U.S. Commercial Real Estate Loans: A Ticking Time Bomb for Banks

Commercial real estate loans pose a significant threat to the stability of US banks, potentially leading to widespread financial distress and defaults.

The global commercial real estate (CRE) sector is under intense pressure as elevated interest rates persist worldwide. Nowhere is this more evident or crucial than in the United States, home to the world's largest commercial property market. With a significant wave of property debt maturing over the next three years, there is growing concern that rising CRE loan-default rates could trigger a major crisis in the US banking sector.

CRE loans represent a substantial portion of the US banking system's assets, accounting for about one-quarter of the average lender's assets and totaling approximately $2.7 trillion in 2024. Many of these loans were issued at low rates during the past decade's low-interest environment. However, repaying these loans at today's sharply higher rates is straining borrowers and placing immense pressure on American lenders, who are struggling to avoid selling loans at heavily discounted prices.

Adding to the challenges for CRE lenders are the slowing economy and the strong post-pandemic preference for remote and hybrid work arrangements. These factors have exacerbated the distress in the US CRE market and negatively impacted commercial property prices. Green Street’s Commercial Property Price Index (CPPI) shows that commercial property prices fell by 7 percent over the past year and by 21 percent since their peak in March 2022.

It is unsurprising that delinquent loans tied to commercial properties such as malls, offices, and industrial units totaled an estimated $24.3 billion last year, more than double the $11.2 billion recorded in 2022. Data firm MSCI reports that over $38 billion of US office buildings are currently threatened by defaults, foreclosures, or other forms of distress—the highest amount since late 2012. Additionally, the Mortgage Bankers Association’s (MBA) “2023 Commercial Real Estate/Multifamily Survey of Loan Maturity Volumes” revealed that 20 percent ($929 billion) of the $4.7 trillion of outstanding commercial mortgages will mature in 2024, a significant increase from 2023.

The banking sector is feeling the strain of these alarming figures. According to the Financial Times, Federal Deposit Insurance Corporation (FDIC) filings show that US banks currently hold $1.40 in reserves for every dollar of delinquent CRE loans, down from $2.20 a year ago and the lowest level in over seven years. At major banks like JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, Goldman Sachs, and Morgan Stanley, reserves have fallen from $1.60 to $0.90 per dollar of delinquent CRE debt. This indicates that delinquent CRE loans, which tripled to $9.3 billion for the six largest US banks over the last year, now exceed the reserves set aside to cover them, posing a significant risk if defaults occur.

While large banks may manage the situation at current levels, smaller and regional US lenders face higher risks. CRE accounts for around 11 percent of the average loan portfolio at big banks but jumps to 21.6 percent at small banks. S&P Global Ratings warned that regional lenders could see asset quality and performance deteriorate due to CRE market stresses, predicting a decline in asset quality and performance. Consequently, S&P lowered its outlook on five regional banks with high CRE loan exposures: First Commonwealth Financial (FCF), M&T Bank, Synovus Financial, Trustmark, and Valley National Bancorp.

Klaros Group, a consulting firm, found that 282 banks, mostly smaller lenders with less than $10 billion in assets, face threats from CRE loans and potential losses tied to higher interest rates. Although these banks are not insolvent, they are stressed, which could hurt communities and customers.

Recent casualties include New York Community Bancorp, which suffered massive CRE loan losses, wiping almost $6 billion off its market value and leading to a Moody’s downgrade to “junk” status. Pennsylvania Real Estate Investment Trust (PREIT) faced $1.1 billion in debt repayments, prompting its second Chapter 11 bankruptcy since 2020. However, some commercial borrowers, like a mall retail space operator, have successfully restructured and exited bankruptcy by significantly reducing their debt.

These developments indicate more stresses and failures are likely in the coming months and years, potentially plunging the US banking sector into another crisis. A National Bureau of Economic Research (NBER) working paper found that recent property-value depreciations and higher interest rates have placed about 14 percent of all loans and 44 percent of office loans in "negative equity." Depending on the default rates, US banks could face substantial losses, with a 10 percent default rate resulting in $80 billion in losses and a 20 percent rate causing $160 billion in losses.

The prevailing high-rate environment means refinancing loans will remain expensive for CRE borrowers, with many banks seeking to reduce their overall CRE exposures. The FDIC's 2023 annual report noted that banks have tightened underwriting standards and may continue to do so.

Federal Reserve Vice Chair for Supervision Michael S. Barr confirmed that regulatory supervisors are closely monitoring banks’ CRE lending practices, including risk measurement, mitigation steps, risk reporting, and provisioning.

Despite the risks, US commercial banks have continued to amass CRE loans, with the latest reading for March at $2.985 trillion. The FDIC and other regulatory bodies issued an Interagency Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts last June, providing guidance for financial institutions working with borrowers experiencing financial difficulties.

As the situation evolves, the US CRE market's challenges and their impact on the banking sector will continue to be closely watched.