Published by Harvard Business Review | July 23, 2024
The risks of U.S. commercial banks being overexposed to CRE have intensified as the global pandemic upended long-held economic assumptions: perpetually subdued inflation, low interest rates, and in-office work.
U.S. banks face a reckoning: Over the next two years, more than $1 trillion in commercial real estate (CRE) loans will come due, according to The Conference Board calculations using MSCI Real Assets data. Institutions with the most concentrated exposures, insufficient capital cushions, and limited lifelines from larger institutions or regulators face significant losses.
The damage could metastasize into a full-blown financial crisis if scores or even hundreds of small- and midsize commercial banks fail simultaneously. A worst-case scenario might include contagion to other economies and banking deserts across the U.S.
As the Federal Reserve keeps interest rates elevated and CRE risks worsen with falling property values, businesses will continue to experience restrictive financing conditions. Executives can nonetheless take steps to potentially mitigate the fallout — including examining banking relationships, extending debt maturities, and securing adequate working capital.
How Did We Get Here?
The risks of U.S. commercial banks being overexposed to CRE have intensified as the global pandemic upended long-held economic assumptions: perpetually subdued inflation, low interest rates, and in-office work.
Exacerbating the situation are CRE management costs — including insurance premiums, labor, and energy prices — which have skyrocketed. An aging U.S. population is fueling labor shortages, forcing wages higher as firms aim to attract and retain talent. What’s more, natural disasters are increasing property insurance premiums, and dated electricity grids and the uneven energy transition are raising building power costs.
There’s Trouble Brewing
Hundreds of banks hold an outsized amount of CRE loans on their books relative to capital. Small banks (assets of $100 million to $1 billion) and midsize banks (assets of $1 billion to $10 billion) have CRE loan values far exceeding risk-based capital levels at 158% and 228%, respectively, according to The Conference Board calculations using FDIC Institutional Financial Reports data. This is compared to 142% for large banks (assets of $10 billion to $250 billion) and 56% for the largest banks (assets greater than $250 billion). The smallest banks (assets less than $100 million) issue few of such loans.
As CRE property values fall and the debt service on associated loans accumulates, borrowers are becoming delinquent or defaulting. The portion of these loans that are nonperforming more than doubled — from 0.54% to 1.25% — over the six quarters from the Q3 2022 cycle low, according to data compiled from BankRegData.com and the FDIC. Compare this with the just 0.87% rate six quarters after the cycle low, in the second quarter of 2006, which preceded the 2008–09 Great Recession.
However, only the largest banks are reporting increases in nonperforming loans and charge-offs (i.e., losses). Reported CRE loan delinquencies exceeding 90 days have surged from under 1% in mid-2022 to 3% in early 2024 for the largest banks, while delinquency reports for all other banks remain near 1%, according to The Conference Board calculations using FDIC Institutional Financial Reports data. (By comparison, delinquency rates reached 5% in 2010 in the wake of the 2008–09 Great Recession.)
Meanwhile, CRE loan losses for the largest banks spiked to 0.6% in early 2024, while other banks are reporting virtually zero losses. By comparison, such losses topped 1.4% in 2010.
The reason for the different behaviors is that the biggest banks face greater regulatory scrutiny and are required to maintain larger capital cushions, prompting swifter realization and write-offs of souring loans. Smaller and midsize financial institutions — many of them regional and community banks — are evidently not marking down CRE loan losses but may be managing stresses differently.
These institutions are likely engaging in “extend and pretend” behaviors that lengthen loan maturities with the hope that property valuations will recover in the future. They also may be seeking to widen capital buffers through M&As with similarly sized or larger financial institutions.
