There’s a crisis brewing in American real estate, according to Barry Sternlicht, CEO of Starwood Capital Group.

In an interview with iConnections, Sternlicht said, “We have a problem in real estate. In every sector of real estate, not just office, because of the 500 basis point increase in rates that was vertical.”

The investment executive was referring to the Fed’s aggressive rate hikes since March 2022 to combat inflation. The central bank raised rates 11 times over 17 months, pushing up the federal funds rate from near zero to 5.5%.

One of the biggest casualties of the Fed’s inflation fight was real estate as higher financing costs dragged home sales to a three-decade low.

As bad as housing is, commercial real estate is in even worse shape—especially office space.

“The office market has an existential crisis right now,” he said. “It’s a $3 trillion asset class that’s probably worth $1.8 trillion [now]. There’s $1.2 trillion of losses spread somewhere, and nobody knows exactly where it is.”

The problem isn’t just limited to office towers in downtown cores, but “buildings that surround towns and municipalities,” he explained.

If Sternlicht’s calculations are correct, office properties risk a 40% price drop from current levels. That’s a disaster not just for commercial property owners, but for banks that financed the loans.

Are banks sitting on bad loans?

Covid has had a permanent displacement effect on office workers. Nearly three years after lockdowns, a large swathe of white-collar workers continue to work from home all or most of the time.

As a result, there’s nearly 1 billion square feet of empty office space across the U.S., the highest on record.

These office owners have mortgages to pay whether they have tenants or not. If they can’t make payments on time, they risk defaulting on their loans—something researchers say is increasingly likely.

According to the National Bureau of Economic Research (NBER), 14% of all commercial real estate loans are in negative equity, meaning the current value of the properties is below the loan balance.

Shockingly, 44% of office loans are in this predicament.

Major banks are sitting on $2.7 trillion in commercial real estate loans. Even a fairly conservative 10% default rate would create an $80 billion hole for these banks, according to the NBER researchers.

If defaults reach 20%, losses could climb to $160 billion.

Small banks face the greatest threat over the short term, as a wave of defaults “can induce anywhere from dozens to over 300 mainly smaller regional banks joining the ranks of banks at risk of solvency runs,” the NBER researchers wrote.

The dangerous mix of falling commercial property values, rising vacancy rates, and higher interest rates hasn’t gone unnoticed. The Fed has increased its scrutiny of commercial real estate loans and is prepared to act if things go sideways.

Under the Fed’s microscope

According to Michael Barr, the Fed’s vice chair for supervision, regulators are monitoring banks for “potential credit deterioration,” particularly in commercial real estate lending.

His comments came on the heels of the Fed’s Financial Stability Report, which identified office space as a primary source of concern.

“A correction in office property valuations accompanied by even a mild recession could result in significant losses for a range of financial institutions with sizable exposures, including some regional banks and insurance companies,” the Fed explained in its report.

Fed chair Jerome Powell didn’t mince words when asked about whether banks would experience losses on their office loans.

“There will be losses for sure,” he said in an interview with Bloomberg. “You can drive down through most downtowns—many downtowns anyway—and see buildings that are empty.”

Some experts say empty office space could be the silver lining the housing market needs to increase supply. But converting empty office space into livable housing units is easier said than done.