Commercial Real Estate Turmoil: The Next Financial Crisis for Banks?

As the office sector struggles, banks with significant exposure to commercial real estate face mounting risks

2 mins read

Key Takeaways

  • Recent bank failures and a potential recession are causing concern over banks’ commercial real estate exposure
  • The office sector, in particular, faces challenges due to remote work trends and high vacancy rates
  • Banks with significant office exposure are becoming more cautious and adapting their lending strategies

Commercial Real Estate Lending: A Looming Threat?

Following the collapse of Silicon Valley Bank, Signature Bank, and Silvergate Bank, analysts and investors are growing increasingly concerned about the potential impact of commercial real estate loan losses on the banking industry. With a recession potentially on the horizon, coupled with stubborn inflation and soaring interest rates, many are scrutinizing the risks associated with commercial real estate, especially within the struggling office sector.

The Office Sector’s Perfect Storm

The ongoing shift towards remote work and the high cost of living in major cities have led to companies scaling back on office space as leases expire. Simultaneously, the technology industry faces widespread layoffs, compounding the issue. These factors are leaving landlords with increased vacancies and declining revenues, making it increasingly difficult for them to service their debts.

Recent data from IBISWorld revealed that the U.S. office sector vacancy rate increased from approximately 12% at the beginning of 2022 to 17% in early 2023, matching the rate observed during the 2008 financial crisis. D.A. Davidson analysts suggest that, when considering subleasing, the total vacancy rate may be above 20%.

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A Challenging Road Ahead

Despite historical rebounds in office properties following downturns, the current slump in the office sector is expected to worsen before it improves. Kastle Systems found that average office attendance is only 58% on the busiest days, dropping to 35% on the slowest day, Friday. The potential recession and increasing interest rates could exacerbate the situation, prompting companies to cut real estate costs further.

Banks with substantial exposure to the office sector have already begun to pull back. S&P Global data shows that out of 17 banks with at least $400 million in office loans, nine reduced their exposure during Q4. Bank executives are increasingly cautious, particularly in downtown areas of major cities that rely on office tower occupancy.

Adapting Lending Strategies

In response to the office sector’s challenges, some banks have shifted their focus to suburban properties. For instance, FB Financial Corp. in Nashville, which has 23% of its commercial real estate loans related to office spaces, is now concentrating on smaller workplaces in suburban areas, avoiding high-rise buildings in central business districts.

Eagle Bancorp in Bethesda, Maryland, also favors suburban properties. The bank operates in and around Washington, D.C., where economic activity in suburban areas continues to outpace downtown D.C., which has been negatively impacted by the pandemic and ongoing remote work trends.

The Ripple Effect

Analysts at Keefe, Bruyette & Woods predict that office property values will drop by 30% or more from mid-2022 to late 2023, with at-risk markets including San Francisco, New York City, Seattle, Austin, Phoenix, and Washington, D.C. They warn that these issues could spread to nearby apartment and retail properties, which rely on workers living and shopping close to their workplaces.

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Trepp analyst Manus Clancy believes that the problems in the office sector will substantially worsen this year, with knock-on effects developing in tandem. As office values continue to fall, the delinquency rate for offices is expected to rise, potentially spelling trouble for banks with significant exposure to commercial real estate.

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