Cracking Commercial Real Estate Market Stressing Banks

Problems in the commercial real estate  (CRE) sector continue to bubble under the surface. This is a major stress point for US banks and could precipitate the next phase of the financial crisis.

A combination of high interest rates and declining tenancy is putting the squeeze on commercial real estate owners. As a result, banks hold a growing portfolio of delinquent CRE loans.

As Reuters reported, “Weak demand for offices could trigger a wave of borrowers to default on their loans and put pressure on banks and other lenders, which are hoping to avoid selling loans at significant discounts.”

Anticipating this problem, banks reported big provisions for credit losses and chargeoffs in their latest financial statements.

For instance, Morgan Stanley set aside $134 million for credit losses in the third quarter. This was on top of a $161 provision for losses in Q2. The bank’s statement noted that the big reserve for chargeoffs was due to “deteriorating conditions in the commercial real estate sector.”

Wells Fargo reported an even bigger increase of $333 million in its allowance for credit losses.

Meanwhile, banks reported a growing number of non-performing and delinquent loans in Q3. According to Bank of America’s most recent financial statement, the total value of its non-performing loans (at least 90 days past due) increased to nearly $5 billion in the third quarter. That was up from $4.27 billion in Q2. The big increase was largely due to its CRE portfolio.

PNC’s non-performing commercial real estate loan balance more than doubled to $723 million in the third quarter. The bank’s chief financial officer said, “Pressures we anticipated within the commercial real estate office sector have begun to materialize,”

There is also a growing number of CRE chargeoffs. Wells Fargo reported $93 million in net CRE loan charge-offs in the third quarter. That was up from $79 million in the second quarter and $17 million during Q1.

Big banks can likely weather a CRE crash, but smaller regional banks can’t, and they hold the vast majority of commercial real estate loans. Small banks have more than 4.4 times the exposure to CRE loans than the major “too big to fail” banks. According to an analysis by Citigroup, regional and local banks hold 70% of all commercial real estate loans.

THE BIG PICTURE

The commercial real estate market might be the next thing to crack in this bubble economy due to the relatively high interest rate environment created by the Fed to battle price inflation. This could drag a lot of banks down with it.

The rampant money creation and zero percent interest rates during the COVID pandemic on top of three rounds of quantitative easing and more than a decade of artificially low interest rates in the wake of the 2008 financial crisis created all kinds of distortions and malinvestments in the economy and the financial system. It was inevitable that something would break when the Federal Reserve tried to raise interest rates in order to fight the price inflation it caused with its loose monetary policy.

Easy money is the lifeblood of the economy and the financial system. The Fed started draining that lifeblood away when it stepped in to fight the price inflation it could no longer write off as transitory. There was no way the central bank wasn’t going to break something.

The first crack in the dam was the failure of Silicon Valley Bank, Signature Bank, and First Republic Bank. The Fed rushed in to shore up the financial system with a bank bailout but problems continue to bubble under the surface. In August, Moody’s and S&P Global slashed the credit ratings of a number of banks. Along with the impact of rising interest rates on bank balance sheets, the S&P report also cited high commercial real estate (CRE) exposure as a reason for the downgrades.

In another sign of underlying stress in the banking system, financial institutions continue to take out loans from the Fed bailout program. Banks borrowed over $2 billion from the program in August.

The bailouts might have plugged the hole in the dam, but they did not address the underlying problem – high interest rates in a world drowning in debt. The bottom line is that it is inevitable that something else will break — there will be more cracks in the dam.

Commercial real estate is a good candidate for breakage.

On top of surging borrowing costs, commercial real estate owners continue to deal with the fallout from government shutdowns of the economy during the COVID pandemic. Even today, a lot of commercial real estate sits empty while people work at home.

There is an even bigger problem looming on the horizon.

Loans are coming due.

According to Trepp (a real estate data provider), $448 billion in commercial real estate (CRE) loans will mature in 2023, along with around $20 billion worth of office commercial real estate mortgage-backed securities. Banks hold $227 billion of those loans. Over the next five years, $2.56 trillion in commercial real estate loans will mature with $1.4 trillion held by banks.

Building owners face significant problems as they try to refinance these maturing loans. They will have to pay much higher interest rates. This is set against declining occupancy and revenues. Trepp said, “With rates rising and credit conditions tightening, many loans may face an uphill battle as refinancing becomes more costly, especially if banks and other lenders look to reduce their CRE exposure as we saw happen during previous recessionary cycles. This could lead to lower property values and larger losses for lenders.”

As already noted, small to mid-size banks hold most of the commercial real estate mortgages. According to a report by a Goldman Sachs economist, banks with less than $250 billion in assets hold more than 80% of CRE loans. These are the banks under the most pressure due to the financial crisis still bubbling under the surface.

For instance, the now-defunct Signature Bank was a big lender in the New York City commercial real estate market, extending loans for office towers and multifamily properties. As of the end of 2022, Signature held some $36 billion in commercial real estate loans.

The CRE sector is one of many blocks about to be jerked out of this financial Jenga tower. It is something to watch closely in the months ahead.