America’s largest banks could be sitting on hundreds of billions of dollars in bad loans tied to commercial real estate, potentially setting the stage for a 2008-style banking collapse, researchers warn.

According to a December working paper from the National Bureau of Economic Research (NBER), banks with the most exposure to commercial real estate could lose up to $160 billion on their holdings in the event of defaults.

The researchers analyzed banks where commercial real estate accounts for about a quarter of their assets. These banks combined had $2.7 trillion in commercial real estate loans.

According to the paper, 14% of all commercial real estate loans and 44% of office loans are in “negative equity,” meaning the properties’ current values are below the outstanding loan balances.

A 10% default rate on these loans would result in $80 billion in losses, whereas a 20% default rate could lead to $160 billion in losses. Both scenarios are entirely feasible, as they fall within the default range banks faced during the 2008 financial crisis.

How did banks get into this mess? It didn’t happen overnight but resulted from a perfect storm of factors: Rising interest rates, declining property values, and the growth of hybrid or remote work since the pandemic.

These factors have reduced the demand for commercial property, as evidenced by the scores of empty skyscrapers in cities like New York, Chicago, and San Francisco.

The impact of rising interest rates has been especially crippling. After the Fed’s 2022 hikes, banks' commercial real estate assets shed 10%, or a whopping $2.2 trillion, in value, according to another NAR paper.

But the problems don’t end there.

“[A]round one-third of all loans and the majority of office loans may encounter substantial cash flow problems and refinancing challenges, reflecting in part more than doubling of the cost of debt after the Fed’s rate hikes," warn researchers.

In November, Creditnews reported on refinancing challenges office owners face due to rising interest rates. Nearly one-quarter of office mortgages were due for refinancing at multi-fold higher rates in 2023.

More losses are in the cards, analysts warn

During the Fed's 2022 rate hikes, commercial real estate faced the largest decline in prices since the 2008 housing collapse.

The Green Street Commercial Property Index, which tracks the value of retail, office, apartment, healthcare, lodging, industrial, and other properties, peaked in April 2022—mere weeks after the Fed began raising interest rates.

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By December 2023, the index had declined by a whopping 21.6% from its peak, erasing all of its gains since the pandemic. The index is now at the lowest level since the depths of Covid lockdowns in mid-2020.

Capital Economics, a London-based research firm, estimates that commercial real estate prices plunged by 11% in 2023—a colossal $590 billion. The losses are expected to snowball in 2024, with losses of up to 10% or $480 billion.

Kiran Raichura, Capital Economics’ deputy chief property economist, wrote that office properties are expected to fall another 20% between 2024-2028.

“Four years after the pandemic, and the outlook for the office sector is still the joint-worst” along with industrial space, he wrote.

Analysts at Morgan Stanley are even more pessimistic about commercial real estate prices, forecasting a fall of up to 40% in 2024.

Office vacancy rates to rise

The research from NBER, Capital Economics, and Morgan Stanley share one conclusion: Rising vacancy rates are expected to be one of the biggest drags on the commercial property market.

According to Fitch Ratings, a big three credit rating agency, the national office vacancy rate reached 13.5% in 2023—up from 9.5% before the pandemic.

Fitch expects the vacancy rate to rise to 15.7% in 2024 and 16.6% in 2025.

“The top metropolitan areas by asset value with current vacancy rates above the national average are San Francisco (20.3%), Houston (19.2%), Dallas/Ft. Worth (19.0%), Chicago (16.1%), Washington DC (15.8%), Los Angeles (15.6%) and New York (15.1%),” Fitch said.