Crisis Ahead: Commercial Real Estate Crash Lurks as Major Risk to US Economy

The $20 trillion commercial real estate market has emerged as the next substantial risk on the horizon for US banks, amidst an era of financial market instability. With approximately $1.5 trillion in mortgages due for renewal within the next two years, this ticking time bomb may disrupt property values as increasing interest rates coincide with escalating office vacancies.

The exposure of regional and smaller lenders, who account for 70 percent of bank-held commercial mortgages, could mean significant repercussions for the financial system and potentially the broader economy. This is a looming concern as the 2024 presidential campaign approaches, just as the nation seems on the brink of a possible recession.

Against the backdrop of recent turbulence instigated by the collapse of three regional banks, the impact of a commercial real estate market downturn would be particularly calamitous. Policymakers in Washington are acutely aware of this potential crisis, albeit admitting that their options to mitigate it are limited.

Sen. John Kennedy (R-La.), a senior member of the Senate Banking Committee, expressed his apprehension about the situation. “Am I worried? The short answer is yes,” he said in an interview. “The long answer is hell yes.” He urged banking regulators and the Federal Reserve to be proactive and not repeat previous mistakes.

The Federal Reserve has recently escalated interest rates for the 10th consecutive time, a quarter point increase that further burdens the real estate industry and banks. While Chair Jerome Powell maintains the banking system is “strong and resilient,” he has downplayed the threat posed by the commercial real estate market. Conversely, FDIC Chair Martin Gruenberg underscored the substantial risk during a recent press conference, prompting lenders to manage their exposure to this sector.

The Fed’s May Financial Stability Report highlights commercial real estate as a potential area of concern, warning that a correction in property values could lead to credit losses for banks and investors holding commercial real estate debt.

Such concerns are echoed by lawmakers. Sen. Mark Warner (D-Va.) stressed the compounded impact of higher interest rates and a post-Covid commercial real estate market shock. He underscored the need for immediate intervention and additional measures to support regional banks.

White House economic advisor, Jared Bernstein, acknowledged the potential for a significant market downturn, confirming the issue is under close observation. Similarly, Sen. Elizabeth Warren urged regulators to ensure banks and other lenders adequately hedge against a significant downturn in commercial real estate.

As remote work becomes the new norm in a pandemic-stricken world, office vacancies are hitting unprecedented highs. The office vacancy rate stood at 18.6 percent in Q1 2023, far above pre-pandemic levels, according to estimates from Cushman and Wakefield. The impact is not limited to the office market; higher interest rates influence all types of real estate.

Stijn Van Nieuwerburgh, a Columbia Business School professor of real estate and finance, suggests a significant market disruption would occur if banks refuse to refinance approximately 10 percent of commercial real estate loans due to increasing caution about real estate lending.

The ripple effects of the crisis are evident, with commercial real estate stocks experiencing a decline this year and commercial mortgage loan originations down 56 percent from the previous year. The future remains uncertain, and as Sen. Jon Tester (D-Mont.) opines, perhaps the most logical solution lies in developing policies that promote the conversion of commercial properties to housing or apartments.