Will Commercial Real Estate Cause the Next Financial Crisis?

The banking industry is staring down the barrel of a potential black swan event. High commercial vacancy rates following post-COVID workplace shifts are being compounded by the drastic increases in commercial real estate exposure the industry has taken on in recent years, particularly among regional banks. Add in rising interest rates and the picture gets much uglier.

America's regional banks have more than tripled their collective exposure to the commercial real estate market in just the last five years. The combined exposure of regional banks now stands at more than $1.5 trillion according to FDIC data, while large banks are holding only around half a trillion.

Sales of commercial office space properties in our biggest cities are down nearly 70 percent, and the recent sale of a NYC office building for around the same price as a similarly sized vacant lot did not bode well for the market's outlook in the near future.

As a result, many owners are trying to hold onto such properties, even when they are largely vacant, in the hopes that the market eventually recovers. However, many of those loans are based on variable interest rates. If interest rates remain relatively high, refinancing that debt will prove challenging to say the least.

To make matters worse, banks also have considerable additional exposure via products that are related to the commercial real estate market, including mortgage-backed securities and loans to real estate investors. The end result could be a massive realignment that includes an enormous government bailout and an even tighter consolidation of the banking industry among America's largest banking institutions.

Convert commercial to residential?

Given the shortfall in housing stock, particularly workforce housing in some of the cities that are most impacted by the floundering commercial market, many people are advocating for such buildings to be converted to residential housing stock. That is not as easy as it may seem, however.

The architectural designs of most commercial buildings are not very conducive to an easy, relatively low-cost residential conversion, primarily because of things like prohibitive building codes and infrastructure not being in the right place, such as elevators, or water pipes not designed to reach as many places as a residential building in which there is a kitchen and at least one bathroom in every unit.

That is not to say it cannot be done, however, and developers in several cities, including San Francisco, Washington D.C., have had some success, as shown in the videos below.