Earlier this year, Jerome Powell, Chair of the Federal Reserve, warned the Senate Banking Committee about the impending failure of small banks handing out commercial real estate (CRE) loans.[1] As of June 2024, outstanding CRE loans in America amount to nearly $3 trillion,[2] and about $1 trillion will become due and payable within the next two years.[3] In addition, CRE loan delinquency rates have increased significantly since 2023.[4] Roughly two-thirds of the currently outstanding CRE debt is held by small banks,[5] so business owners should be wary of the growing potential for a devastating market crash in the near future.

As lockdowns, restrictions and panic over COVID-19 gradually subsided in America near the end of 2020, the CRE market experienced a surge in demand.[6] Businesses capitalized on low interest rates and acquired properties at a greater volume than the pre-recession real estate market in 2006.[7] In many ways, businesses committed to the idea of a post-pandemic “migration” of workers from their remote positions back to the office.[8]

However, contrary to the hopes of many business owners, workers have not re-entered the office. In fact, office vacancy rates reached a record high of 13.2% in 2023.[9] Additionally, significant post-pandemic growth in the e-commerce industry has American malls reaching a record-high vacancy rate of 8.8%.[10] This decrease in demand has resulted in a decrease in CRE property values,[11] thus negatively affecting lenders’ positions via increased loan-to-value ratios (LTV). Yet, while larger banks have already begun reporting CRE loan losses, small banks have not followed suit.[12]

Because many CRE loans are structured in a way that requires interest-only payments, it is not uncommon for business owners to refinance or extend their loan maturity date to obtain a more favorable interest rate before the full principal payment becomes due.[13] Given the state of the current CRE market, however, large banks—which are subject to stricter regulations—are likely reluctant to engage in this practice. And because the typical CRE lease term ranges from about three to five years,[14] many commercial landlords are fighting against the clock to prevent delinquency or even defaulting under their loan terms.[15]

The current lack of reporting losses by small banks is not an indication that they are not at risk.[16] Rather, these institutions are likely extending CRE loan maturities with their fingers crossed, hoping that property values in the commercial sector recover in a timely manner.[17] This is a dangerous game because it carries the risk of creating insufficient capital for small banks—an effect that could lead to the destabilization of the U.S. banking system as a whole.[18]

Business owners borrowing CRE loans should act quickly to increase their liquidity in the event that they are unable to refinance or extend their loan maturity date and are forced to begin paying the principal for a property that does not produce sufficient returns. This requires business owners to work with their banks to seek a favorable solution for both parties in the event of a crisis, and if possible, diversify their assets to create a financial buffer.

Counsel for at-risk businesses should carefully review the provisions of all loan agreements, mortgages, and other documentation encumbering subject properties and keep management informed as to any terms creating elevated risks for the business as set forth therein.

While business owners should not panic, it is imperative that they begin taking preventative measures now. The survivability of their businesses may very well depend on it.

Sources:

[1] Tobias Burns, Wall Street braces for commercial real estate time bomb, The Hill: Business (Mar. 14, 2024) https://thehill.com/business/4526847-wall-street-braces-for-commercial-real-estate-timebomb/amp/.

[2] NAR, commercial real estate market insights report 4 (2024).

[3] Dana M. Peterson, U.S. Commercial Real Estate Is Heading Toward a Crisis, Harv. Bus. Rev.: Corporate Finance (July 23, 2024) https://hbr.org/2024/07/u-s-commercial-real-estate-is-headed-toward-a-crisis.

[4] Id. (CRE loan delinquency rates were .77% in 2023 and 1.18% in 2024).

[5] Id.

[6] Milton Ezrati, Covid’s Long Shadow Still Spreads Over Commercial Real Estate, Forbes: Leadership Strategy (Mar. 17, 2023) https://www.forbes.com/sites/miltonezrati/2023/03/17/covids-long-shadow-still-spreads-over-commercial-real-estate/.

[7] Scholastica Cororaton, Commercial Weekly: Commercial Real Estate Outperforms Expectations in 2021 and is Poised to Strengthen in 2022, NAR: Economist’s Outlook (Dec. 23, 2021) https://www.nar.realtor/blogs/economists-outlook/commercial-weekly-commercial-real-estate-outperforms-expectations-in-2021-and-is-poised-to.

[8] Id. (referring to the “big re-entry” as being dependent on the efficacy of the COVID-19 vaccine against different variants of the virus).

[9] Fin. stability oversight Council, Annual Report (2023).

[10] NAR, supra note 2, at 7.

[11] Peterson, supra note 3.

[12] Id.

[13] Konrad Putzier, Interest-Only Loans Helped Commercial Property Boom. Now They’re Coming Due., WSJ: Property Report (June 6, 2023) https://www.wsj.com/articles/interest-only-loans-helped-commercial-property-boom-now-theyre-coming-due-c375494.

[14] Burns, supra note 1.

[15] Id.

[16] Peterson, supra note 3.

[17] Id.

[18] Id.