U.S. Treasury Secretary warns about another banking crisis

One of America’s most powerful officials says banks are in for a rude awakening as trillions of dollars in commercial real estate (CRE) loans come due.

Appearing before an annual Senate Banking Committee, U.S. Treasury Secretary Janet Yellen told lawmakers that defaults in this sector could deal a heavy blow to smaller and mid-sized banks.

That's all thanks to a combination of high interest rates and rising vacancy rates in offices. “It’s obvious that there’s going to be a stress and losses that are associated with this,” she said.

Of course, it's not just the banks that are on the hook. Property owners, including funds and investors, also risk losing money unless they can find new tenants to fill their empty office space.

“The higher interest rate environment and, in some cases, particularly the case of office buildings, shifts in work patterns due to the pandemic coupled with many commercial real estate loans coming due and needing to be financed, refinanced in a context where vacancy rates in some cities are quite high—it’s going to put a lot of stress on the owners of these properties,” Yellen explained.

According to Moody’s Analytics, office vacancy rates rose to a record-breaking 19.6% in the fourth quarter of 2023. There are nearly 1 billion square feet of unoccupied office space across the country, also the highest on record.

Experts say part of the problem is that the market is shifting away from large office spaces toward smaller ones. But that alone doesn’t explain the enormous jump in vacancies since the pandemic.

As Yellen alluded to, demand simply isn’t what it used to be because of shifting work trends.

“The office sector faces the most severe challenges because demand for office space has been weak, particularly in the largest U.S. markets,” according to the Financial Stability Oversight Council, which reports to the U.S. Treasury.

If these shifts become permanent, experts say banks could be looking at losses that rival the 2008 financial crisis.

Banks have massive CRE portfolios

There’s a reason why Yellen’s warning focused on smaller and mid-sized banks: they hold nearly $2.7 trillion in CRE loans, according to the National Bureau of Economic Research (NBER).

“There are several reasons why CRE has been viewed as having an elevated distress risk,” NBER researchers wrote in a December working paper.

In addition to higher interest rates and shifting work trends, “Most of these loans mature in the next few years and may have to be refinanced at significantly higher rates (typically more than double relative to original loan) resulting in increased risk of maturity default,” the paper explained.

In fact, U.S. banks have already soaked in a $2.2 trillion drop in CRE loan value after the Fed's interest rate hikes alone:

If 10% of commercial property owners default on their loans, banks could lose $80 billion on their CRE portfolios. This figure doubles to $160 billion in the event of a 20% default rate. NBER said both scenarios are in line with the default rates seen during the 2008 financial crisis.

According to Trepp, $2.81 trillion worth of CRE loans will come due in the next four years, including $544.3 billion this year. If there are more cracks in the CRE loan market, we’ll probably hear about it soon.

CRE’s precarious position has many experts questioning whether vacant properties can be put to better use. After all, America has a serious housing shortage that’s not expected to get better anytime soon.

Unfortunately, repurposing decades-old buildings is easier said than done.

Putting empty office space to better use

Industry data shows that more developers are planning to convert empty office space into residential apartments.

The number of office spaces scheduled for conversion has grown from 12,100 in 2021 to 55,300 in 2024, according to RentCafe.

But the problem is conversion projects aren’t scalable enough to fix the housing shortage.

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

While older buildings aren’t always a problem, they often lack the smaller floor plans that are ideal for conversion.

Developers say there aren’t a lot of financial incentives to carry out these massive, complicated projects—even as the Biden administration rolls out ultra-low financing programs to encourage office conversions.

“The economics of these projects, they're not slam dunks," said Guilherme Almeida, a director at architecture firm Hickock Cole. “They actually are pretty complex and expensive projects to execute.”

"I think it's great, but it still requires a lot of stars to align,” Eddie Lorin, co-founder and chief executive officer of Alliant Strategic Development, said of Biden’s plan.