The limited bank run of the first quarter of 2023 is nigh forgotten, and the bank sector at large got a clean bill of health from the Fed stress test on June 28th. However, there remains a looming threat to smaller banks; demand for commercial real estate, especially office real estate, seems to have drastically, and perhaps permanently, changed over the pandemic.
While fully remote work is unlikely to stay, hybrid work seems to have become the new normal. This has led to a smaller demand for office space in dense city centers, as fewer workers come in day to day. This change can be seen in metropolitan public transit usage. San Francisco ridership of the local BART systems are 40% of their 2019 levels. Los Angeles and Chicago numbers are near 50%. NYC is better off, but not by much– New Yorkers are riding at 65% of pre-pandemic levels.[1] Office tenants have taken this opportunity to aggressively negotiate with their landlords for lower rental rates and better amenities. In some cases, tenants are paying hefty fees to end leases early. In May, Toast, a Point-of-Sale tech company based in Boston, paid $16 million dollars to end its lease six years early. This destruction of demand is leaving the banks who are backing these office spaces with a looming deadline as more and more leases extended at the start of the pandemic look to expire this year.
The worst-case scenario is a second panic being caused as bank liquidity shrinks if they are forced to unload office assets at heavily discounted prices. This, however, will likely only affect smaller banks with less well-run portfolios of loans. Smaller banks’ exposure can vary drastically by institution. By the end of 2022, real estate in the commercial sector owed some $5.6 trillion dollars in loans, half of which was owed to banks. According to the Fed, small banks’ loan portfolios can range from 15% to 40% of their loans in commercial real estate, with a subset specifically being office real estate.[2]
We can expect the commercial real estate market to get worse before it gets better, with greater scrutiny on smaller banks from the government. We can also expect businesses supporting downtown financial centers to falter and cities to reallocate assets as their economic engines move from being highly centralized to wider spread. There is opportunity in the coming storm. New loans are coming as businesses move into different style offices that meet their modern needs. Old office spaces may be sold at enough of a discount that they may be undervalued. This may be the end of our current highly centralized office system , but there will be a new office system to replace it.
[1] Mass transit systems in American cities face post-pandemic ‘fiscal cliff’, yahoo.com
[2] https://www.investopedia.com/fed-cre-report-7496531