In its 2023 annual report, the Financial Stability Oversight Council — a legacy of the Dodd-Frank Act that includes a broad array of federal banking regulators and others — pointed to multiple financial risks for the U.S. First on the list, commercial real estate.
At the top of the CRE section, $6 trillion in loans as of 2023 Q2, with half sitting on the balance sheets of banks, because these don’t get sold off to government agencies the way residential mortgages do. CRE loans are also the largest loan category for almost a half of all U.S. banks.
The concentration makes for a systemic weakness, especially as “the CRE market faced a rise in vacancy rates and declines in value for some property types, elevated interest rates, heightened CRE loan maturities, inflation in property operating costs, and an increase in CRE loan delinquencies.”
None of this should be a surprise to anyone who has been monitoring the market.
The agency’s concern is the one many in CRE have expressed.
“High interest rates increase refinancing costs for borrowers and can lead to decreasing property values across CRE sectors,” the report said. “If the decline in property value is significant relative to the time of financing, then the borrower may not be qualified to refinance the loan at maturity without an additional injection of equity. Thus, the loan may need to be restructured or entered into default, causing losses for the lender. As losses from a CRE loan portfolio accumulate, they can spill over into the broader financial system.”
That can cause banks to dump loans and properties, driving down values further and creating a vicious circle and also tightening credit availability. There are already signs of loan distress, with the delinquency rate for banks up 0.74 percent in the second quarter of 2022. CMBS delinquencies are also up.
Another concern is that bank stress could spread through interlinkages among banks, insurance companies, REITs, and private lenders.
The FSOC has some recommendations, that “supervisors, financial institutions, and investors continue to closely monitor CRE exposures and concentrations, and to track market conditions.”
The suggestions include ongoing evaluation of loan portfolios’ “resilience to potential stress, ensure adequate credit loss allowances, assess CRE underwriting standards, and review contingency planning for a possibly protracted period of rising loan delinquencies.”