longer-term, banks could face stricter capital requirements, which would bring their capital ratios closer to less regulated non-bank lenders that retain more than twice as much capital buffers as banks. Increased capital buffers would make the U.S. banking system more resilient to adverse shocks to their asset values.
Tomasz Piskorski is the Edward S. Gordon Professor of Real Estate at Columbia Business School.
More: Commercial mortgage-backed securities are in the spotlight again, but this isn’t 2008
Plus: San Francisco’s push to turn office buildings into homes hinges on this simple idea
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