U.S. Banks Brace for $1 Trillion Commercial Real Estate Reckoning

As reported by Harvard Business Review

Driving the news: Over the next two years, U.S. banks will face a daunting challenge as more than $1 trillion in commercial real estate (CRE) loans come due, according to data from The Conference Board using MSCI Real Assets. Institutions with heavy CRE exposure and insufficient capital are at significant risk.

Why it matters: The scenario could escalate into a financial crisis if numerous small- and midsize banks fail simultaneously, potentially triggering economic contagion and creating banking deserts across the U.S.

The big picture: As the Federal Reserve maintains high interest rates and CRE risks grow with falling property values, businesses face restrictive financing conditions. However, executives can take steps to mitigate fallout by examining banking relationships, extending debt maturities, and securing adequate working capital.

How we got here:

• Pandemic impact: The global pandemic disrupted economic norms, including low inflation, low interest rates, and in-office work.
• Rising costs: CRE management costs, such as insurance premiums, labor, and energy prices, have surged.
• Labor shortages: An aging U.S. population is fueling labor shortages, driving wages higher.
• Natural disasters: Increasing property insurance premiums and outdated energy infrastructure are raising costs.

The numbers:

• CRE loan exposure: Small banks (assets of $100 million to $1 billion) and midsize banks (assets of $1 billion to $10 billion) have CRE loan values far exceeding risk-based capital levels, at 158% and 228% respectively.
• Delinquencies: Nonperforming CRE loans more than doubled from 0.54% to 1.25% over six quarters from Q3 2022, according to BankRegData.com and the FDIC.

What to watch:

• CRE crisis triggers: A potential U.S. recession, prolonged high interest rates, and financial market upheaval from fiscal crises could exacerbate the situation.
• Bank failures: A 10% loss on CRE loans would leave more than 100 mostly small and midsize banks, representing nearly $700 billion in assets, undercapitalized. A 20% loss would render over 900 banks undercapitalized, including some larger banks.
• Regulatory response: The Federal Reserve and FDIC may be reluctant to rescue multiple banks simultaneously, wary of encouraging future risk-taking.

The bottom line: Companies should brace for tight lending standards and elevated borrowing costs. To navigate the CRE storm, corporations should extend debt maturities, add liquidity buffers, and diversify financial instruments to ensure access to capital. Monitoring the liquidity risk of key counterparties and reviewing banking relationships will be crucial for corporate survival in a potential CRE crisis.