Bad Commercial Real Estate Loans Put Strain on Banking System

By Mike Maharrey, Money Metals Exchange

The commercial real estate market continues to deteriorate in this high-interest rate environment, putting stress on the banking system.

The dollar amount of bad commercial real estate loans has ballooned beyond the loss reserves held by big banks to cover them as more and more borrowers struggle to keep up with payments.

Commercial real estate investors face a double whammy of higher interest rates driving up loan payments coupled with a sagging market and falling property values.

According to reporting by the Financial Times, average loss reserves held by big banks including JPMorgan Chase, Wells Fargo, Bank of America, Citigroup, Goldman Sachs, and Morgan Stanley have dropped to 90 cents for every dollar of commercial real estate debt 30 days late or more. That’s down from $1.60, according to bank filings to the FDIC.

That means if lenders were to default on all those late loans, banks would be on the hook for 10 cents of every dollar. This isn’t enough to sink a big bank, but it reveals just how shaky the commercial real estate market has become, and it raises more significant questions about regional and small banks that hold the bulk of commercial real estate loans.

Over the last year, delinquent commercial real estate debt held by the six largest U.S. banks tripled to $9.3 billion.

A BankRegData analyst told the Financial Times that it is imperative that banks raise their loss reserves.

There are banks that may have looked fine six months ago, that are going to look not so good next quarter.

Even more alarming is the $24.3 billion in delinquent commercial real estate loans held throughout the U.S. banking system. Bad loans on office buildings, malls, apartments, and other commercial properties have more than doubled over the last 12 months, up from $11.2 billion.

Small and regional banks still have enough reserves to cover their bad debt, but the situation is deteriorating quickly. Overall, U.S. banks hold $1.40 in reserve for every dollar of bad commercial real estate debt, dropping from $2.20 just one year ago. That’s the lowest reserve level in seven years.

And it’s only going to get worse.

As current loans mature in the next few years, borrowers will be forced to refinance at much higher interest rates.

According to the Mortgage Bankers Association, around $1.2 trillion of commercial real estate debt in the United States will mature over the next two years. Zooming further out, $2.56 trillion in commercial real estate loans will mature over the next five years, with $1.4 trillion held by banks, according to real estate data provider Trepp.

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.

Reuters warned about this situation last fall, reporting, “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.”

Tremors have already rumbled through the banking system.

Earlier this month, New York Community Bank lost more than 50 percent of its market value after reporting potential losses in its commercial real estate loan book totaling hundreds of millions of dollars. Meanwhile, the failure of the Pennsylvania Real Estate Investment Trust ranked as the biggest bankruptcy in 2023. The company was loaded up with more than $1 billion in liabilities.

According to a recent working paper published by the National Bureau of Economic Research, approximately 300 regional banks are at risk of collapse due to problems in the commercial real estate sector.

Researchers estimate that 44 percent of office loans appear to be in “negative equity. That means the current property values are less than the outstanding loan balances.

Additionally, around one-third of all loans and the majority of office loans may encounter substantial cash flow problems and refinancing challenges.

Regulators and Federal Reserve officials insist the problems in the real estate market don’t pose a broader threat to the banking system and everything is fine. Of course, these are the same people who claimed the subprime mortgage market wasn’t a problem in 2006 and the situation was “contained” or “ring-fenced” in 2007.

The Federal Reserve Set the Stage for This Problem

The central bank sowed the seeds for this problem more than a decade ago when it slashed interest rates to zero and launched the first round of quantitative easing in the aftermath of the 2008 financial crisis. It doubled down on these policies during the pandemic, slashing interest rates to zero again, and injecting trillions of dollars of new money into the economy.

This incentivized excessive borrowing and created all kinds of malinvestments in the economy.

This was a repeat of the Fed’s monetary policy after the dot-com bubble burst. Artificially low-interest rates in the aftermath of that crisis set the stage for 2008.

When price inflation forced the Fed to hike rates last year, it exposed these problems. It was inevitable that things in the bubble economy would go “pop” when the central tried to raise interest rates to fight the price inflation it caused with its loose monetary policy.

The first pop was the failure of Silicon Valley Bank and Signature Bank last March. The Fed managed to paper over problems in the banking system with a bailout. But despite assurances from the powers that be that everything is fine, it’s clear issues in the commercial real estate market could cascade into an even bigger series of bank failures, similar to how subprime mortgages crashed the financial system in 2008.

The commercial real estate market is just one of many distortions Fed monetary policy created. Most of them are just bubbling under the surface waiting to explode. Which one ultimately precipitates a crisis remains to be seen. It could be commercial real estate or something else.

But ultimately something will break. The economy is not “fine.” It’s just a matter of time.

Originally Published at Money Metals Exchange.