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The near-failure earlier this month of New York Community Bancorp and its rescue through $1 billion in new investments led by former treasury secretary Steven Mnuchin’s private equity firm, reignited concerns about regional banks that began after two firms collapsed in spring 2023. Midsize banks underwrite a huge volume of loans for commercial real estate, so if developers and property owners have a hard time paying them off, that could set off a chain reaction in the financial sector, too.
“There are going to be challenges,” said Matt Reidy, director of commercial real estate economics at Moody’s. “It could look a lot like last year.”
The office market could bring the most serious issues. For example, more than $17 billion of commercial mortgage-backed security (CMBS) office loans are coming due in the next 12 months, double the 2023 volume. Among those, 75 percent have certain characteristics that could make them hard to refinance, according to estimates from Moody’s. That can include properties with canceled leases, vacant buildings or other cash-flow problems.
From there, options for borrowers can range from less-than-ideal to bleak. In many cases, borrowers took out cheaper loans before inflation spiked and interest rates shot up. If companies were to refinance now, they’d probably be shouldering higher borrowing costs on top of their existing problems. Otherwise, borrowers can try pushing a deadline off into the future — or face defaulting altogether.
There is hope for some improvement this year: Moody’s data showed the office loan payoff rate in January and February was 48 percent, several notches above 2023’s overall performance of 35 percent. Plus, not all property types are as desperate as offices. Hotels, for example, are generally performing much better after rebounding from the pandemic. Industrial properties finished last year strong, too.
But economists emphasize that it is way too early to draw bigger conclusions about whether the higher payoff rate will keep up, or if more bad news is yet to come. Based on the portfolio of loans coming due this year, Moody’s is still eyeing some $10 billion of CMBS office loans that are looking troubled. If all of those loans default, the CMBS office delinquency rate could rise from the current 6.2 percent to more than 13 percent. That would spell trouble for banks holding the loans — especially if their portfolios are strongly weighted toward the office market — and for downtowns already struggling to attract new tenants.
Even if it takes a few more months to get a complete picture, early signals should bubble up somewhat soon, said Lonnie Hendry, chief product officer at the analytics firm Trepp.
“Do they get extensions or modifications? Are they able to refinance?” Hendry said. “If that doesn’t happen and they’re lingering, that could bode negatively for the stuff that’s remaining for 2024.”
Zoomed out, the country has made a remarkable comeback since the pandemic upended every corner of the economy and daily life. Growth is keeping a solid pace, the job market is still tight and the Federal Reserve’s aggressive attempts to hike interest rates and tame inflation didn’t cause the recession that seemed practically guaranteed.
But hazards tied to commercial real estate — namely offices — still loom. Buildings nationwide sit empty as companies rethink how much in-person space they need, settle for smaller spaces or go completely remote. Restaurants in major downtowns are still closing their doors, bemoaning quiet weekdays and empty weekends. Some economists fear a kind of “doom loop” that starts with empty buildings here and there, and then spirals into something scarier for city budgets that rely heavily on property and wage taxes.
Ultimately, the hazards will bubble up from individual banks and borrowers themselves, many of whom are using a practice known as “extend and pretend” to get through these bumpy years.
Popularized after the Great Recession, the first step is to extend a loan’s deadline, keeping the payments and interest rate on the same schedule rather than refinancing or paying it off. Then the borrower and bank effectively “pretend” that the value of the loan is still intact — and hasn’t gone down. That means banks don’t have to write down loans that aren’t worth what they were when they were first made.
The workaround gained traction after the Great Recession when the Fed was lowering interest rates, and keeping them low, to stimulate the economy. Back then, it meant that struggling borrowers could refinance their loans and get rates that were oftentimes lower than what they’d paid before.
But over the past two years, rates have moved in the opposite direction. The Fed’s sprint to hoist borrowing costs and catch up with soaring inflation ultimately brought rates to their highest level in 23 years. The central bank is expected to cut rates multiple times this year, but those moves won’t bring borrowing costs down considerably. And in the end, that could leave lenders and borrowers to face the tough reality that they can’t “pretend” their properties and loans haven’t lost value any longer.
Hendry said the strategy of extending and pretending might be the wrong medicine for the current moment.
“There’s some revisionist history about why it worked, so people are leaning into it now,” Hendry said. “If enough lenders extend loans and the market doesn’t improve, it could have some real catastrophic impact.”
One sign of trouble is that some buildings are already selling at steep losses. Data from Trepp shows that commercial property prices declined last year by 5.3 percent. In downtown Washington, one building that cost $100 million in 2018 sold in December for just $36 million. Outside Boston, an office that fetched $43 million six years ago just sold for $6 million.
Overall, the discouraging picture has policymakers and economists keeping a close eye on small and midsize banks — lenders with less than $250 billion in assets — which hold about 80 percent of the overall stock of commercial mortgage loans, according to Goldman Sachs estimates. That scrutiny intensified last year, after two regional banks — Silicon Valley Bank and Signature Bank — suddenly failed, though not primarily due to commercial real estate loans. The collapses caused brief but considerable panic throughout the financial system and prompted an emergency government response.
NYCB wound up buying up a large share of Signature’s assets after that, which added to some preexisting trouble. Much of the bank was concentrated in rent-controlled apartment complexes as well as offices — a combination that made cash flow even tighter when people are still working from home and residential landlords also can’t keep up with market rents.
Still, regulatory experts say they are confident that commercial real estate isn’t on the verge of imploding or endangering the entire financial system. They argue that the risk is well understood, and that banks are aware of the loans on their books. Even if 2024 brings a batch of defaults, the consequences could feel more like a rising pool of water than a sudden tidal wave.
For its part, the Fed is looking at the potential for large commercial real estate losses as a financial stability risk. The central bank is also using a marked drop in commercial real estate prices as part of its regular test of the banking system’s resilience to major shocks and stressors.
“We have identified the banks that have high commercial real estate concentrations, particularly office and retail and other ones that have been affected a lot,” Fed Chair Jerome H. Powell told lawmakers earlier this month. “This is a problem that we’ll be working on for years more, I’m sure. There will be bank failures, but not the big banks.”
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