Commercial real estate is heading for meltdown, new paper warns

The U.S. commercial real estate (CRE) market is facing a major crisis—putting hundreds of midsized banks at risk, a new paper warns.

According to author and Conference Board chief economist Dana M. Peterson, the pandemic has permanently altered “long-held economic assumptions” that benefited the CRE market, such as perpetually low inflation, near-zero interest rates, and in-office work.

The end result is that commercial banks risk being “overexposed” to CRE at a time when office vacancy rates are at record highs and when more than $1 trillion in loans are coming due over two years.

Peterson said this could be the fuse that sparks the next commercial real estate meltdown.

“Institutions with the most concentrated exposures, insufficient capital cushions, and limited lifelines from larger institutions or regulators face significant losses,” he warned while explaining that regional banks face the biggest risk of all.

“The damage could metastasize into a full-blown financial crisis if scores or even hundreds of small- and midsize commercial banks fail simultaneously. A worst-case scenario might include contagion to other economies and banking deserts across the U.S.,” Peterson added.

According to the economist, banks holding bad CRE loans won’t be able to delay recognizing their losses for much longer.

They could start reporting losses later this year during what’s expected to be a “vulnerable period for the economy,” marked by slowing growth, higher unemployment, and still-elevated interest rates.

If depositors find out that troubled banks are trying to raise equity, it could spark a series of bank runs that would only exacerbate CRE woes.

From the “warning stage” to the critical stage

There have been many clues that the CRE market is one contagion away from a full-blown crisis.

In March, Federal Reserve Chairman Jerome Powell told a Senate Banking Committee hearing that “there will be bank failures” because of negative exposure to commercial real estate.

At the time, losses were said to be concentrated mainly in smaller- and mid-sized banks. JPMorgan further corroborated this, showing that smaller banks have 4.4 times the CRE exposure as large institutions.

That same month, Creditnews reported that 22 regional banks had reached a dangerous threshold on their CRE loans, meaning that their commercial loan balances were more than triple the size of their capital.

At the time, former acting comptroller of the currency Keith Noreika said, “We’re at the warning stage” of the CRE meltdown.

It turns out that small banks weren’t the only ones feeling the pressure of bad CRE loan exposure. As The New York Times reported, Wall Street mega banks like Goldman Sachs, CIBC, and Deutsche Bank have been quietly offloading hundreds of millions of dollars in office mortgages.

“The banks know they have too many loans on their books,” said Jay Neveloff, a real estate lawyer at Kramer Levin.

That’s why Florida Atlantic University professor Rebel Cole believes that “we’re still in the first or second innings” of a commercial real estate meltdown. “There’s a tsunami coming, and the waters are pulling out from the beach,” he said.