In the wake of the global pandemic, the United States is grappling with a mounting crisis in its commercial real estate sector. The third quarter of 2023 witnessed the distress in this market reach its highest level in a decade, nearing an astounding $80 billion in value. As interest rates continue to rise and the demand for office space wanes due to the remote work revolution, the property market is facing unprecedented challenges.
A Sobering Reality
According to a report by MSCI Real Assets, the distress in the US commercial real estate sector has increased by a net $5.6 billion in the third quarter of 2023. Office properties account for a substantial 41 percent of the total distressed value, highlighting the severe impact of remote work and dwindling tenant demand in this sector. In fact, MSCI’s report states that the office sector remains the primary driver behind the growing distress, contributing a staggering 93 percent to the additional balance for the quarter.
Though the current distress levels remain lower than those seen during the global financial crisis, a looming shadow of potential trouble hovers over the market. MSCI identifies approximately $215.7 billion worth of properties that are susceptible to issues such as delinquent payments or sluggish lease-ups.
Multifamily Assets and At-Risk Properties
Interestingly, apartment buildings make up nearly a third of these at-risk properties, which MSCI attributes to the sheer number of multifamily assets rather than any intrinsic sector-wide collapse. This suggests that the multifamily sector may be more resilient than it appears at first glance.
Banking Sector Under Pressure
Banks that financed these distressed properties are also bearing the brunt of this crisis. High interest rates and vacant offices, as employees opt for remote work, are squeezing building owners. As the demand for office spaces continues to plummet, a wave of borrowers may default on their loans, putting immense pressure on banks and other lenders. The prospect of selling loans at significant discounts is something financial institutions are eager to avoid.
Rebel Cole, a finance professor at Florida Atlantic University, warns in a recent report by Reuters, “This is going to go on for at least a year, where NPLs (Non-Performing Loans) continue to rise, followed by charge-offs – it’s going to be really ugly.” Banks are cautious about selling their worst properties, as each sale sets a comparable benchmark for property appraisals, potentially worsening their financial position.
Banking Sector Reserves and Challenges
Morgan Stanley, for instance, set aside $134 million for credit losses in its third-quarter earnings release. Similar to the $161 million allocated in the second quarter, the bank attributed this to the “deteriorating conditions in the commercial real estate sector.” Goldman Sachs has significantly reduced its exposure to office-related CRE holdings by approximately 50 percent in the same year.
Bank of America also faced challenges, with its non-performing loans increasing to nearly $5 billion in the third quarter, primarily due to its CRE portfolio.
Borrowers have encountered significant difficulties refinancing their CRE loans as property values decline and interest costs rise. Notably, about $20 billion of office commercial mortgage-backed securities are set to mature in 2023, creating a potential pressure point for the market.
Regional Banks and Diverse Business Lines
Regulators are closely monitoring banks’ CRE risk, and while larger institutions like JPMorgan and Goldman Sachs have relatively less exposure to CRE, smaller regional banks are facing greater challenges. Small banks, according to research from JPMorgan and Citigroup, hold 4.4 times more exposure to CRE loans than their larger counterparts, with regional and smaller lenders holding 70 percent of CRE loans.
Mayra Rodriguez Valladares, a bank and capital markets risk consultant, points out in the Reuters report, “A lot of these big banks benefit from all of these different business lines, whereas once you start being regional and once you start being a community bank, there isn’t all of that business diversity.”