Dive Brief:

• Top U.S. regulators flagged the commercial real estate market as a leading risk to financial stability in 2024, noting rising vacancy rates, declining values of office properties, high interest rates and the possibility of an economic slowdown.
• “CRE is the largest loan category among almost one-half of U.S. banks, and more than one-quarter of U.S. banks have CRE loan portfolios that are large relative to the capital they hold,” the Financial Stability Oversight Council said in its annual report.
• “The office sector faces the most severe challenges because demand for office space has been weak, particularly in the largest U.S. markets,” FSOC said in a report released Thursday.

Dive Insight:

The work-from-home trend and a surge in borrowing costs since early last year has sideswiped the commercial real estate market, creating vulnerabilities at many banks and other financial institutions.

Banks during the second quarter held $6 trillion in commercial real estate loans, or about half of the total, FSOC said. The delinquency rate on CRE loans held by U.S. banks, although “modest,” rose to 0.81% in the second quarter from 0.74% the prior year, FSOC said.

Three out of four analysts at financial services firms ranked real estate as the top threat to financial stability, tied with inflation and a jump from fourth place in May, the Federal Reserve said in its quarterly Financial Stability Report published in October.

“Signs of stress emerged in 2023, and the market outlook is challenging,” FSOC said, referring to the CRE market. “In many major U.S. cities, the office vacancy rate is at a multiyear high as the shift toward hybrid work arrangements in many industries following the COVID-19 pandemic reduced demand for office space.”

The collapse in demand for office space has proven especially severe in the largest U.S. cities, according to FSOC, which includes top regulatory officials from the Fed, U.S. Treasury, the Securities and Exchange Commission and other agencies. In the largest 20 markets the vacancy rate rose to 14.2% in the second quarter from 13.2% in Q2 2022.

“The decline in property demand may take time to stabilize as tenants navigate remote-work decisions and adjust how much space they need,” the council said. “A slow return to densely populated urban office centers could reduce the desirability of office properties located there and even nearby retail space.”

The yield on the benchmark 10-year Treasury note underscores the coming challenge many owners of commercial property may face as they seek to refinance loans in 2024.

During the past three years, the yield has increased to roughly 4% from 1% as the Fed hiked the federal funds rate from near zero to a range between 5.25% and 5.5% in its most aggressive fight against inflation in four decades.

“Elevated interest rates, high costs and potential structural changes in demand for CRE have heightened concerns about CRE,” FSOC said. “Maturing loans and expiring leases amid weak demand for office space have the potential to strain office sector conditions further, which could cause stress to spread beyond this segment of the CRE market.”