An upcoming commercial real estate crisis could negatively affect the US economy in a way not seen since the real estate collapse of 2008. Workers aren’t returning to their offices at anywhere near pre-pandemic levels, leaving building owners and banks up against a looming default crisis.
That drag could in turn slow the entire US economy, bringing financial pain to a broad swath of the country. Preventing that may require a bolder national solution – possibly for policymakers to find a way to allow banks to take their commercial real estate assets off their books without penalty.
That would mirror the approach the US government took in creating the Resolution Trust Corporation of the 1980s, which unwound the savings and loan crisis. It was a messy process, but it worked. Something similar, targeted to commercial real estate, is needed now.
Most bank lenders have been operating under an “extend and pretend” strategy, holding onto commercial real estate loans they don’t want in hopes the market will turn around. That might work in a cyclical situation, but the current market isn’t likely to turn around anytime soon. There’s just too much excess real estate.
It’s a ticking time bomb for banks and commercial real estate companies nationwide — FDIC-regulated banks hold some 80% of U.S office-building mortgages — and it’s going to take a major effort to defuse the situation. Some $270 billion of these loans are set to expire this year.
Current regulations don’t allow devalued real estate to work its way through the system without penalizing the banks that hold the mortgages.
Bank regulators could help by lowering the level of reserves banks have to hold against assets while those assets are going through the foreclosure process. The Federal Reserve could help by adding liquidity to the banking system to give banks more room to maneuver. Lawmakers could help by creating a tax incentive program to encourage commercial real estate owners to repurpose their buildings.
Some landlords are still covering their bills, at least paying common-area and maintenance charges if not their full mortgages. That’s allowed commercial buildings to limp along, but it’s not a permanent solution. Soon, the banks are going to have to call the loans, whether they like it or not.
There’s so much excess commercial real estate out there that lenders can’t sell it. They will have to reserve capital against their bad assets and eventually write down those bad loans — and that won’t look good to regulators.
The current crisis is more narrowly focused than the 2008 residential mortgage meltdown, in that it involves real assets rather than derivatives. But it has the potential to be just as bad for banks, and their shareholders, if regulators don’t give them a way out.
Commercial real estate loan originations were down 42% year over year in the fourth quarter of 2022, and by the first quarter of 2023, they had dropped by 56%. And the numbers for the current quarter are likely to be even worse.
Regional and local banks, already reeling from shocks like the collapse of Silicon Valley Bank, stand to be the hardest hit among lenders. Some insurance companies are exposed to commercial real estate, but they tend to invest in the type of Class A, urban office buildings that house the investment banks and consulting firms that are bringing workers back to the office. They’re better prepared to weather the storm than a regional or community bank or a credit union.
So far, there’s been no sense of urgency for a large-scale solution. But if Congress, state legislatures, and banking regulators do nothing, mortgage defaults could trigger bankruptcies. Property taxes won’t get paid, hurting state and municipal budgets. Commercial and residential real estate values will plunge, hurting just about every city in the United States.
And there’s the added wrinkle of a potential banking crisis as banks write down large numbers of defaulted mortgages.
There are some creative solutions taking hold around the country. Some developers are repurposing office buildings into living spaces. A tax credit program that would absorb some of the costs of adapting the infrastructure could encourage more of this, potentially averting a crisis.
An RTC-like program seems daunting in the current political climate, but it may be the only way out. There’s a crisis brewing, and it’s going to affect all of us if someone doesn’t step up with a broad-based solution.
