Opinion: A Looming Commercial Property Crisis Exists


Rudi Dornbusch, the late MIT economist, famously observed that economic and financial crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.

Next year, Mr. Dornbusch’s warning could again prove to be prophetic as far as the commercial real estate sector and the regional banks are concerned. To be sure, four years on since 2020’s Covid pandemic upended the commercial property market, we have yet to have a full-blown financial crisis. However, next year could be the year when the commercial real estate market and the regional banks unravel at a faster pace than we thought possible.

At the heart of the commercial property sector’s woes is the fundamental change in work and shopping habits triggered by the pandemic. Companies have found that they no longer need to have their workers work full time in the office while shoppers have found the greater convenience of shopping online than at the mall.

There is every sign that there will be no reversal in these changed work and shopping habits anytime soon. Underlining this point is the fact that during the course of this year, the number of companies allowing their employees to work at least part of the week from home rose from 52% to 61%.

Not surprisingly, at the national level office vacancy rates have spiked to an all-time high of more than 13%, and in major cities like San Francisco and Houston, vacancy rates have risen to around 20%. It is expected that as leases expire next year, these vacancy rates could go even higher.

High vacancy rates have already caused commercial property prices to decline by more than 20% from their March 2022 peak level. Meanwhile, Morgan Stanley is warning that by the end of this cycle, commercial price prices could decline by 40% from their peak. That would rival the decline during the 2008-2009 Great Economic Recession.

The Fed’s pursuit over the past two years of an aggressive monetary policy to regain inflation control has added to the commercial property sector’s woes. Next year those property companies will need to roll over around $500 billion in maturing loans at very much higher interest rates than those at which those loans were contracted.

With vacancy rates so high, it is difficult to see how those companies will succeed in rolling over those loans without debt restructuring. As a sign of things to come, it has to be of concern that major commercial property companies, like Brookfield and Blackstone, are walking away from their mortgages and handing back the keys to the lenders.

All of this spells real trouble for the banking sector in general and the regional banks in particular. With as much as 18% of their loan portfolio consisting of commercial real estate loans, the regional banks can ill-afford a wave of property loan defaults.

This is especially the case at a time when these banks are still losing deposits in the wake of the Silicon Valley Bank failure and at a time when they are nursing very large mark-to-market losses on their bond portfolios as a result of the Fed-induced rise in long-term interest rates. According to a recent National Bureau of Economic Research Study, commercial real estate troubles could lead to the failure of 385 regional banks.

The importance of the regional banks for the economy cannot be overstated. Those banks are the major source of finance for the small and medium-sized companies that account for close to half of the country’s economic activity and employment. As such, a regional bank credit crunch triggered by commercial property loan defaults has the real potential to derail the economic recovery.

In 2008, the Federal Reserve was caught flat-footed by the sub-prime mortgage crisis that precipitated the Great Economic Recession despite the many early warning signs of a brewing crisis. This makes it all the more disappointing that in hewing to its high interest rate policy, the Fed is choosing to turn a blind eye to the many signs of real trouble ahead for the commercial property sector and for the regional banks.

American Enterprise Institute senior fellow Desmond Lachman was a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging-market economic strategist at Salomon Smith Barney.