LegiStorm

Summary:

Relatively high interest rates and increased telework opportunities have had significant effects on the commercial real estate (CRE) sector, specifically office buildings. High inflation in the years following the onset of the COVID-19 pandemic resulted in the Federal Reserve (Fed) increasing interest rates in 2022 and 2023. The pandemic itself resulted in a structural shift in where employees work, with significant increases in telework. Higher interest rates are likely to affect industries that rely heavily on borrowing, such as CRE. CRE contributes notably to U.S. economic activity, and banks are major lenders, providing nearly $3 trillion in financing to the sector. Further, tighter credit conditions can affect the ability of builders to obtain financing for new construction, which can in turn reduce CRE growth and, all else equal, increase rents for occupants. Due to the convergence of this new labor market landscape and other economic pressures, including higher interest rates, many companies that would typically rent space from the office subsector of CRE owners are not renewing their leases. This is evidenced by higher office vacancy rates, which continued to rise throughout 2023 and 2024. According to the Fed, banks are reporting weaker demand and tighter loan conditions for all CRE categories. If these trends continue, individuals and institutions that finance CRE face greater risk exposure to losses resulting from loan delinquencies and defaults. Much of this exposure lies within the banking sector. CRE lending often comprises a substantial share of banks’ loan portfolios, especially among small and medium-size banks. Furthermore, the majority of the lossabsorbing capital held by many small banks is apportioned for losses generated by their CRE portfolios. Therefore, regional downturns in subsectors of CRE markets risks local or regional banking stress. Other banks have exposure to potential CRE losses through commercial mortgage-backed security holdings, which may materialize losses if borrowers default or if banks have to sell their holdings at a discount due to higher interest rate environments (in the event of a liquidity shortage). Bank regulators have identified CRE as a key risk to financial stability, particularly within the office subsector. Further, CRS, using proxies for bank supervisory metrics, calculated that nearly a third of banks have significant exposures to CRE lending portfolios. The banking agencies have issued guidance in recent years to the banking industry about supervisory expectations pertaining to CRE exposures. Further, the Fed included CRE loss scenarios in its most recent stress test and found that significant stress could lead to around $80 billion in losses for the banking industry. While this type of stress alone is unlikely to drive a widespread financial crisis, it could lead to solvency or liquidity issues among smaller, regional banks. Regulators have also begun to consider whether and how the existing capital framework can or should address additional risk in the CRE market. Congress has held numerous hearings on the health of the banking system and on oversight of bank supervision, particularly in the wake of the regional banking crisis of 2023. There has been considerable legislative debate about how and whether to adjust the way banking agencies are adjudicating risk in the banking system, capital requirements, and incentives among bank executives for taking on certain exposures. While these debates are generally applicable to any risk a bank may take, CRE is a possible area of risk that has potential to materialize losses in the next year, and so it may be a suitable test case for the ongoing policy discussions around risk management.