The chairman of the Federal Reserve didn’t mince words when asked about the risks facing America’s smaller banks due to their exposure to commercial real estate (CRE).

“There will be bank failures,” Jerome Powell told a Senate Banking Committee hearing earlier this month.

“It’s not a first-order issue for any of the very large banks. It’s more smaller and medium-sized banks that have these issues. We’re working with them. We’re getting through it. I think it’s manageable, is the word I would use,” he said.

Powell reiterated that the Fed continues to supervise banks’ exposure to the CRE market and is in “dialogue with them” around their risk management practices.

As Powell explained, the Fed is asking banks questions such as, “Do you have your arms around this problem? Do you have enough capital? Do you have enough liquidity? Do you have a plan? You’re going to take losses here—are you being truthful with yourself and with your owners?”

The Fed has been tracking the CRE market like a category 5 hurricane, sounding the alarm on the issue in its May 2023 Financial Stability Report. At the time, central bank researchers flagged the sharp rise in office vacancy rates due to shifting work trends—telework, specifically.

The combination of falling demand, declining commercial property values, and higher interest rates during refinancing windows is a nasty recipe for building owners and banks that financed them.

Although Powell described this phenomenon in more polite terms—calling it a “secular change”—the situation is really as dire as it appears on the surface.

Empty office space threatens the CRE market

With a national office vacancy rate hovering close to 20%, landlords are desperate to fill their buildings. But with nearly 1 billion square feet of empty office space lying dormant across the country, there’s going to be a nasty spillover on restaurants and retailers that have lost business due to the white-collar exodus.

According to Kiplinger, the vacancy rate will climb higher in 2024, reaching a peak of around 21%.

Unfortunately, the problem predates Covid, so it’s not as easy as hoping for companies to adopt a full return-to-office mandate.

As The Wall Street Journal reports, the surge in vacancy rates began in the 1980s and 1990s following years of overbuilding. With so much commercial real estate on the market, landlords have long struggled to find tenants when the economy enters a downturn.

“The bulk of the vacant space are buildings that were built in the 1950s, ’60s, ’70s and ’80s,” Mary Ann Tighe, chief executive of the real-estate brokerage CBRE, told the Journal.

“The building I built was almost a million square feet—100% empty,” lamented Bruce Eichner, a developer who built an office tower on Broadway Street in Manhattan.

Empty office space might seem like a landlord problem, but as Powell alluded to in his testimony, there’s an entire economy that runs on CRE loans. Banks are first in line to fall should things go south.

Banks are overexposed

Bloomberg recently sounded the alarm on around two dozen U.S. banks that have crossed into “dangerous” territory on their CRE loans. These mainly small- and mid-sized banks include the likes of Valley National Bancorp, BCI Financial Group, First Foundation, and WaFd.

What all these banks have in common is a CRE loan portfolio that’s at least three times bigger than their capital.

And that’s the main reason why the Fed is so fixated on smaller banks.

Whereas larger institutions with more than $100 billion in assets have average CRE portfolios that represent 12% of their overall lending, this figure is 38% for banks with less than $10 billion in assets, according to S&P Global Ratings.

If and when the losses add up, smaller, regional banks will be the first to suffer the consequences.

“Valuation deterioration will lead to difficulties in refinancing certain office properties underwritten during the low rate environment, particularly in larger central business districts. This will ultimately increase CRE credit costs for the banking industry,” credit rating agency Fitch Ratings warned in December.

“As long as interest rates stay high, it's hard for the banks to avoid problems with CRE loans,” William C. Martin of Raging Capital Ventures told Reuters.

“The regional banks [are] doubly more exposed to rates,” according to Dan Zwirn, co-founder and CEO of debt investment firm Arena Investors.