Commercial real estate trouble could trigger systemic credit crash, fund managers say

Commercial real estate crash seen as most likely catalyst for systemic credit event

Fund managers are growing more worried that trouble in the commercial real estate sector could trigger a credit crisis in the U.S., according to a new Bank of America survey.

About 16% of participants in the global fund manager survey identified a "systemic credit event" as the top risk to markets in February, compared with just 11% the prior month. It marked the third-largest tail risk for markets, behind sticky inflation and geopolitics. 

The most likely source of a credit event, according to the fund managers, is the commercial real estate market. 

Other possible sources include shadow banking, or non-bank financial institutions that are not subject to regulation, including hedge funds, private equity funds, investment banks and mortgage lenders, as well as U.S. corporate debt.

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Wall Street in New York

A "Wall Street" sign in New York City on Jan. 27, 2023. (Photographer: John Taggart/Bloomberg via Getty Images / Getty Images)

About $1.5 trillion in commercial mortgage debt is due by the end of 2025, but steeper borrowing costs, coupled with tighter credit conditions and a decline in property values brought on by remote work, have increased the risk of default. 

Roughly $929 billion worth of commercial real estate loans are set to mature this year, according to the Mortgage Bankers Association. Borrowers may have no choice but to refinance with significantly higher interest rates or sell their properties at a steep loss. 

The Federal Reserve raised interest rates to the highest level since 2001 in response to sky-high inflation. Rates are poised to remain elevated for some time, as policymakers have signaled they are not prepared to start reducing rates until they are more confident that inflation has returned to 2%.

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Complicating the matter is the fact that small and regional banks are the biggest source of credit for the $20 trillion commercial real estate market, holding about 80% of the sector's outstanding debt. Regional banks were at the epicenter of the upheaval within the financial sector last year following the collapse of Silicon Valley Bank, and there are concerns that the turmoil could make lending standards drastically more restrictive.

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During a credit crunch, banks significantly raise their lending standards, making it difficult for businesses or households to get loans. Borrowers may have to agree to more stringent terms like high interest rates as banks try to reduce the financial risk on their end.

Those fears were reignited earlier this month when New York Community Bank slashed its dividend and revealed an unexpected quarterly loss on real estate loans tied to both office and apartment buildings. Its shares have lost about half of their value since then. 

Treasury Secretary Janet Yellen has sought to downplay the growing woes within the commercial real estate sector and their potential effect on the banking system. 

New York Stock Exchange traders

Traders work on the floor of the New York Stock Exchange during morning trading on March 13, 2023, in New York City. (TIMOTHY A. CLARY/AFP via Getty Images / Getty Images)

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While testifying before the Senate Finance Committee two weeks ago, Yellen said that she expects additional bank stress and financial losses as a result of weakness within the commercial real estate sector, but believes it will not end up being a "systemic risk to the banking system. The exposure of the largest banks is quite low, but there may be smaller banks that are stressed by these developments."