FAU Experts: Commercial Real Estate Exposures Could Lead to Bank Failures

Sinking demand for office space in the commercial real estate market could lead to bank failures in parts of the country, according to two finance experts at Florida Atlantic University.

The combination of rising interest rates, high office vacancies due to remote work, as well as lowering returns on investment in these buildings has exposed vulnerabilities in the banking system as hundreds of billions of dollars in commercial real estate loans are coming due.

“The demand for office space has fundamentally shifted downward. During the pandemic, people began to work from home instead of heading into the office. Now, four years later, that is still the case,” said Rebel A. Cole, Ph.D., Lynn Eminent Scholar Chaired Professor of Finance in FAU’s College of Business. “It’s a problem for the banking system as there are a lot of banks that have extensive exposure to risk.”

Among banks of any size, 1,522 out of 4,641 banks in the United States have total commercial real estate exposures (amount of CRE relative to amount of equity capital) greater than 300 percent; 732 have exposures greater than 400 percent; 320 have exposures greater than 500 percent; and 113 have exposures greater than 600 percent; according to Cole’s analysis of the most recently available bank regulatory data for Q4 2023.

“Inflation hasn’t cooled as fast as the Fed has hoped, which should lead to a more hawkish Fed,” said Ken H. Johnson, Ph.D., real estate economist in FAU’s College of Business. “A less favorable rate environment combined with declining rents is affecting the value of commercial office space, worrying banks and bank regulators.”   

Experts agree that it is possible some banks will fail, particularly in areas like the Northeast and California, where many offices remain vacant due to remote work. The Sunbelt states – Colorado, Florida and Utah – are less prone to bank failures due to the demand for office space as workers and businesses migrate into these areas.

 According to Johnson, these potential closures should be minimal and should not cause too much stress on the banking system as banks will try and work out deals with investors instead.

“There is a lot of investment capital looking to step in and buy shares, if you will, of these buildings due to the large amount of perceived equity. Banks have opportunities for deals to be worked out short of the owner simply turning over the keys to the building,” Johnson said. “The likelihood of a massive financial crisis similar to 16 years ago is very small.”  

For Cole, it is difficult to quantify how large the impact will be, but another large bank failure during the next year or so could cause panic in the system.

“This is a very serious development that won’t go away,” he said. “Higher mortgage rates affect all properties, including both commercial and residential mortgages. There’s growing concern that, with higher interest payments, these properties will no longer be cash flow positive. If owners walk away from these buildings, it creates a comparable sale at a huge discount, leading appraisers to mark down the value of other properties with positive cash flows.”

-FAU-