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Does commercial real estate really threaten to destabilize banks, especially internationally?

The commercial real estate market is experiencing significant economic difficulties. This puts the creditor banks at risk for the debts associated with these assets. Anne-Sophie Alsif explains why official communications from central banks and governments point to a possible – but still limited – systemic risk.

In the United States and the euro area, commercial real estate is showing a significant loss of profitability as well as a decline in the number of transactions. According to the European Central Bank’s Financial Stability Report published at the end of 2023, rising interest rates and general uncertainty, combined with the inherent illiquidity of commercial real estate markets, have led to a 47% decrease in the number of commercial real estate transactions in the euro area during the 1st half of 2023 (year-on-year). According to the IMF, in the United States – the world’s No. 1 market – prices have fallen by 11% since the Fed began raising interest rates in March 2022.

The least well-placed assets with the worst energy performance are the most affected. According to the ECB, the outlook for the non-prime market is particularly negative. According to Immostat, the immediately available supply of offices in Paris has reached an unprecedented level. Similar phenomena are observed in other countries such as China. According to the National Bureau of Statistics, in the summer of 2023, the office vacancy rate reached an all-time high of 18%. According to the ECB, the decline in profitability exposes borrowers who own commercial real estate to potential debt service risks.

Regional banks’ exposure to commercial real estate

Although generally small, banks’ exposure to these assets can pose a stability risk, particularly in the United States, particularly via regional banks. Within the euro area, banks have around 10% of loans exposed to commercial real estate. However, the weaknesses of this portfolio have been proven. Moody’s, for example, has carried out numerous downgrades for real estate companies, regularly referring to the deterioration of debt-to-asset ratios. According to the Mortgage Bankers Association, about $1.2 trillion of commercial real estate debt in the U.S. will mature by 2026 (25% office and retail), most of which is owned by banks. In addition, in the US, risk is concentrated in regional banks. According to Goldman Sachs, banks hold 50 percent of the country’s real estate debt, 75 percent of which is concentrated in small and medium-sized banks — almost 40 percent of the total. According to the IMF, these regional banks are five times more exposed than the big banks.

While not systemic, the risks could exacerbate an imbalance foreign to the real estate sector. According to the ECB, “poor performance in the commercial real estate market can significantly amplify an adverse scenario”, increasing the likelihood that the banking system will suffer systemically important losses. In addition, such an event would weaken other parts of the financial system that are heavily exposed to residential real estate, such as investment funds and insurers. In the U.S., regional banks would face significant declines in the value of commercial real estate loans. This would then pose the risk of a credit crunch that would extend beyond real estate.

All in all, while banks are indeed exposed to a risk related to commercial real estate, it appears that this risk is indirect. A significant shock to another asset class could thus be aggravated by the destabilization of the commercial real estate market. These systemic risks still seem remote, although they should not be overlooked.

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