Commercial Loans are Under Pressure
Commercial real estate owners are coming under increasing pressure from a dangerous combination of falling commercial real estate value and high interest rates. The combination of the post-Covid continuation of the trend of many white-collar employees to work from home and the Federal Reserve’s (The Fed) interest rate hikes, in an effort to defeat inflation by slowing down the economy, has led to a worrisome situation.
After all, if a given percentage of a corporation’s employees have the option to work at home, at least some of the time, the corporation would be able to reduce their rent by cutting down on the amount of space they rent in a commercial building. The multiplying effect of many corporations doing the same thing would drive rents down through the basic law of supply and demand.
Not surprisingly, office vacancy rates across the country have risen to 13.5% in 2023 from 9.5% in 2019 (pre-pandemic) and could hit 16.6% by the end of next year, according to the credit rating company Fitch Ratings in a December report.
This shift in work patterns has caused the commercial real estate sector to lose a third of its value, which could lead to many problems in the macro economy. Of $737 billion in office property mortgages, $206 billion (about a quarter) are set to mature this year, according to the Mortgage Bankers Association. (By law commercial loans must be renegotiated every 5-10 years.)
On a side note, let’s remember that empty space hurts retailors of all kinds (particularly restaurants) in the area where the office buildings are located. The financial loss among these retailers will likely cause many to close, leading to higher unemployment and less personal spending. All of which will have a negative effect on the economy.
Secondly, when it comes time to refinancing, rates are far higher than they were for many years. These two factors would put serious stress on commercial landlords to meet their mortgage payments.
As a result, late payments of mortgages on commercial properties have jumped in the last year. Commercial real estate loans at least 30 days delinquent soared to $9.3 billion among the top banks last year.
According to the Financial Times, the amount of delinquent commercial property debt held by the biggest banks almost tripled in 2023 to $9.3 billion. For the overall banking sector, delinquencies on loans backed by offices, malls, apartment buildings, and other commercial properties more than doubled last year to $24.3 billion from $11.2 billion the prior year.
Additionally, over 20% of the total debt owed on U.S. commercial property is set to mature this year. Those property owners, as alluded to earlier, will face a combination of falling demand (meaning lower rents) and far higher interest rates than when they last financed.
Michael Barr, the head of the Bank of Supervision at The Fed said last month that the decreased demand for office space and higher interest rates have put pressure on commercial banks property valuations, particularly in the office sector. Barr added that The Fed has been focusing on banks’ commercial mortgage lending, with a special emphasis on whether the banks have appropriate provisions (cash reserves) in place to sustain potential future loan losses.
The risk, according to Ernst and Young Chief Economist, Gregory Daco, is a “chain reaction” which has the potential to cause defaults in the banking sector and all that that portends. “While large establishments have the capacity to absorb some losses these could prove a massive blow to smaller banks,” Daco added.
"If properties are sold for less than financial institutions anticipate, it could set off a domino effect, causing banks to reassess the potential losses they are exposed to and the needed credit loss provisions to cover them," said Ryan Sweet, chief U.S. economist at Oxford Economics.