US banks confront challenges in shifting commercial real estate dynamics

The global commercial real estate (CRE) market is navigating turbulent waters, with US banks at the forefront of challenges stemming from a combination of economic shifts. The International Monetary Fund (IMF) recently expressed its concerns, highlighting an 11% decline in commercial property prices in the US since the Federal Reserve (Fed) began raising interest rates in March 2022. The IMF described the fall as “striking,” and notes that it surpasses previous episodes in terms of severity.

A number of factors work together to create the disquiet in the US CRE market. A key catalyst is the Fed raising interest rates from near zero to around 5%. It raised interest rates 11 times from March 2022 until December 2023. This rapid increase has led to a corresponding surge in mortgage rates and interest on mortgage-backed securities, placing added pressure on building owners who borrowed money to finance their properties.

The pandemic-induced shift towards remote and hybrid work also decreased the demand for office spaces, exacerbating the strain on the CRE market. As many companies downsize their office spaces, if not forego them entirely, foot traffic is reduced in key retail activity areas. This, in turn, placed additional strain on businesses struggling to pay rent or fulfill loan obligations as profits fell. This creates a dangerous feedback loop that spawns more vacancies in the CRE market, reinforcing the problem.

In response, US banks are grappling with the consequences within their portfolios. The IMF anticipates that soured CRE loans will continue to rise for at least a year, leading to subsequent charge-offs.

Bank of America (BoA) reported an increase in non-performing loans, reaching nearly $5 billion in the third quarter, predominantly due to challenges within its CRE portfolio.

In third-quarter earnings releases, major banks, including Morgan Stanley and BoA, have recorded increased provisions for credit losses. Morgan Stanley set aside $134 million for credit losses, attributing it to “deteriorating conditions in the commercial real estate sector”. This trend reflects a concerted effort by banks to brace for the anticipated wave of defaults.

Goldman Sachs, another US banking giant, disclosed a significant reduction in its exposure to office-related CRE holdings by approximately 50% in the current year. The move signals the recognition of the prevailing climate in the sector, and a proactive stance to mitigate potential risks.

Wells Fargo witnessed an increase in net charge-offs on its CRE portfolio in the third quarter, reporting $93 million in net CRE loan charge-offs, reflecting the strain on its commercial real estate holdings. Its allowance for credit losses witnessed a significant increase of $333 million in the third quarter.

PNC, another regional banking heavyweight, reported a substantial increase in its non-performing CRE loan balance in the third quarter. The balance more than doubled to $723 million from $350 million in the second quarter.

While larger banks strategically position themselves to weather the storm, the landscape is different for smaller regional banks. According to research from JPMorgan and Citigroup, smaller regional banks are almost five times more exposed to CRE loans than larger counterparts. The lack of business diversity compounds the vulnerability of small banks, leaving them susceptible to the ripple effects of a potential CRE downturn.

‘New normal’ work culture

According to Harvard Business Review, the number of companies offering hybrid and remote work options is expected to increase in the coming years. The reduction in commuting time and expenses has made remote work an attractive option for both employers and employees. Furthermore, the development of technology has bridged issues in communication and collaboration despite not being in the same workspace.

Many companies that were established in the midst of the pandemic have also embraced remote work as a standard, unencumbered by traditional office structures.

Employee preference also plays a pivotal role in driving the remote work revolution. According to studies, employees value remote work highly and consider their savings on commutes to and from work a ‘pay raise’. This sentiment is reflected in decreased turnover rates among companies offering remote work options.

Decline in working-age population

Since 2010, the US has witnessed a 34% increase in the population aged 65 and older, representing a significant rise of approximately 13.8 million individuals, while the population aged 14 and under has observed a contraction. This demographic transformation is not merely a statistical blip but signals a societal change with far-reaching implications for various sectors.

The past decade has also seen an imbalance between the working-age population and the non-working-age population aged 0 to 14, and 65 and older. Contrary to historical trends, growth in the non-working-age population has surpassed that of the working-age population.

This is a trend that can be observed in many parts of the world—Europe in general, China, Japan, South Korea, Singapore, and many other major economies are currently dealing with ageing populations.

The decline in the working-age population will continue to put a strain on the future of commercial real estate, along with the increasing preference for online-based activities.