The Commercial Real Estate Industry is About to Tank, and Nobody is Talking About It

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It has been a year since several U.S. regional banks failed, and the collapse of Credit Suisse led to widespread fears of an impending financial crisis. However, by the summer of 2023, the panic-induced withdrawals from depositors had largely calmed. In February, though, New York Community Bank (NYCB) rekindled these fears with an announcement of $2.4 billion in losses, the dismissal of its CEO, and subsequent credit downgrades from Fitch and Moody’s.

NYCB’s stock price plummeted by 60% almost overnight, wiping out billions in market value and causing a mass exodus of depositors. This scenario, which has become all too common among U.S. regional banks, underscored the precariousness of the banking sector. Peter Earle, a securities analyst and senior research fellow at the American Institute for Economic Research, suggested that more turbulence could be on the horizon.

A significant factor behind this instability is the large portfolios of distressed commercial real estate (CRE) loans held by many regional banks. These banks often engage in “extend and pretend” tactics, granting more time to insolvent borrowers in hopes of eventual recovery. While this may delay immediate financial pain, it ultimately leads to a more fragile financial system in the medium term.

NYCB’s troubles were worsened by its heavy exposure to struggling New York landlords, with over $18 billion in loans tied to multifamily, rent-controlled housing developments. This was especially troubling given NYCB’s role in rescuing Signature Bank, another failing regional bank, in March 2023. Signature Bank’s downfall was partly due to its high concentration of uninsured deposits from wealthy and corporate clients, which fled en masse during the crisis.

Regional banks have also been hit hard by the Federal Reserve’s aggressive interest rate hikes aimed at combating inflation. Banks with large portfolios of low-yield bonds saw sharp declines in their value, creating unrealized losses. Although these bonds, often U.S. Treasury securities, are safe from a credit perspective, their market value dropped significantly, raising concerns about the banks’ solvency if forced to sell.

This combination of market pressures led to a vicious cycle where unrealized losses became actual losses as banks sold off bonds and loans at a loss to cover depositor withdrawals. Despite interest rates stabilizing at high levels, worries about the health of regional banks persist due to their substantial exposure to CRE, including office buildings, multifamily housing units, and retail spaces. CRE loans account for 44% of regional banks’ lending portfolios, compared to 13% for the largest U.S. banks. The proportion of nonperforming CRE loans has doubled, reaching 0.81% by the end of 2023.

In the U.S., approximately 130 regional banks hold just over $3 trillion in assets. These banks, typically holding between $10 billion and $100 billion in assets, are vulnerable to local market fluctuations and specific sector downturns. Unlike larger financial institutions that dominate home mortgages, car loans, and corporate loans, regional banks have carved out a niche in real estate lending. However, this specialization has become a double-edged sword.

The COVID-19 pandemic and the rise of remote work have led many corporations to cut back on office rents, leading to an 18.2% office vacancy rate across the U.S. by March 2023. This trend is broader than one sector or market, impacting cities like San Francisco, Seattle, Dallas, Charlotte, and Boston. Companies are increasingly reluctant to invest in office space as employees favor working from home.

A report by TD Bank noted that remote workdays have surged from 5-7% pre-pandemic to 30% over the past two years. This shift has dramatically reduced the value of office properties, making loans riskier and refinancing more challenging. Nearly $1 trillion in CRE loans are due this year, with an additional $535 billion maturing in 2025. Higher refinancing costs and declining rental incomes strain debt service ratios, posing significant risks to lenders.

Retailers also face challenges from rising “retail shrink” due to shoplifting and inventory damage, which led to over $100 billion in profit losses in 2022. Major retailers like Walmart, Target, CVS, and Walgreens have closed stores in high-crime areas, citing unsustainable business performance due to theft and organized crime.

Fed and FDIC regulators closely monitor the situation and work with banks to address loan portfolio issues. Fed Chairman Jerome Powell has acknowledged that this problem will persist for years. However, he foresees minimal bank failure.

Peter Earle anticipates inflation will come under control, potentially leading to lower interest rates and a “soft landing.” He suggests rezoning properties for different uses, such as residential spaces or assisted living facilities, could improve profitability. Regional banks are trying to downsize their CRE loan portfolios, often at a loss, impacting their capital base and necessitating recapitalization through equity sales or acquisitions.

While the Standard & Poor’s regional bank index has risen nearly 30% from a year ago, indicating some optimism, it remains below its 2022 high. Regional banks need to clarify their path to profitability and convince investors of their potential for recovery to rebuild their capital base.