Commercial Real Estate and Banking Sector Risks

Recent stress in the banking sector, brought about in part by the Federal Reserve’s aggressive rate hike campaign, has led to heightened investor scrutiny of areas of the economy that could be vulnerable to a pullback in lending activity. Elevated interest rates and lingering effects of the pandemic have increased uncertainty around the outlook for commercial real estate (CRE)—offices, in particular. This piece addresses three related topics. First, we provide a short overview of the market environment that has brought CRE into the spotlight. Next, we explore the linkages between smaller banks (those not considered global, systemically important banks, or GSIBs) and CRE, and assess the risks facing the banking industry. Lastly, we discuss the risks that a weaker CRE outlook poses to the broader economy. We conclude that CRE presents a greater risk to smaller community banks than larger institutions, but solid fundamentals outside of office and a well-capitalized banking industry are expected to mitigate spillover to the overall economy.

CRE market environment

Financial conditions have tightened over the past year as a result of the Fed’s efforts to combat inflation, leading to an anticipated slowdown in CRE market growth as borrowing costs rise.[1]Over the past year, the Fed has raised its benchmark interest rate from almost zero to a range of 5%–5.25%, the fastest tightening of U.S. monetary policy since the 1980s. (We discuss how this could affect the banking ecosystem in a related blog.) In 2022, the number of CRE loans issued fell 10%, dropping from $891 million in 2021 to $804 million, and it is forecast to fall another 15% this year. Meanwhile, the sale of commercial mortgage-backed securities (CMBS) has dropped 85% from this time last year.[2]The most recent senior loan officer survey showed tighter lending standards and weaker demand for CRE loans compared to prior quarters. Nonfarm nonresidential loans (which doesn’t include multifamily loans) experienced the largest drop in demand, while the more cyclical construction and land development loans showed the greatest tightening in standards.[3]

The tightening of credit conditions and higher rates will impact the market by making it more expensive to refinance loans. There are $540 billion in CRE loans set to mature in 2023 that will see higher refinancing costs, raising the risk for defaults.[4] We believe office loans have the highest near-term refinancing risk, with $160 billion in loans maturing over the next two years. However, since around 80% of bank lending to CRE is done through banks with less than $250 billion in assets, we could estimate that these loans, as a group, represent less than 2% of those banks’ total balance sheet assets.[5]

While the CRE market faces a more challenging macro environment this year, we believe that recent concerns are largely overstated. First, asset quality is still healthy and many of the loans maturing in 2023 and 2024 still have lower loan-to-value (LTV) ratios than those originated in the years before the GFC. That means borrowers have more equity (and proportionally smaller loans) on their properties, which helps when refinancing.[6] We have yet to see a material decline in asset values outside of older, B-class office buildings in select coastal cities. To be sure, geography matters here, with certain office buildings in specific large coastal cities such as San Francisco and New York City posing the greatest risks while other cities and regions are seeing relatively little stress, even in office buildings. 

In addition,  most borrowers remain current on their loans. The delinquency rate among loans underlying CMBS was 3.0% in February, less than the rate a year earlier (3.87%), and well below the GFC (10.3%) and 2020 pandemic (10.3%) levels. [7] Also, many borrowers have swapped their floating-rate financing effectively into fixed-rate loans. An additional mitigant is that many CRE and specifically office bank loans carry multiple levels of recourse against the borrower, including guarantees at the business and personal levels. Last and perhaps most importantly, while the office sector continues to struggle in certain major coastal cities, fundamentals remain strong across most other industries, with the “national occupancy rate” hitting a record high last year.[8] (And even for office, occupancy rates tend to be higher in many owner-occupied properties.) In the multifamily sector, which comprises 43% of outstanding loans, potential homeowners are renewing their apartment leases rather than buying houses due to higher mortgage rates and a tight housing market. Supply-chain reshoring combined with e-commerce trends are also driving stable demand for distribution centers in the industrial sector. Given offices are a small percentage of outstanding loans today, we believe the overall CRE market is on solid footing.

CRE risks to banks

Small and mid-sized banks with less than $250 billion in assets have traditionally played a critical role in CRE lending by providing financing to small businesses that might not be able to obtain loans at larger banks. These banks have a combination of regional knowledge and expertise that helps to make lending more efficient, while investing a lot of time into developing relationships with local real estate developers and managers. Larger banks are less likely to offer this level of service to middle-market firms. The importance of smaller banks in CRE lending has increased in recent years, in part due to the Fed’s 2018 decision to apply lighter regulatory oversight to banks below the $250 billion in assets threshold (defined broadly through the rest of this note as small and medium-sized banks). These banks are believed to pose less systemic risk to the economy on an individual basis and are not currently subject to the same reporting requirements as larger banks. [9]

CRE lender exposure

As of April 2023, there are $4.5 trillion of outstanding commercial/multifamily mortgages in the U.S., with banks accounting for 38% of total lending (Figure 1). A considerable portion of CRE has migrated from bank balance sheets to agencies, life insurance companies, securities markets, and lenders in the private market ecosystem, leaving traditional banks with a relatively modest share of CRE on their balance sheets.

Small, and medium-sized banks with assets under $250 billion account for approximately 80% of all CRE lending within the banking sector. When considering the full universe of lenders in the U.S., this segment of the banking industry comprises 30% of the overall lending ecosystem. Breaking it out further, the 135 U.S. regional banks ($10 billion to $160 billion in assets) hold 13.8% of all debt on income-producing properties, while the top 25 largest banks, which includes super regionals, own 12.1%. The 829 smaller banks (with $1 billion to $10 billion of assets) hold 9.6%, and the remaining 3.2% is spread among the 3,726 local banks with less than $1 billion in assets.[10]

Figure 1

CRE exposure to banks

Share of outstanding $4.5 trillion U.S. debt backed by income-producing CRE, by lender type

As of 4Q 2022. Source: Mortgage Bankers Association.

CRE balance sheet exposure

Within the banking sector, regional and smaller institutions have the highest exposure to CRE loans on their balance sheets, at an average of 20% of total assets (Figure 2). Thus, any loan losses resulting from a downturn in CRE will not fall evenly across the banking sector. Importantly, only 3% of total assets are office loans.[11] The banks with the highest concentration of CRE loans relative to capital are usually found among institutions with assets under $100 billion that are not globally systematically important (GSIBs).[12] Following the global financial crisis (GFC), when overall CRE prices declined by 30%, small banks with assets under $1 billion suffered the most delinquencies. Since then, regulators have closely monitored CRE concentration risk. Bank capital losses are estimated to be moderate on average under a number of CRE price scenarios, but are much larger for small and geographically concentrated community banks, especially if the downturn is persistent and represents a structural shift in demand (e.g., offices).[13] While banks of that size do not pose the same risks to financial stability as larger money centers and regionals, they play an outsized role in small business lending.[14]

Figure 2

Overall share of banks’ assets exposed to CRE loans

Exposure is highest among banks with assets under $160 billion

As of March 23, 2023. Source: FDIC

CRE risks to the economy

Ultimately, a pullback in lending negatively affects economic growth, but quantifying the risk is challenging for several reasons. First, if inflation has moderated, the Fed may try to offset the potential impact via less restrictive monetary policy and other backstops. Second, larger, better capitalized banks may step in to fill the void. The U.S. banking system is also in much stronger financial shape since the GFC with more conservative lending standards. Many of the banks that failed during the recession in the wake of the GFC had outsized exposure to the extremely risky and cyclical construction lending sector, which represents just 4% of loan books today.[15] Overall, banks entered the 2020 pandemic with much higher capital ratios and liquidity than going into the GFC. CRE loan delinquencies remained at historically low levels and losses were minimal. Government stimulus and relief programs provided support, and lenders continued to lend even as they tightened standards to reduce the risk of defaults.[16]

When assessing the potential impact of a sharp decline in the CRE market, it is also helpful to look at periods more typical of a normal business cycle, such as the one we see today. For example, between 1989–1993, CRE prices dropped by 25%–30%. At the same time, the U.S. economy experienced a mild recession in 1991, with GDP falling by just -0.1%.[17] This would suggest that a decline in CRE alone does not necessarily foreshadow sharply negative consequences for banks and the broader economy.

Core narrative

While rising interest rates and a slowing economy have exposed poor risk management polices at some U.S. regional banks, we believe the risk of contagion is likely to be contained. Regulators in the U.S. acted quickly to mitigate contagion risk in March, and markets have since stabilized. However, we do expect tighter credit conditions moving forward as small-to-mid sized banks focus on firming up their balance sheets and addressing potential new regulations. While this has sparked concerns about implications for CRE, banks, and the broader economy, we believe any fallout from bank tightening will be limited to the riskiest loans, primarily in the office sector, which represents a relatively modest 15%–20% of outstanding loans. Fundamentals remain solid across most other CRE sectors, and banks have become more conservative since the GFC, lowering the risk of defaults and delinquencies. We are positioning portfolios conservatively in anticipation of a mild recession, and at this time we do not expect a CRE slowdown to materially worsen the anticipated economic contraction.

[1] CoStar Group. “After Peaking In Summer 2022, Prices Continued To Fall In January 2023 As Higher Interest Rates Affect Lending Markets.” February 2023. 

[2] Bloomberg. Carmen Arroyo and Charles E Williams. “Commercial Property Market Freezes, Sending Bond Volume Plummeting”, February 17, 2023.   

[3] Senior Loan Officer Opinion Survey on Bank Lending Practices

[4] Reuters. Matt Tracy and Saeed Azhar. “U.S. banks highlight office real estate as next big worry.” April 14, 2023

[5] 2023 FDIC Report

[6] Income Research & Management. Checking in on the CMBS Market (Again). April 27, 2023.

[7] Goldman Sachs. Chandni Luthra. “State of CRE and a Closer Look at Commercial Mortgages and DQ Rates in RE.”  March 2023.

[8] Ned David Research (NDR). Joe Kalish. “Commercial real estate in trouble again.” April 2023.

[9] WSJ. Andrew Ackerman  “Fed to Consider Tougher Rules for Midsize Banks After SVB, Signature Failures.” March 14, 2023.  

[10] Moody’s Analytics. Kevin Fagan & Matt Reidy & Thomas Lasalvia & Blake Coules & Victor Calanog. “What’s the Real Situation with CRE and Banks: Doom Loop or Headline Hype?” April 2023. 

[11] Cohen and Steers. Rich Hill. “The commercial real estate debt market: Separating fact from fiction.” March 2023. 

[12] Federal Reserve.

[13] IMF | Monetary and Capital Markets

[14] Federal Reserve Bank of St. Louis. Why Does the Fed Supervise Small Banks? July 23, 2017.

[15] S&G Global..Market Intelligence. Zoe Sagalow, Ronamil Portes. “Construction loans grow, delinquencies level off at US banks.” March 3, 2023.

[16] FDIC. Commercial Real Estate: An Update on Bank Lending Amid the Evolving Pandemic Backdrop. March 15, 2023.

[17] Bureau of Economic Analysis, Federal Reserve Board

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