By Daniel Brown, Jeff Huther and Sharon Whitaker
ABA Data Bank
Economic growth is powered by businesses that need real estate to build, innovate, and sell goods and services. Much of this commercial real estate is financed by banks, and some small portion of that bank-financed space is in office towers in large cities. Despite this fraction-of-a-fraction exposure, recent commentary (here and here, for example) has expressed fears that bank lending to CRE owners is building into a major problem.
In reality, banks have limited and diverse CRE exposures, CRE loans have been made prudently, underlying cash flows may be stronger than critics assume, and banks are likely to be resilient to adverse outcomes.
Fear: Banks are overexposed to downtown office buildings.
Reality: There have been several articles studying nonfarm nonresidential CRE loans that assume these properties have tenants who have switched to fully remote work policies, and that these properties are at risk of default. However, as a previous ABA analysis has clearly illustrated, office properties account for just 17 percent of bank CRE holdings (and those non-office subsectors have significant tailwinds), but there are also subcomponents within office that have not been affected by the change to a work-from-home framework (medical offices, for example). This diversity means that any potential overall bank CRE losses are likely to be small.
Fear: Banks will face losses on CRE loans.
Reality: Since the 2008 financial crisis, banks have required borrowers to put more money down when originating CRE loans. This reduced leverage, combined with office property appreciation during the 2010s, has reduced banks’ risk of losses even for office towers with low occupancy. As Figure 1 (taken from Moody’s Analytics and the American Council of Life Insurers) shows, CRE loans originated during 2013 and 2018 were originated with significantly more capital than before the financial crisis (a shift that has undoubtedly continued).
Fear: Small banks are over-exposed to CRE.
Reality: Small and regional banks generally provide more CRE funding as a share of assets than large banks, leading to worries that small and regional banks are vulnerable to the office CRE downturn. However, bank CRE lending as a percent of total assets, both in aggregate and for various size cohorts of banks, has stayed relatively constant for both small and large banks (See Figure 2; note that some regional banks are included in the “large bank” category). CRE lending has been proportionately higher for smaller banks for decades, in large part because of their role as vital lenders to small businesses in their local communities. Combined with the previous section’s emphasis that these holdings are well diversified, these numbers highlight not only moderate growth in CRE lending by banks of all sizes, but also that lending has been conducted in a safe and sound manner.
Fear: The coming maturity wall could lead to a wave of defaults.
Reality: Unlike a conventional mortgage for a homeowner, commercial mortgages typically have shorter maturities, are more likely to have adjustable rates and may not require principal payments until maturity. The rapid rise in interest rates, coupled with lower demand for office space, has led to speculation that banks will be inundated with defaults as CRE loans mature. Borrowers and lenders in this market, however, have well established protocols for refinancing and banks have been proactive in working with borrowers ahead of maturities to avoid default shocks. This kind of proactivity can include initial periods of interest only with amortization beginning after a short period of interest only and deferral of principal and interest if necessary. By aligning maturity dates to allow refinancings, new rates and terms align debt repayments that are appropriate for changes in cash flow, market conditions, income and expenses. In July, regulators formally encouraged banks to work with commercial loan customers to provide assistance to a borrower experiencing financial difficulty. Offering short-term and long-term workouts demonstrates the flexibility to absorb any losses over a longer period of time. As Figure 3 from Trepp shows, even ahead of the July regulatory guidance, commercial mortgage maturities are not a massive imminent wall that will hit next year but rather are fairly evenly spread out over the next several years.
Fear: Companies don’t need office space anymore—it’s all Zoom from here on out.
Reality: With the labor market starting to show signs of softening, companies that initially advocated for fully remote work are starting to require workers to be in the office on a more consistent basis. Several tech companies that were more in favor of fully remote policies have recently reversed their positions and are bringing workers back into the office. Add this to Wall Street firms further restricting remote work, as well as a renewed push for more in person work for federal government employees, the share of fully remote positions seems to be significantly diminishing.
Although it may still be early, there are early signs of recovery in key office property metrics. According to a Q2 2023 office report by JLL, conversion and demolitions of older buildings and return to office trends are pointing toward a bottoming in office vacancy rates that may start to recover in 2024. Rent price growth has stabilized as well, increasing 0.6 percent quarter over quarter in Q2, with trophy class office buildings experiencing higher rental growth rates amid a “flight to quality” by companies that prefer higher quality space while slightly reducing square footage. Even San Francisco, which is seen by many as the most vulnerable city for CRE, is beginning to turn the corner. A recent Wall Street Journal article reported that between lower office property valuations, and the growing artificial intelligence industry, 2023 is already the most active year for San Francisco office building sales since 2019. Although the article noted there could be further valuation declines, investors are gearing up for new investment in central business district properties if the price is right.
Conclusion
While the “new normal” in the CRE market is uncertain, and data gaps make fully assessing the CRE market quite challenging, safe and sound lending practices by the US banking industry are a source of stability for the CRE market. Because of the spread-out maturity schedule, the loan repayment process will be drawn out. This timeline will help CRE lenders and borrowers work out viable repayment solutions to support these properties and, in some cases, allow time for prices to recover. Finally, a CRE worst-case scenario of a fully remote office workforce is unlikely, and inconsistent with a broader sense that urban areas have lasting attraction as sources of economic growth.
Dan Brown is a senior director and economist at ABA. Jeff Huther is VP for banking and economic policy research at ABA. Sharon Whitaker is VP for mortgage finance policy at ABA.
