Commercial real estate is in a debt trap
Lending for commercial real estate (CRE) projects keeps growing despite the sector being in the worst turmoil since the 2008 housing collapse. However, it might not be a sign of optimism but rather one of desperation.
According to Fed data, CRE lending jumped by 3% in 2023. By comparison, loans for general commercial and industrial projects fell by 1%.
Meanwhile, lending for construction and land development surged by almost 9%, nearly matching the growth in consumer loans.
Under normal circumstances, this would suggest that the commercial property market is booming. But in 2023, that wasn’t necessarily the case.
According to the Fed, the lion's share of the rise in CRE loans in 2023 is due to commitments made before demand for commercial property began to wane.
When a land developer gets a loan from a bank, the funds are paid out incrementally over time as the project passes through various stages of development.
According to Unique Properties, a full-service commercial real estate firm based in Denver, commercial loans can range from three years for an intermediate project to more than five years for a larger project.
For example, an office developer who was approved for a loan in 2020 may still be receiving loan installments three years later—even if demand for office space fell over that period.
The Fed brought up this risk in a November 2023 regulatory report, noting that “delinquencies for CRE and some consumer sectors have increased from their low levels.”
Regulators are also evaluating the fallout from New York-based Signature Bank, which had a massive $33 billion CRE loan portfolio when it collapsed in March 2023.
“Some firms have indicated in public earnings releases that they expect increased loan losses, particularly within the office segment of CRE,” the Fed wrote.
“Supervisors, therefore, continue to closely monitor underwriting and loan quality. Recent efforts include a horizontal review to address exposures to potential deterioration in CRE markets.”
Banks are sitting on bad loans
While banks appear to be hush-hush about potential losses from commercial real estate loans, Creditnews Research has reported on a $2.7 trillion CRE debt trap in the banking sector.
According to Creditnews Research, U.S. banks have issued roughly $2.7 trillion in commercial real estate loans as of last quarter.
The problem? Roughly 14% of their CRE loans and 44% of their office loans are in “negative equity,” which is another way of saying that the market value of a property falls below the outstanding amount of a mortgage secured on it.
The sector isn't likely to be out of the woods anytime soon, as one in three CRE loans have “substantial” cash flow problems, according to the Fed.
Even a 10% default rate on these loans—which is the lower end of what we saw during the 2008 financial crisis—would result in $80 billion in losses. Losses would balloon to $160 billion at a 20% default rate.
2024-2025: Make or break years for CRE?
Analysts at Morgan Stanley think the next two years could be a watershed moment in commercial real estate as hundreds of billions of dollars’ worth of loans mature.
These properties either refinance, hopefully at reasonable interest rates, or default due to the combination of still-elevated rates, declining property values, and lower demand for office space.
The Wall Street investment bank estimates that nearly $1.5 trillion in commercial real estate will be due for repayment by the end of 2025. The default risk is very real, given that property valuations could plunge by as much as 40% from their peaks.
“Refinancing risks are front and center” for owners of commercial properties, the analysts wrote. “The maturity wall here is front-loaded. So are the associated risks.”
According to investment manager PIMCO, 2024 could be especially volatile for CRE. By its calculations, more than $1 trillion in CRE loans are due that year.
“CRE market distress set to accelerate” in 2024, analysts Megan Walters, John Murray, and Francois Trausch wrote. Although the analysts view this as a potential opportunity for alternative lenders, it’s difficult to predict how a wave of defaults would impact the market.