Is commercial real estate the next ticking time bomb?

The Fed’s latest Financial Stability Report sounds the alarm about commercial real estate.

According to the report, this segment—which includes everything from office space to strip malls—faces unprecedented risks following a year of rising interest rates and shifts in white-collar work.

“The shift toward telework in many industries has dramatically reduced demand for office space, which could lead to a correction in the values of office buildings and downtown retail properties that largely depend on office workers,” the report read.

Declining demand for office space couldn’t come at a worse time.

Mortgage rates have soared from around 3% in early 2022 to close to 7% today. According to the Fed, the steep rise in rates “increases the risk that [commercial real estate] mortgage borrowers will not be able to refinance their loans when the loans reach the end of their term.”

The problems don’t end there.

Authors of the Financial Stability Report say commercial real estate valuations remain “elevated.” If a correction escalates, it will devastate not only landlords but also the banks that bankrolled them.

Whether this ends in a 2008-style property crash depends on one crucial factor.

It’s all about leverage

If commercial property values fall, borrowers who have gotten in too deep face the greatest risk of default. The less equity they have, the less cushion there is to withstand a steep fall in prices.

Especially if financing costs increase.

One of the best ways to measure this risk is to divide the current loan balance by the appraised value of the property. This is known as the loan-to-value (LTV) ratio.

For example, if a commercial property is valued at $1 million and the owner’s current loan balance is $800,000, the LTV ratio is 80%. The higher the LTV, the greater the perceived risk.

According to the Fed, current LTVs for mortgages backed by offices and downtown retail properties are between 50-60%. That’s nothing to worry about.

For now.

But if commercial property values decline, “Current LTVs could rise considerably,” according to the Fed. In the above example, the LTV could spike if the borrower’s current loan balance is $800,000, but the appraised value of their property falls to $900,000.

And it would be disastrous if the appraised value fell below the borrower’s loan amount. That’s called negative equity—it means the borrower owes more on their property than it’s worth.

Experts say risk of default is growing

The risk of default in commercial real estate appears to be growing, according to U.S. investment bank Morgan Stanley.

In a note to clients, analyst Lisa Shalett warned that commercial property values could fall by as much as 40%—that’s “worse than in the Great Financial Crisis” of 2008.

The problem could come to a head in the next two years. “More than 50% of the $2.9 trillion in commercial mortgages will need to be renegotiated in the next 24 months when new lending rates are likely to be up by 350 to 450 basis points,” she said.

Banks and other commercial lenders see the writing on the wall. They’ve already started pulling funding from the sector.

According to Bloomberg, commercial real estate lending has collapsed as funds associated with major investors such as Blackstone, KKR, and Starwood Capital Group have slashed originations.

The dollar volume of new commercial loans issued by banks plunged by 69% in the second quarter compared to the year before, according to Mortgage Bankers Association. Loans issued by private equity and debt funds fell by 60%.

It seems everyone is exiting the commercial real estate sector. And for good reason: even property owners are struggling to make payments.

As more landlords struggle with rising costs, there’s a risk they could pass them along to their tenants. About 72% of landlords plan to increase rent within 12 months, according to Urban Institute, a research-focused non-profit. The top reason given was increased ownership costs.

A severe downturn in commercial real estate wouldn’t be an isolated event—it could lead to a recession marked by widespread defaults, bankruptcies, and job losses.

Economists are already calling for a modest downturn in 2024, but there would be nothing modest about it if commercial real estate flounders.

In the meantime, the Fed has increased monitoring of commercial property loans and banks with significant exposure to them.