Since 2021, the commercial real estate (CRE) market has been at a critical juncture of significant adjustment. By 2021, the first wave of ultra-low-interest three-year loans had come due. By the end of 2024, nearly $1 trillion in CRE mortgage loans must be repaid, refinanced, or extended – smart money has begun to exit.
So far, banks’ primary response to this issue has been to kick the can down the road, extending maturing loans for another three years at the same low rates, hoping for a decrease in rates.
However, by doing so, the loan portfolio rates are lower than market rates. How long can financial institutions continue to sustain this?
If forced to refinance at current high rates (up 50% or more from 2021, varying by category), it’s not just one or two types of commercial real estate facing the risk of becoming distressed assets; endangered commercial properties include office buildings, multi-family residential units, retail centers, and hotels.
While primarily attributed to the return of high rates, there is a laundry list of factors compromising the financial viability of commercial real estate.
At the forefront is the Federal Reserve, which has held rates at unreasonably low levels for nearly a decade, fixing commercial real estate profit margins and valuation calculations at artificially low rates considered “normalized” but historically unrealistic. Since 2012, CRE rates have hovered between 4% to 6%. Therefore, the Fed artificially suppressed rates, distorting the market and normal economic conditions.
However, government policies responding to the global effects of the COVID-19 pandemic, such as prolonged lockdowns, have had a more significant impact on the normal operations of urban office buildings, apartment complexes, retail centers, and hotels. With office tenants’ employees opting for remote work, demand for office space has plummeted. Occupancy rates, rents, and customer traffic for apartments, retail centers, and hotels have also seen substantial declines. Over the next few years, total rental income decreases, space utilization and occupancy rates remain insufficient, leading to a significant drop in income for these commercial properties.
As a result, the market’s chain reaction is alarming. On one hand, vacancy rates in many urban areas for apartments have surged. This has led to a fourfold increase in converting office buildings into apartment complexes in cities like Washington, New York, and Dallas.
In other cities, such as San Francisco and Los Angeles, a combination of high taxes, a rise in homelessness, and an increase in crime rates has prompted major corporations and residents to flee urban centers. Despite California historically attracting homeless individuals with generous social welfare programs, decriminalizing thefts involving up to $950 has led to a sharp spike in city crimes involving retailers. High tax rates will only further drive businesses away from California’s major cities to states more friendly to corporations.
Consequently, foreclosures on commercial real estate are on the rise for banks, meaning they are under greater pressure. The question remains: how significant will the impact be on banks due to underperforming loans and increasingly foreclosed commercial real estate properties? The trend is worrisome. In March this year alone, the number of commercial real estate foreclosures reached 625, a 117% increase from the same period last year. Additionally, in March 2024, California saw the highest number of commercial real estate foreclosures at 187, a 405% increase from the previous year.
As a result, the current value of commercial buildings and retail center loans held by CRE banks across the nation is only a small fraction of the face value of the loans held by the banks. While losses may vary, the final outcome may not differ significantly. Banks will find it increasingly challenging to manage the crisis.
According to certain professional assessments, the risk of widespread commercial bank failures remains low. However, this depends on how one defines “low.” It’s estimated that as many as 300 banks face risks due to holding CRE loans. Many CRE loan portfolios consist entirely of underwater loans, where the property’s current value is less than the mortgage loan; this is reflected not only in the contrast between loan yields and current rate yields but also in the collapse of office and apartment building values. Therefore, some industry observers believe we will witness hundreds of commercial bank closures, leading to ongoing consolidation in the banking sector.
This realization has led some real estate investment trust (REIT) shareholders to opt for liquidation, especially in REITs investing in office buildings, multi-family residential units, and retail centers. The visible increase in investor cash outflows has forced real estate investment trust companies to extract funds from liquidity sources to meet demands.
As expected, Federal Reserve Chairman Jerome Powell addressed this issue in March this year, openly stating that due to the collapse in CRE values and yields, there will be “bank failures” in the future.
The question remains, “How bad will the situation get?”
At times, commercial borrowers may decide to abandon these properties, similar to the actions of millions of residential borrowers during the 2008-2009 financial crisis. This could trigger a chain reaction or contagion effect throughout the US economy. It sparked a credit crisis, tightened lending significantly, leading to economic recession and a sharp decline in economic activities.
These memories still linger in investors’ minds today. Some experts view this as more dangerous than the impending bank failures themselves. Does this mean public fears of bank failures could have a more destructive impact than the actual occurrence?
The actual answer remains to be seen. Let’s wait and see.
*This translation is based on the original article, “How Will Banks Survive the Commercial Real Estate Meltdown?,” published in The Epoch Times English edition.