Empty Offices, Soaring Debt, Nervous Investors — Exactly How Much Trouble Are Banks In Amid CRE Market Turmoil?

• U.S. banks face increasing risks as CRE loan maturities loom and clash with record-high office vacancy rates amid changing work patterns.
• Banks are reacting by slowing CRE lending, bolstering loan loss reserves, and cautiously selling off debt portfolios.
• Global CRE markets, while stressed, are less critical outside the U.S., with banks overall better prepared than in previous real estate downturns.

Banks in the U.S. have nearly $5 trillion of commercial real estate loans on their books. At the same time, office vacancy rates in America have reached 20% — breaking the record last set in 1990. This is not a comfortable situation for the banks, because the landlord companies owning such empty or half-empty buildings will not be able to service those CRE loans for long. 

Bank investors and short sellers have started to take notice of the risks of banks with large CRE portfolios and are trying to spot those under the most stress. An early target was Aozora Bank, a mid-sized Japanese bank with a large U.S. loan portfolio, whose shares fell a third in two days in late January as rumors swirled about its bad debt level. Chairmen of other banks are looking nervously at their share price as the market opens each morning in case their bank is the next in the firing line. 

Why so many vacancies? 

When the last record was set in 1990/91, the cause of the record-high vacancy rate was a recession in the U.S. and in other countries, including the U.K. — suppressing the demand for office space. That is not the case today, with U.S. economic performance breaking all sorts of positive records, even if the current administration gets no credit for it. Today’s empty offices are rather attributable to a longer-term shift in working patterns, with companies questioning whether they really need a desk for every worker, at the same time as those workers are questioning whether they really want to commute to work on America’s congested highways. 

Not all offices are equally affected by this drop in demand. The market seems to be bifurcating into prime, new buildings, with good energy ratings and excellent facilities on the one hand, and everything else on the other. Take-up of the new stock is still holding up reasonably well, whereas the secondary, grade B or C space is finding no takers. Office workers are, it seems, becoming very picky about where they toil, and employers are having to offer high-quality space to attract them into work. 

The other distinction that seemed to apply, at least up to the end of last year, was location. Location has always been the prime determinant of real estate value, of course, but since the Covid pandemic, it is the city center prime locations — traditionally the best places to own — that suffered the most from weak demand, whereas the previously unloved suburban locations proved more resilient. Commuting a couple of miles into the local town center seems more acceptable than an hour’s drive into the city. However, the latest reports indicate a slackening of demand for suburban centers as well, at least for conventional lettings if not for flexible space, so it may be just a delayed reaction. 

A looming loan crisis

For landlords, the fall in demand for office space is exacerbated by the fact that virtually all of the loans they took out to buy buildings will experience significant increases in cost when they come up for refinancing, because of the rise in interest rates since they were first drawn down. Many CRE loans are due to mature in the next three years with Trepp, a firm that tracks real estate trends, putting the figure at $2.2 trillion. Some have described this as a “wall” of debt maturities. 

Banks are therefore anticipating a major deterioration of credit quality on their CRE portfolios with up to a quarter of loans already classified as “criticized.” If they cannot look to an economic upturn to solve the problem this time around, what can they do? 

Some steps that have already been taken are a slowdown in new lending for CRE, and attempts to sell off existing portfolios of debt. Goldman Sachs is reported to have shrunk its CRE loan portfolio by 10% in 2023, though this still leaves it with $26 billion. For a disposal strategy to work there must of course be buyers willing to take on the loans, and the evidence so far has not been encouraging, with relatively few transactions having closed. Those portfolios that have been sold have been described as either “trophies or trash.” That is to say, high-quality buildings that are in good demand from occupiers, or those which are so awful that banks want to get rid of them, whatever the cost. 

The second step that most banks have taken is to increase loan loss reserves to provide some room to write off loans without causing capital adequacy problems. A number of U.S. banks have reported increasing reserves on CRE portfolios above 10% and this seems to be the current view in general. Increasing reserves is only feasible if a bank is profitable overall, but as commented earlier, the strong economy has made this possible. 

So, what is the outlook for banks? Will losses on CRE cause any banks to fail? What does the situation look like outside the U.S.? 

Can banks avoid collapse? 

The good news is that banks are in better shape generally today than they were the last time there was a crisis in real estate. Loan-to-Value percentages, that is to say how much of the building’s value was lent by the bank, are much lower than during the last crisis. Some of the banks at least, learnt their lesson from that time and have kept their LTV at a more conservative 60%, leaving more room for a building to lose value without causing a default. 

As already noted, the banks’ loan loss reserve position is in general better than it was, as is the banks’ deposit position, and they are less reliant than they were on funding from the capital market. This is important because customer deposits are more reliable than wholesale funding, as banks discovered in the global financial crisis.

Banks also claim to have been originating loans more carefully than they did in the first decade of this century and that, as a result, their loan portfolio is better quality than it was at that time. Even assuming this is true, if demand for space continues to fall, with occupiers not renewing, or taking less space, and landlords being unable to refinance loan maturities at prevailing higher rates, or defaulting because buildings cannot be let, the knock-on effect on banks will start to be visible by 2025 at the latest. 

Outside the U.S. the situation is similar but less acute. Taking the U.K. as the most similar European market to the U.S., vacancy rates are also rising here, but are still little more than half those in the U.S. — with the key London market reporting a vacancy rate around 12%, up from 9% a year ago. British workers have been a lot less reluctant to return to the office than Americans, perhaps because British homes are, on average, much smaller than American ones, making WFH a less attractive proposition.  

The same bifurcation between new, high-quality space and older, less efficient space is also visible in the U.K., with new, attractive buildings still finding takers relatively easily at good rents. This distinction is sharpened in the U.K. by legal requirements for energy efficiency that will mean that buildings rated below a prescribed minimum level will either require substantial remedial investment over the next few years or in the worst cases, may have to be demolished. 

According to Knight Frank, one of the U.K.’s largest realtors, lateral thinking is required for the owners of older buildings, which may include conversion of such buildings into flexible, serviced space. There are numerous examples in the City of London of older buildings, particularly early 20th century buildings, that have found a new lease of life as coworking centers and are generating good cash flow for owners and lenders. 

The world of work is in transition at present, we just don’t know exactly what it is transiting to. Some elements of the future are clear, however, and they include a strong preference among big users for new, high-quality, green space. That could spell trouble for owners of grade B space, but some help is at hand, as coworking companies are increasingly taking such buildings and repurposing them as serviced space — because another element of the future is the continued long-term growth of flexible, serviced space, where the quality of the service is as important as the space. 

As for banks, the positives are that they can see what is going to happen in CRE so it will not come as a surprise; loan loss reserves are being strengthened in anticipation and loan portfolios are said to be better quality than they were before. 

Nevertheless, it would perhaps be over-optimistic to imagine that no bank will be caught out by the change in working patterns. When the tide goes out, you can see who’s not wearing any trunks.