In the US, bad commercial real estate loans have surpassed the loss reserves of the six largest banks due to sharp increases in overdue payments for offices, shopping centers, and other properties.

Research by US real estate company Cowei Properties found that by the end of last year, about one-fifth of the US office buildings were vacant, and even in major cities such as Los Angeles and Houston, the vacancy rate of office buildings had reached 25%.

The International Monetary Fund (IMF) said in a blog post that US commercial real estate prices are experiencing the worst sharp drop in half a century and have fallen 11% since the Federal Reserve raised interest rates in March 2022. In a weak commercial real estate environment, the US banking system is also facing tremendous pressure.

According to the data, by the end of next year, the total amount of US commercial real estate loans maturing will exceed 1 trillion US dollars, and by 2027, this figure will reach 2.2 trillion US dollars. This means that the plight of commercial real estate in the US may become the biggest potential crisis in the next two years.

The US banking sector has insufficient reserves for non-performing loans

Federal Deposit Insurance Corporation (FDIC) documents show that for six major banks, including J.P. Morgan Chase, Bank of America, Wells Fargo, Citigroup, Goldman Sachs, and Morgan Stanley, the average reserve for each $1 of non-performing debt of borrowers in commercial real estate debts overdue for at least 30 days has been reduced from the previous $1.6 to $0.9.

Last year, commercial real estate arrears of the six largest US banks almost tripled to $9.3 billion, and the situation worsened dramatically. In the US banking industry as a whole, loan arrears relating to office buildings, shopping centers, condos, and other commercial real estate more than doubled last year to $24.3 billion, far higher than the previous year's $11.2 billion.

Michael Barr (Michael Barr), who is responsible for banking supervision and supervision at the Federal Reserve, said on Friday that regulators “have been closely monitoring banks' commercial real estate loans,” including “how they report risk internally” and whether they “properly prepare and have sufficient capital to cushion potential future commercial real estate loan losses.”

According to FDIC data, the US banking sector now has reserves of 1.40 US dollars for every 1 US dollar of delinquent commercial real estate loans, down from $2.20 a year ago, which is also the lowest level in seven years.

Bill Moreland (Bill Moreland), an analyst at lender data collection and analysis company BankRegData, said there is no doubt that “reserves for these loan losses must be raised substantially” for the industry as a whole. “Some banks may have looked good six months ago, but they won't look good next quarter,” Morland said.

Earlier this month, New York Community Bank's commercial real estate loan business experienced potential losses of hundreds of millions of dollars that had not been disclosed before, causing its stock price to plummet and its market value to shrink by more than 50%.

The method of calculating reserves is questionable

The core of the problem is reserves, which are funds banks are preparing to absorb future losses due to debt arrears. The use of reserves can be harmful to profits, so banks seek to limit how and when to use them. Generally, banks and regulators set reserve levels based on loan types and historical loss rates. Banks hold high reserves (such as 10%) for unsecured loans such as credit card loans, while reserves of 2% or 3% for commercial real estate loans with low default rates.

However, some believe it may be risky to still rely on the historical loss rate of commercial real estate (especially office buildings) to determine an appropriate level of reserves after the COVID-19 pandemic. They believe that banks should build reserves based on current debt arrears.

João Granja (João Granja), an accounting professor at the University of Chicago Booth School of Business, said: “At some point, if the vacancy rate continues to be high, these owners will not be able to repay their debts, and banks will cancel the right to redeem the collateral.”

“I know historical loss rates are low, but we need to see if banks are forward-looking in predicting expected losses rather than just relying on what happened in the past.”

Commercial real estate losses in the next five years are likely to be double that of reserves

Bankers say they are ready. They said that reserves for non-performing loans are higher than needed a year ago, but the relative share of reserves is now declining as the delinquency rate rises. According to them, regulators seem to be more concerned about the risk exposure of small and medium-sized banks.

Bank of America CEO Brian Moynihan (Brian Moynihan) said in December last year that the bank has determined that only $5 billion of commercial real estate debt falls in the real estate sector where prices have declined. He said that for a bank with profits of nearly 30 billion US dollars and assets of more than 3.2 trillion US dollars, this figure is minimal.

However, this month, Bank of America stated in a filing with the Federal Deposit Insurance Corporation (FDIC) that loan arrears relating to office buildings, apartments, and other non-residential buildings soared 50% in the fourth quarter of last year to reach 2.1 billion US dollars. At the same time, the bank cut loss reserves for these loans by $50 million, to just under $1.3 billion.

Richard Barkham (Richard Barkham), global chief economist at commercial real estate company CBRE (CBRE), said that in the industry, “any decline in reserves... is fundamentally wrong.” He estimates that in the next five years, banks may lose as much as 60 billion US dollars due to bad commercial real estate loans, which is about double the 31 billion US dollars set aside by banks for these loan losses.