14% of CRE Bank Loans Are in Negative Equity: Study

CRE-backed bank loans may be in worse shape than realized, according to a new study by researchers at the University of Southern California, Northwestern University, Columbia University, and Stanford University. That isn’t good when, as they noted, commercial real estate loans comprise a quarter of assets for an average bank and $2.7 trillion of total bank assets.

Using loan-level data, the researchers built on previous work of others to analyze the effect of rising interest rates on U.S. bank assets, stability, and the likelihood of sudden depositor withdrawals that forced the closure of banks earlier this year. This new study adds how credit risk can further affect bank assets.

CRE has become a potential source of trouble for banks for reasons including “the potential adverse impact of higher interest rates on the value of CRE assets and their cost of funding, risk of recession, and a lower demand for office due to the hybrid working patterns with potential negative spillovers on other asset classes such as urban retail, multifamily, and hotels.”

They found that “after recent declines in property values following higher interest rates and adoption of hybrid working patterns about 14% of all loans and 44% of office loans appear to be in a ‘negative equity’ where their current property values are less than the outstanding loan balances. Additionally, around one-third of all loans and the majority of office loans may encounter substantial cash flow problems and refinancing challenges. A 10% (20%) default rate on CRE loans — a range close to what one saw in the Great Recession on the lower end — would result in about $80 ($160) billion of additional bank losses.”

The study suggests that the change in interest rates have made the entire system vulnerable, even as federal regulators stress how safe and stable the banking system is.

“If CRE loan distress would manifest itself early in 2022 when interest rates were low, not a single bank would fail, even under our most pessimistic scenario,” they wrote. “However, after more than $2 trillion decline in banks’ asset values following the monetary tightening of 2022, additional 231 (482) banks with aggregate assets of $1 trillion ($1.4 trillion) would have their marked to market value of assets below the face value of all their non-equity liabilities.”

Using the analytic model they developed, in 2023 Q3, “CRE distress can induce anywhere from dozens to over 300 mainly smaller regional banks joining the ranks of banks at risk of solvency runs.”