‘Zombie offices’ spell trouble for some banks

‘Zombie offices’ spell trouble for some banks

Beautiful Art Deco buildings towering over Chicago’s main business district are reporting occupancy rates as low as 17 percent.

A cluster of gleaming Denver office towers that were filled with $176 million worth of tenants in 2013 is now largely empty and was last appraised at just $82 million, according to data provided by Tripp, a research firm that tracks real estate loans. Even iconic buildings in Los Angeles are achieving nearly half their pre-pandemic prices.

From San Francisco to Washington, D.C., the story is the same. Office buildings remain stuck in a slow-burning crisis. Employees sent to work from home at the start of the pandemic have not fully returned, a situation that, coupled with high interest rates, is wiping out value in a key class of commercial real estate. Prices for high-quality office properties have fallen 35% since their peak in early 2022, based on data from Green Street, a real estate analytics firm.

These forces have put banks that hold a large portion of U.S. commercial real estate debt in a hot spot — and analysts and even regulators have said the account has not yet fully taken root. The question is not whether big losses are coming or not. Rather, it is whether it will prove to be a slow bleed or a panic-inducing wave.

Last week brought a taste of brewing trouble when New York Community Bank stock fell after the lender disclosed unexpected losses on mortgages associated with both office buildings and apartments.

So far, “the headlines have moved faster than the actual pressure,” said Lonnie Hendry, chief product officer at Trepp. “Banks are sitting on a bunch of unrealized losses. If this slow leak is detected, it could be triggered very quickly.

When a series of banks failed last spring — in part because rising interest rates reduced the value of their assets — analysts expressed concern that commercial real estate could lead to a wide range of problems.

Banks hold about $1.4 trillion of the $2.6 trillion in commercial real estate loans scheduled to mature over the next five years, based on data from Tripp, and small and regional lenders are particularly active in the market.

Economists and regulators fear that heavy exposure to the seemingly risky industry could scare away bank depositors, especially those with savings exceeding the $250,000 government insurance limit, into withdrawing their money.

But government officials responded aggressively to the turmoil of 2023. They helped sell off failing institutions, and the Fed created a cheap bank financing option. These measures restored confidence, and banking concerns faded from view.

That has changed in recent days with problems at Community Bank of New York. Some analysts dismiss this as a one-time event. The Community Bank of New York absorbed failed Signature Bank last spring, accelerating its problems. 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 are in pain, even if it doesn’t spark system-wide panic. The moratorium the government gave to the banking system last year was temporary: the Fed’s financing program, for example, is scheduled to close next month. Commercial real estate problems are permanent.

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

About 14% of all commercial real estate loans and 44% of office loans are in default — meaning the properties are worth less than the debt behind them — according to a recent National Bureau of Economic Research article by Erica Xujiang of the University of California. Southern California, Thomas Piskorski of Columbia Business School and two colleagues.

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

Some offices remain officially occupied even with a handful of workers — or what Mr. Hendry called “zombies” — thanks to lease terms that extend for years. This allows them to appear viable when they are not.

In other cases, banks are using short-term extensions rather than seizing distressed buildings or renewing now-unenforceable leases — hoping that interest rates will fall, which would help raise property values, and that workers will return.

“If they can extend this loan and maintain its performance, they can postpone the day of reckoning,” said Harold Bordwin, a principal at Ken Summit Capital Partners, a distressed real estate brokerage.

Delinquency rates reported by banks remained much lower, at just over 1 percent, compared to those for over-the-counter commercial real estate loans, which are more than 6 percent. That’s a sign that lenders have been slow to acknowledge mounting pressures, said Mr. Pikorski, the Columbia University economist.

But hopes for a turnaround in office real estate appear less realistic.

The back-to-office trend has stalled. While the Fed has indicated that it does not expect to raise interest rates above their current level of 5.25% to 5.5%, officials have been clear that they are in no rush to lower them.

Mr. Hendry expects delinquencies could nearly double from their current rate to between 10 and 12 percent by the end of this year. As the reckoning continues, hundreds of small and medium-sized banks may be at risk.

The value of banks’ assets has taken a hit amid rising federal interest rates, Mr. Piskorski and Ms. Jiang found in their research, meaning rising commercial real estate losses could leave many institutions in poor shape.

If that were to spook uninsured depositors and lead to a bank run of the kind that toppled the banks last March, many of them could be doomed to total failure.

“It’s a confidence game, and commercial real estate could be the driver of that,” Mr. Pikorski said.

Their paper estimates that dozens to more than 300 banks could face such a disaster. That may not be a crushing blow in a country with 4,800 banks — especially since small and medium-sized lenders aren’t as connected to the rest of the financial system as their larger counterparts. But a rapid collapse would threaten a broader panic.

“There is a scenario where it extends,” Mr. Pikorski said. “The most likely scenario is slow bleeding.”

Officials at the Federal Reserve and the Treasury Department have made clear that they are closely monitoring both the banking sector and the commercial real estate market.

Treasury Secretary Janet L. “Commercial real estate is an area that we have long recognized can create financial stability risks or losses in the banking system, and this is a matter that requires careful supervisory attention,” Yellen said during her testimony to Congress this week.

“There will be losses,” Federal Reserve Chairman Jerome Powell admitted during an interview on “60 Minutes” that aired on Sunday. For big banks, the risks are manageable, Powell said. When it comes to regional banks, he said the Fed is working with them to deal with the expected fallout, and that some will need to close or merge.

“It feels like a problem we’ll be working on for years,” Mr. Powell admitted. He described the problem as “major,” but said, “It does not seem to have the elements of crises that we have seen at times in the past, for example, with the global financial crisis.”

Alan Rapaport Contributed to reports.

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