Thursday, February 22

Problems with “zombie offices” spells for some banks

Graceful art deco buildings towering over Chicago’s main business district have occupancy rates of 17%.

A series of gleaming office towers in Denver that were filled with 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 firm that tracks home loans. Even landmark Los Angeles buildings fetch about half their prepandemic prices.

From San Francisco to Washington, DC, the story is the same. Office buildings remain stuck in a slow-burn 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 value in an important class of commercial real estate. Prices for even higher-quality office properties have fallen 35% from their peak in early 2022, according to data from real estate analytics firm Green Street.

These forces have put the banks that hold a big chunk of America’s commercial real estate debt in a hot spot — and analysts and even regulators have said the reckoning has yet to fully take hold. The question is not whether large losses will come. It depends on whether they will turn out to be a slow bleed or a panic-inducing wave.

Last week saw a glimpse of the emerging troubles when shares of New York Community Bancorp fell after the lender disclosed unexpected losses on real estate loans tied to both offices and condominiums.

So far, “headlines have moved faster than actual stress,” said Lonnie Hendry, Trepp’s chief product officer. “Banks are sitting on a pile of unrealized losses. If that slow leak is discovered, it could be released very quickly.

When a series of banks failed last spring — in part because rising interest rates squeezed the value of their assets — analysts worried that commercial real estate could trigger a broader set of problems.

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

Economists and regulators feared that heavy exposure to a risky-looking sector could scare bank depositors, particularly those with savings above the $250,000 limit for state insurance, into withdrawing their funds.

But government officials responded forcefully to the upheaval of 2023. They helped sell off failing institutions, and the Federal Reserve established a low-cost bank financing option. Stocks restored confidence and banking jitters disappeared from sight.

The situation has changed in recent days with the issues of New York Community Bancorp, which some analysts consider an isolated event. Last spring, New York Community Bancorp absorbed the failing Signature Bank, accelerating its problems. 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 are in trouble, even if that doesn’t cause system-wide panic. The reprieve the government gave the banking system last year was temporary: the Fed’s financing program will be closed next month, for example. The problems associated with commercial real estate are long-lasting.

Commercial real estate is a broad asset class that includes stores, multifamily housing, and factories. The sector as a whole has experienced tumultuous years, with office buildings particularly affected.

According to a recent National Bureau of Economic Research paper by Erica Xuewei Jiang of the University of Southern California, Tomasz Piskorski of Columbia Business School and two of their colleagues.

While large lenders such as JP Morgan 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 are still officially occupied with even a few employees – what Hendry called “zombies” – thanks to lease terms that last years. This allows them to appear vital when they are not.

In other cases, banks use short-term extensions instead of taking over distressed buildings or renewing unworkable leases, hoping that interest rates will fall, which would help raise property values, and that workers will return.

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

Default rates reported by banks have remained much lower, just above 1%, compared to rates on commercial real estate loans traded on the markets, which are above 6%. This is a sign that lenders have been slow to recognize housing stress, said Piskorski, the Columbia economist.

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

The return-to-office trends have stalled. And while the Fed has signaled that it does not plan to raise interest rates above the current level of 5.25 to 5.5%, officials have been clear that they are in no rush to cut them.

Hendry predicts that delinquencies could nearly double from the current rate to 10-12% by the end of this year. And as the reckoning approaches, hundreds of small and medium-sized banks could be at risk.

The value of bank assets has taken a hit from the Fed’s rate hike, Piskorski and Jiang found in their paper, meaning mounting losses in commercial real estate could leave many institutions in bad shape.

If that were to rattle uninsured depositors and cause the kind of bank runs that toppled banks last March, many could be plunged into full-blown bankruptcy.

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

Their study estimates that dozens to more than 300 banks could face such a disaster. This may not be a major blow in a nation with 4,800 banks, especially since 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 sparking a broader panic.

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

Fed and Treasury Department officials have made it clear that they are closely monitoring both the banking sector and the commercial real estate market.

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

Jerome H. Powell, Fed chairman, acknowledged during a “60 Minutes” interview that aired Feb. 4 that “there will be losses.” For big banks, Powell said, the risk is manageable. As for regional banks, he said the Fed is working with them to address expected fallout and that some are expected to close or merge.

“It seems like a problem we’ll be working on for years,” Powell admitted. He called the problem “considerable” but said it “does not appear to have the characteristics of the kind of crisis that we have seen at times in the past, for example, with the global financial crisis.”

Alan Rappeport contributed to the reporting.