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It’s been almost a year since Silicon Valley Bank blew up - with both NY Signature Bank, Credit Suisse, and First Republic Bank following right behind it.

Now, I recently touched on some of the issues potentially plaguing U.S. banks – indicating things may not be on solid footing yet (read here1).

But there’s one issue that’s really worrying. . .

And that’s the potentially ticking time bomb in the commercial real estate market – which is especially worrying for the medium and smaller banks.


Because these smaller banks – such as local and community banks – are sitting on a pile of souring commercial real estate loans.

And I expect things may be approaching a tipping point unless something changes. . .

Let’s take a closer look.

Commercial Real Estate: These Three Things Paint A Grim Picture

So, what is commercial real estate?

Putting it simply, commercial real estate (CRE) refers to properties used for business or investment purposes, rather than for personal residential use. Meaning office buildings, retail spaces, industrial properties, warehouses, multi-family (apartments), and other types of commercial properties.

Commercial real estate is typically purchased, leased, or developed to generate income through rent or resale. Investors and businesses may also use commercial real estate for their own operations, such as leasing office space for employees or storing inventory in a warehouse, etc.

·        In other words, commercial real estate is essentially used for work-related business and thus drives income from such activities.

And this is a huge market.

While estimates vary, there’s evidence from Statista2 that the U.S. commercial real estate market is worth roughly ~$25 trillion.

But after decades of surging growth fueled by low-interest rates and easy credit, commercial real estate is now hitting a brick wall.

And I believe there are three main reasons for this commercial real estate stress:

I. Higher interest rates – which tend to decrease marginal demand for expansion by businesses (less space required), eat into landlord earnings, weigh down asset prices, and also increase the cost of debt.

This is a big problem for commercial real estate as it’s a highly leveraged sector (aka debt-dependent).

Making matters worse is that – according to the Wall Street Journal3 – there’s a record amount of commercial real estate loans maturing this year – following the record-setting $541 billion in 2023.

Thus, rolling over such a massive amount of debt has become much more expensive at a time when prices keep falling.

And defaults are already beginning.

A recent working paper4 published by the National Bureau of Economic Research (NBER) believes there’s currently a 10-to-20% default rate on commercial real estate loansequivalent to between $80 and $160 billion in bank losses.

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Figure 1: December 2023

This somber discovery aligns with Morgan Stanley's earlier estimate, implying that lenders must engage in uncomfortable negotiations regarding over $1.5 trillion of their commercial real estate portfolios by the end of 2025 to prevent defaults.

II. U.S. office space vacancies – according to Moody’s Analytics5 – hit a new record high in 2023 of 19.6%.

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The trend for office demand continues fading as hybrid roles and “work-from home” plans diminish the need for office buildings.

Making matters worse, businesses are canceling leases, or simply selling marginal properties.

For instance, as we’ve seen this over the last year, companies6 from Meta and General Electric to Microsoft and Wells Fargo have downsized in big ways.

Breaking leases and selling commercial real estate will further eat away at rent margins and sink property prices (as supply overwhelms demand).

III. There has been a glut of commercial real estate built over the last few years. And there’s still a ton under construction – specifically offices.

For perspective – as of December 20237 – there’s still about 100 million square feet (M-SqFt) of office space under construction.

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And out of this, the office projects that broke ground in 2023 totaled 40.6 M-SqFt.

Making matters worse – according to data from CoStart8 in late-2022 – there was roughly 230 M-SqFt of surplus commercial real estate up for subleasing (most being offices) - which was twice the level from pre-pandemic.

I expect much of that planned construction won’t continue. But what’s already being built is a huge amount – and it’s not likely that these half-built projects will suddenly stop unless forced to (which may happen).

The issue here is that the added supply will weigh down building prices and rents further as the supply increases at a time when demand is already sinking.

Thus, taken altogether, it’s not hard to see that the commercial real estate market is growing increasingly stretched from both structural (debt and work-from-home) and cyclical (higher interest rates and overbuilding) issues.

But the big question is, “Who’s most at risk of further downside?”

Smaller Banks Are More Exposed To Commercial Real Estate – Which May Be An Issue

I think it’s clear that the downside in commercial real estate outweighs any upside in the years ahead.

And while many focus on this aspect, I’d rather look at what negative ripple effects this may cause.

Hence why I’m looking at smaller banks. . .

Now, what do I mean by smaller banks?

The U.S. government describes small banks (or rather community banks) as having assets of less than $1.384 billion in either of the last two calendar years.

Thus – according to recent data9 – that’s about 97% of all banks.

And while these ‘community’ banks hold less than about 15% of total assets in the banking system (give or take) – they’re the lifeblood in smaller and rural areas.

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So, what’s the issue here?

Well, it appears that these community banks are extremely exposed to the commercial real estate market.

To put this into perspective, commercial real estate loans as a percentage of total assets is significantly higher for smaller banks (30%) than larger ones (7%).

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More worrisome is that the acceleration in commercial real estate loans by small banks has soared over the last few years.

·         For instance, the share originated by local and regional banks has more than doubled since late 2018, to 31% from 15%.

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Other data – according to Goldman Sachs via Financial Times10 – showed that banks with less than $250 billion in assets make up about 80% of commercial real estate loans.

Thus, it’s no stretch to say that the smaller banks are disproportionately leveraged in the commercial real estate market.

But here’s where the amplifying feedback loop comes in. . .

Since commercial real estate depends on a hefty amount of financing from smaller banks, these smaller banks also depend on commercial real estate prices and incomes.

When income streams from leases and property values rise, banks will make loans (as it’s profitable and secured by increasing property prices).

But when property prices (which back the loan) fall, and incomes erode (increasing default risk) – things sour.

Banks will scale back extending new loans into the sector. And without new financing, these commercial real estate owners can’t roll over their debt.

So, they’ll sell, pushing down prices further as supply increases relative to anemic demand - reinforcing the feedback loop as banks suffer losses and tighten credit further. And on and on.

Of course, this is just one potential aspect. But something to monitor.

Wrapping it Up

The main takeaway here is that there’s a glut in the commercial real estate market – specifically in offices – that is worrying.

Making things worse is that most of the commercial real estate loans must be rolled over in the next year or two (refinanced).

Assuming the Federal Reserve does cut interest rates three times this year, that’s still a high cost of refinancing such a large amount of debt that’s seeing underlying values decline – which is a dangerous combination.

No wonder banks are already expecting 10-to-20% default rates for commercial real estate loans. . .

Yet don’t forget, the smaller banks are more exposed to any crisis in commercial real estate.

Further, it’s important to remember that banks are black boxes – aka something with internals that are usually hidden or mysterious to onlookers.

Even the best analysts may not really know what bank loan books are really worth.

But one thing seems clear, the commercial real estate sector is growing more and more fragile.

And with it, so are the smaller banks that extended credit to them.

The black swans are lurking.













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