Could Empty Office Space Spark ‘Systemic Credit Event’ At Regional Banks?

While investor sentiment is running high in the early weeks of 2024, risks remain that could topple the equity market rally that began in the fourth quarter of 2023. Among them: the threat of systemic risk should stresses in the commercial real estate sector hit regional banks.

Data from Apollo Academy suggests that smaller banks hold almost 70% of the outstanding loans from commercial real estate borrowers. Among these, banks with total assets between $1 billion to $10 billion are carrying CRE loans worth an average of nearly 35% of their total assets.

Compare that to the large banks with more than $250 billion worth of assets, and their exposure to CRE loans is little more than 5%.

Should investors be worried about regional banks’ exposure to CRE loans? Bank of America’s fund manager survey for February suggests there is already some concern.

BofA’s poll of global institutional investors shows that 16% of those surveyed thought a systemic credit event represents the biggest tail risk for markets in 2024.

Michael Hartnett, lead analyst on the BofA report, said: “U.S. commercial real estate takes the number one spot for the most likely source of a systemic credit event in 2024.”

Non-bank — or shadow bank — lending remains a concern, while China’s real estate meltdown is also seen as a possible source of a credit event.

Office Vacancy Rates Rise

Rising office vacancy rates are at the heart of the problem. As workers were increasingly asked to do their jobs from home during the COVID-19 pandemic, the trend has continued and nearly 19% of U.S. office space is empty.

While the office sector represents only a small part of the overall economy, regional banks are among the most exposed.

“Layer on top of this the Federal Reserve’s historically rapid pace of interest rate rises, plus accelerating layoffs in professional and business services and the obsolescence of older office buildings, and it’s not hard to see pain in the office sector getting worse,” said Joe Seydl, senior markets economist at JPMorgan Private Bank.

Credit Availability Shrinks

The availability of credit and sources of refunding is shrinking. The decline in bank lending as well as higher interest rates have driven demand for CRE loans to their lowest levels since the financial crisis in 2008.

So, as vacant…