Growing Peril for Small US Banks Amidst Commercial Real Estate Downturn

The ongoing commercial real estate downturn is sounding alarm bells for a substantial number of small and regional banks across the United States. A concerning slump in property values has left a significant portion of buildings underwater financially, which could spell trouble for these financial institutions. 

According to an analysis prepared for the National Bureau of Economic Research, approximately 14% of all commercial real estate loans are now worth less than the properties they were used to purchase. This figure is even more pronounced in the office building sector, where close to half of all loans are facing negative equity. The implications of this are stark; borrowers may default on their loans if they perceive that their equity stakes have been obliterated. 

The report suggests that this wave of negative equity could lead to a crisis for many smaller banks, with estimates ranging from a few dozen to potentially over 300 banks being at risk of experiencing runs on solvency. As it stands, US banks hold an immense $2.7 trillion in commercial real estate debt—a hefty sum that underscores the potential scale of this issue. 

The root cause behind this downturn can be traced back to interest rate hikes initiated by the Federal Reserve since early 2022 as part of its anti-inflationary measures. These increases have had a cascading effect on property values, with overall commercial-property valuations plummeting by 22% and office prices taking an even steeper dive at 35%. This situation has been exacerbated by shifts in work culture, notably the rise in remote working which has dampened demand for physical office spaces. 

Read more: Tightening Credit Conditions and an Ongoing Liquidity Crunch Intensifies Challenges in US Commercial Real Estate 

These economic conditions have already contributed to notable banking failures and distressed sales earlier in the year—a warning sign that further upheaval may be on the horizon if current trends persist. Should default rates reach 10%, banks could face upwards of $80 billion in losses, with potential losses doubling if defaults hit 20%. 

To put these figures into context, during the global financial crisis roughly a decade and a half ago, delinquency rates peaked at around 9%, and charge-offs were at 3.3%. Although current delinquency rates reported by the Mortgage Bankers Association remain below those levels at 0.85%, there’s been an upward trend from just a year prior. 

While prospective Fed rate cuts in 2024 signal some hope on the horizon, the overall situation remains in flux, with the future still to be written for a whole host of different property types- from office to warehouse and everything in-between. 

Read more: The End of the Warehouse Expansion Era in the U.S.? 

The implications drawn from these findings emphasize critical considerations for financial regulation and risk supervision, highlighting how shifts in monetary policy can significantly impact banking stability.  

If you’re interested in gaining deeper insights into this critical issue affecting small US banks amid the commercial-property downturn, check out this report available at Bloomberg 

December 29, 2023