Opinion | For banks, commercial property is a risk — and an opportunity

Policymakers should act now to soften the blow.

The numbers are alarming. The transition to remote or hybrid working has seen office lease revenue fall 19 percent since the start of covid, while vacancy rates are hitting all-time highs. Our research suggests that the value of office buildings in New York City may have already fallen by 40 to 45 percent, and other cities will be hit even harder. Nationwide, we project a decrease of $500 billion in the overall value of commercial office buildings.

The dire situation extends beyond offices. Urban retail has also been hit hard by the absence of downtown workers, and the acceleration of e-commerce has brought forward the existential crisis confronting many brick-and-mortar outlets.

Higher interest rates are compounding these issues. As much as $2.56 trillion in commercial property debt must be refinanced between now and 2027, and cracks in the edifice are beginning to appear, with delinquency rates on commercial mortgages rising. Trepp, a commercial property data analytics firm, reported that about 5.4 percent of office loans were in special servicing — meaning the loan payments are 60 days late — as of April. This number was about 3.4 percent just a year ago.

To make matters worse, this seismic shift has happened against a challenging background. In particular, many commercial property owners are struggling to meet the costs of regulation that demands expensive capital investment to hasten the green transition, since buildings account for up to 60 percent of carbon emissions in urban areas.

It all adds up to rising costs and falling revenue for many commercial properties around the country. And that is an especially grave development for regional banks that are overly exposed to the commercial real estate sector. The Federal Reserve Board’s Financial Stability Report for May shows that smaller and regional banks are estimated to hold more than 50 percent of all commercial real estate loans outstanding, including more than $600 billion in office and downtown retail commercial property. At some banks, commercial property portfolios are more than 100 percent of equity capital.

Declining property valuations will weigh heavily on these banks, which will lead them to tighten lending standards and pull back from the sector. What follows will be a vicious downward spiral, with banks cutting off credit to property owners, who are forced to turn the keys over to the banks, who then sell off those real estate assets at fire-sale prices. The implications will not be limited to the property sector, as many small and medium-size companies rely on funding from those same small and medium-size banks.

We have seen this movie before. Between 1980 and 1994, more than 1,000 banks failed from a combination of higher interest rates and distress in the commercial property market. In 2008, the subprime mortgage crisis also resulted in the collapse of several major financial institutions. It took five years to nurse bank balance sheets back to some kind of health.

The ideal response both gets ahead of the crisis and makes use of the opportunities it presents. Policymakers could encourage debt modification, through regulatory forbearance and subsidies, to soften the blow to bank equity and avert a full-blown crisis. However, this carries the risk of encouraging “zombie” lending, in which nonviable property projects lurch forward — with the help of the taxpayer.

Alternatively, letting the commercial real estate market correct itself might accelerate the transition to more efficient uses of real estate space. But this approach could exacerbate fire sales and bank distress, resulting in a credit crunch and a more severe and prolonged downturn.

Instead, a wiser use of taxpayer money would be targeting subsidies to properties that have a bright future once repositioned. Clever uses of taxes, zoning and building code regulations would help transition properties into more useful buildings. Additional federal funds, already appropriated under the Inflation Reduction Act, could also be used to encourage the conversion of brown offices to green apartments.

Such programs would pay for themselves if they averted a downward spiral of bank insolvency and lower commercial property prices, and helped local governments recover property tax revenue sooner, thereby short-circuiting the urban doom loop.