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Faculty Viewpoints

Is Commercial Real Estate in for a Downturn…or a Crisis?

Between higher interest rates and workers’ slow return to offices, the commercial real estate sector is facing a painful downturn. Normally such a slide wouldn’t create a threat to the financial system, but Yale SOM’s Andrew Metrick sketches a plausible nightmare scenario showing why this time might be different.

An empty ground-floor commercial space, seen through a window.

An empty commercial space in San Francisco in October 2022.

Justin Sullivan/Getty Images

“We’ve had a change, perhaps a permanent change, in the usage of space,” said Yale SOM’s Andrew Metrick. Swipe card data show about half as many people coming into offices as pre-pandemic. “There ain’t no way we’re going to keep the same amount of commercial real estate if that stays steady,” he explained, adding that estimates have office building valuations down about 30%.

Compared with home mortgages, commercial loans have much shorter duration and typically end with a balloon payment for the remaining value of the property. Few owners can afford to pay off the full value, so refinancing is the norm. In the next four years, roughly two thirds of the commercial office real estate will need to be refinanced. When lower valuations meet significantly higher interest rates, “the math isn’t going to work,” Metrick warned. There will be losses all around.

“It’s going to be a very difficult environment to be getting loans from the institutions that typically give these loans. That’s the bottom line,” Metrick, the Janet L. Yellen Professor of Finance and Management and director of the Yale Program on Financial Stability, said in a talk at the Yale Alumni Real Estate Association Conference on October 27.

Historically, for every one percentage point increase in the policy rate from the Fed, banks take 1% hits to their capital. If banks lose 5% of their capital, there are going to be a lot of banks in trouble.

One reason it will be so challenging is the collapse of Silicon Valley Bank in early 2023. While SVB was a consumer-focused bank, the rapid rise in interest rates that was a key piece of its failure has also put other smaller banks under stress. “Everybody started running towards the largest banks when they got nervous about Silicon Valley Bank.”

The smaller banks had to either endure outflows as customers left or increase the interest they pay to depositors. “They’re facing pressure on their ability to earn, and they’ve been hit on the asset side,” Metrick said.

With the failures of Signature Bank and First Republic Bank following Silicon Valley Bank’s collapse, according to all the technical definitions, we had a banking crisis in 2023. It wasn’t terrible as crises go, but “it happened outside of a recession, which is really, really rare,” Metrick said. The driver wasn’t banks’ credit losses, but the runup in interest rates as the Federal Reserve tried to end inflation. “In the United States, we’ve never had interest rates go from zero to 5%,” he added. “We’ve had larger increases in interest rates, but they were starting with a higher base.”

“Historically, for every one percentage point increase in the policy rate from the Fed, banks take 1% hits to their capital over the next eight quarters,” Metrick said. That’s a tradeoff policy makers are willing to make to cool the economy, but “if banks lose 5% of their capital, there are going to be a lot of banks in trouble,” he warned.

Awareness of the past pattern has banks nervous. As a result, they will be cautious lending to the owners of commercial real estate while interest rates stay high and, Metrick explained, “we have this structural adjustment that we pretty much know is coming.”

The situation is exacerbated by the fact that it’s not big banks but regional and community banks that dominate commercial real estate. “The banking system has about $3 trillion of commercial real estate on balance sheet,” Metrick noted. “Roughly two thirds of that is held outside of the largest 25 banks.”

Again in contrast to residential loans, which are packaged and resold to investors, a significant part of commercial loans generally remain on banks’ balance sheets. Thus far, the loans largely continue to perform because they still have very low interest rates. And the drop in the valuation of the properties remains hypothetical.

That potentially leaves room for a promising path forward. “If we manage to avoid a recession and get a soft landing, the banks will recover,” Metrick said. “Past commercial real estate downturns have been slow moving things,” he explained. “We spent 10 years after the global financial crisis working out a whole lot of problems.” Because they take a long time and are spread over thousands of banks, “it’s not the kind of thing that gives us a Lehman moment where all of a sudden it makes the system overall collapse.”

On the other hand, Metrick said, “I study financial crises, so I try to think, ‘What are the things that can go wrong?’”

In this case, he worries about not sticking the soft landing. “What happens if we actually get a recession and cyclical bad stuff starts to happen to bank balance sheets?” Metrick asked. “That’s the real concern.” He believes the likelihood of a recession has been falling but added, “we’re certainly not out of the woods. There are plenty of people staring at the recession indicators saying, ‘We still think it’s going to happen.’”

If it does, the painful but slow processing of commercial real estate losses could quickly turn urgent. “That would make it really bad,” Metrick said.

A rule implemented since the last downturn could be a trigger. It used to be that a bank didn’t adjust the expected value of a loan on its balance sheet as long as payments were coming in on time. But, in 2016, the Financial Accounting Standards Board implemented Current Expected Capital Losses (CECL), a new accounting standard for how banks set aside reserves for expected losses from existing loans.

“Think about all the commercial real estate loans that are approaching the time when they need to be refinanced,” he said. They are paying 1%. Current rates are closer to 7%. And the value of the building is down significantly. In many of those cases, the question will be how the losses will be divided. “With the new rule, banks are supposed to take seriously what they think the probability is of something paying off in the future, even if it’s current,” Metrick said. However, banks haven’t done significant provisioning for losses under CECL.

What looked like a slow-moving downturn suddenly crystallizes as an expected value disaster that everybody has to put in their balance sheets at the same time.

“My nightmare scenario is the following,” Metrick said. “This whole thing is governed by the accountants, not by the regulators, so just imagine for a moment when the Silicon Valley Bank of commercial real estate fails all of a sudden. Immediately after that, we have congressional investigations.”

The investigations find that the bank hadn’t set aside sufficient reserves for the losses from commercial loans and hadn’t warned shareholders. As a result, Metrick said, “That next quarter, every accountant in the world is going to tell their banks, ‘I’m not going to be the one blamed if you fail.’ They’re going to get very tough on CECL, and what looked like a slow-moving downturn suddenly crystallizes as an expected value disaster that everybody has to put in their balance sheets at the same time.”

Suddenly 500 banks are insolvent on paper. “That is the nightmare scenario. We are at risk of it happening as long as interest rates stay high,” Metrick cautioned. Absent the added pressure of a recession, the slow working out of the issues remains the likely scenario, but Metrick concluded, “Not to leave you super scared, but you should be a little scared because I’m a little scared.”

Department: Faculty Viewpoints