22 banks have crossed a dangerous threshold on their commercial real estate (CRE) loans, raising concerns about the state of America's banking system.

According to Bloomberg data, the affected banks include Valley National Bancorp, WaFd, Axos Financial, BCI Financial Group, and First Foundation.

While these banks aren’t exactly household names, they each hold between $13 billion and $61 billion in total assets. In the case of Valley National Bancorp, the CRE portfolio was a whopping 471% of its total capital.

“We’re at the warning stage,” said Keith Noreika, former acting comptroller of the currency. “There’s a light going off on the dashboard and now people are opening up the hood to see: Is it really wrong or do we just need to keep our eye on it?”

Last year, the Fed, FDIC, and Office of the Comptroller of the Currency established a standard that would help regulators identify banks with high-risk CRE loans.

The first red flag is banks whose CRE loan portfolios are more than triple their capital. Within this group, the regulators said they’d focus on banks that had grown by at least 50% in the past three years.

As Creditnews reported, markets are on high alert about possible regulatory action after New York Community Bancorp booked a surprising $252 million loss in the final quarter of 2023, largely due to underperforming office loans.

Following the report, the bank's stock shed half its value, triggering a bloodbath among smaller and mid-sized bank stocks.

The concern is that small banks have 4.4 times the exposure to commercial real estate as larger financial institutions, according to JPMorgan.

Another report from Goldman Sachs found that lenders with less than $250 billion in assets account for roughly 80% of CRE lending.

That means if the CRE bubble is bursting, there could be significant collateral damage. And although regulators are well aware of the risks, they believe there's no quick and easy way out at this point.

No easy fix

There’s a reason why regulators are scrutinizing commercial real estate loans: Office vacancy rates are at record highs, building valuations are dropping quickly, and $2.2 trillion in mortgages will mature over the next four years.

In a recent interview with 60 Minutes, Fed Chair Jerome Powell said the problem will take years to fix.

“There’s some smaller and regional banks that have concentrated exposures in these areas that are challenged, and you know we're working with them,” he said. “It feels like a problem we’ll be working on for years.”

Powell sounded the alarm on commercial real estate long before his interview with 60 Minutes. Back in June, he told reporters that “the system could take losses,” referring to banks’ exposure to commercial properties.

“We do expect that there will be losses, but there will be banks that have concentrations, and those banks will experience larger losses,” he said.

Kevin Fegan, the lead CRE analyst at Moody’s Analytics, agrees that commercial real estate faces a “concentration risk,” meaning some banks have greater exposure than others.

“The current vulnerability of CRE property performance is highly concentrated among office properties, particularly for those with near-term loan maturities and high lease rollover,” he said.

“With roughly $325 billion of loan maturities coming, some loans will have issues refinancing into a higher interest rate environment and, in some cases, slowing CRE space demand,” Fegan explained.

Slowing demand is a colorful way of explaining that prices are plunging.

The CRE price shakeout continues

While it’s difficult to predict just how badly CRE valuations are declining, recent trends across major cities are beginning to paint a clearer picture. And it’s not pretty.

Data from MSCI Real Assets found that office buildings have experienced massive price reductions in recent quarters. In the case of San Francisco, for example, office buildings have lost 39.9% of their value year-over-year.

The value of office buildings is down 15.4% in Manhattan, 13.2% in Boston, and 8.9% in Los Angeles.

Billionaire real estate investor Barry Sternlicht predicts office buildings will lose $1 trillion when the market finally bottoms. He said the office market is currently in an “existential crisis” because of elevated interest rates and declining demand.

Scott Rechler, chief executive of New York landlord RXR, compared the office property market to the five stages of grief, which begins with denial and ends with depression.

“In 2024, we’re at that fifth stage of grief. People are now in acceptance,” he said.