‘Zombie offices’ causing problems for some banks

The graceful Art Deco buildings dominating Chicago’s main business district boast occupancy rates as low as 17 percent.

A collection of gleaming office towers in Denver that were full of tenants and worth $176 million in 2013 are now largely empty and were last valued at just $82 million, according to data provided by Trepp, a research company that tracks home loans. Even famous Los Angeles buildings are back to about half of what they were before the pandemic prices.

From San Francisco to Washington, DC, the story is the same. Office buildings remain stuck in a slowly spreading crisis. Employees sent to work from home at the start of the pandemic have not fully returned, a situation that, combined with high interest rates, is wiping out the value of a large category of commercial real estate. Prices for prime office buildings have fallen 35% from their peak in early 2022, according to data from Green Street, a real estate analytics firm.

These forces have put the banks that hold much of America’s commercial real estate debt in the hot seat — and analysts and even regulators have said the balance sheet is not yet fully addressed. The question is not whether big losses are coming. It’s a question of whether it will be a slow bleed or a panic-inducing wave.

Last week gave a taste of the trouble brewing when shares of New York Community Bank plunged after the lender revealed unexpected losses on real estate loans tied to office and apartment buildings .

So far, “the headlines have moved faster than the actual stress,” said Lonnie Hendry, product manager at Trepp. “Banks are sitting on a pile of unrealized losses. If this slow leak is revealed, it could be released very quickly.

When a series of banks failed last spring – in part because rising interest rates had reduced the value of their assets – analysts feared that commercial real estate would trigger a deeper set of problems. wide.

Banks hold about $1.4 trillion of the $2.6 trillion in commercial real estate loans that will mature over the next five years, according to Trepp data, and smaller regional lenders are particularly active on the market.

Economists and regulators feared that heavy exposure to this seemingly risky sector could scare bank depositors, particularly those whose savings exceed the $250,000 government insurance limit, into withdrawing. their funds.

But government officials responded forcefully to the upheaval of 2023. They helped liquidate failed institutions and the Federal Reserve established a cheap bank financing option. These measures have restored confidence and the nervousness of the banks has disappeared.

That has changed in recent days with the problems at New York Community Bank. Some analysts consider this to be an isolated phenomenon. New York Community Bank absorbed the bankrupt Signature Bank last spring, accelerating its difficulties. And so far, depositors are not withdrawing their money from banks in large numbers.

But others see the bank’s plight as a reminder that many lenders will suffer, even if it doesn’t cause system-wide panic. The government’s reprieve from the banking system last year was temporary: the Fed’s financing program is about to stop next month, for example. Commercial real estate problems persist.

Commercial real estate is a broad asset class that includes retail, multi-family housing, and manufacturing. The sector as a whole has had a tumultuous few years, with office buildings particularly hard hit.

About 14 percent of all commercial real estate loans and 44 percent of office loans are undervalued – meaning the properties are worth less than the debt behind them – according to a recent article from the National Bureau of Economic Research by Erica Xuewei Jiang of the University of Southern California, Tomasz Piskorski of Columbia Business School, and two colleagues.

While big lenders like JPMorgan Chase and Bank of America have started setting aside money to cover expected losses, analysts say, many small and mid-sized banks are downplaying the potential cost.

Some offices are still officially occupied, even with few workers — what Mr. Hendry called “zombies” — thanks to multi-year leases. This allows them to appear viable when they are not.

In other cases, banks are resorting to short-term extensions rather than taking over distressed buildings or renewing leases that are no longer feasible – hoping that interest rates will fall, helping to increase property values. properties, and that workers will return.

“If they can extend this loan and keep it performing, they can postpone the day of reckoning,” said Harold Bordwin, principal at Keen-Summit Capital Partners, a troubled real estate brokerage.

Delinquency rates reported by banks remained much lowerat a little more than 1 percent, than those of the commercial real estate loans that negotiate in the markets, which exceed 6 percent. It’s a sign that lenders have been slow to recognize the stress in the construction sector, said Mr. Piskorski, the Columbia economist.

But hopes of a recovery in office real estate seem less realistic.

Return-to-office trends have stalled. And although the Fed has indicated that it does not plan to raise interest rates above their current level of 5.25 to 5.5 percent, officials have made clear that they are not in a hurry to reduce them.

Mr Hendry expects delinquencies could almost double from their current rate to between 10 and 12 per cent by the end of this year. And as the accounts move forward, hundreds of small and medium-sized banks could be at risk.

The value of bank assets has been hurt by the Fed’s rate hike, Mr. Piskorski and Ms. Jiang found in their paper, meaning that rising commercial real estate losses could leave many institutions in poor financial condition. situation.

If this were to undermine uninsured depositors and cause the type of bank run that brought down banks last March, many could slide into outright bankruptcy.

“It’s a confidence game, and commercial real estate could be the trigger,” Mr. Piskorski said.

Their article estimates that dozens, if not more than 300 banks, could face such a disaster. That might not be a big blow in a country with 4,800 banks, partly because small and medium-sized lenders are not as connected to the rest of the financial system as their larger counterparts. But a rapid collapse would risk causing wider panic.

“There is a scenario where it spills over,” Mr. Piskorski said. “The most likely scenario is slow bleeding.”

Officials at the Fed and Treasury Department have made clear they are closely monitoring the banking industry and the commercial real estate market.

“Commercial real estate is an area that we have long been aware could create risks to financial stability or losses in the banking system, and this is something that requires careful supervisory attention,” Treasury Secretary Janet L. Yellen said in congressional testimony this week.

Jerome H. Powell, the Fed Chairman, acknowledged during a “60 Minutes” interview broadcast Sunday that “there will be losses.” For big banks, Mr. Powell said, the risk is manageable. As for regional banks, he said the Fed is working with them to deal with the expected consequences and that some are expected to close or merge.

“This looks like a problem we will be working on for years,” Mr. Powell admitted. He called the problem “significant” but said “it does not appear to have the characteristics of the kind of crises we have sometimes seen in the past, for example with the global financial crisis.”

Alan Rappport reports contributed.