The stress in the US commercial real estate (CRE) market is unlikely to trigger another 2008-type financial system collapse, even as rising interest rates put a strain on firms refinancing more than $1 trillion in loans in 2023 and 2024.

About $1.078 trillion in commercial real estate loans are scheduled to mature in 2023 and 2024, according to S&P Global Market Intelligence data. Regional banks, which hold about 70% of those loans, face having to absorb defaults and devalued assets amid sharply higher refinancing costs at a time when their balance sheets are under a microscope following the failures of Silicon Valley Bank, Signature Bank and First Republic Bank, and the government-brokered merger of Credit Suisse AG into Swiss rival UBS Group AG.

The added stress, combined with changes to work and shopping habits that erode CRE asset value, puts increased pressure on regional banks concerned with preserving liquidity on their balance sheets. This scenario has drawn comparisons with the wave of foreclosures and credit crunch of the Great Recession, yet the fears of a broader crisis may be overblown as banks appear to be well-positioned to handle losses in segments of the CRE market.

"I am relatively optimistic about that," said Vincent Deluard, director of global macro strategy at StoneX. "The average commercial lease is five years so losses will be spread over time, rather than a one-time shock like the collapse of Lehman Brothers.

Riding it out

Nearly half of US office real estate investment trust leases expire more than five years out, while property sectors such as healthcare and single-tenant retail typically have even longer-term leases, according to Market Intelligence data.

A rise in defaults on real estate loans would force banks — typically smaller, regional banks — to take possession of the assets and then look to quickly offload them, particularly as deposit outflows and lower share prices have weakened balance sheets. CRE loans make up 30.4% of the assets on smaller banks' balance sheets and just 8.9% for banks with more than $10 billion in total assets, Market Intelligence data shows.

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"We don't believe a repeat of the 2008 liquidity crisis is likely," said Solita Marcelli, chief investment officer Americas at UBS Global Wealth Management. "CRE exposure at banks is currently manageable with potential loss levels even in a hard landing scenario likely causing earnings pressure rather than capital depletion."

Pressure on CRE

Commercial real estate is a broad classification of assets including everything from offices and warehouses to supermarkets and department stores. Much of the concern about defaults is focused on specific sectors, including offices.

In New York, for example, the rise of remote work during and after the COVID-19 pandemic has hammered the office sector. A record 93.95 million square feet of office space is available in Manhattan, up 74.5% from pre-pandemic levels, according to real estate services firm Colliers. The average price per square foot of that space dropped 22.4% year over year to $656.10, the lowest since 2012.

"[CRE] has been hit by all of the migrations away from the office and now companies are negotiating their leases downwards," said George Lagarias, chief economist at Mazars.

Prices also declined in major office space locations such as Chicago; Houston; Austin, Texas; and the Northern Virginia suburbs near Washington.

Offices, however, are a relatively small portion of the overall CRE market, with just $125.72 billion of debt maturing by the end of 2024. Segments of retail, which have suffered from changing shopping habits and took a further blow during COVID-19, have $78.56 billion maturing.

While the banking system as a whole can handle losses in the CRE market, localized concerns could be a problem for banks in those regions.

Banks under stress

Concerns about liquidity in the regional banking system deepened in April with JPMorgan Chase & Co.'s takeover of First Republic Bank, while the share prices of California-based PacWest Bancorp and Phoenix-based Western Alliance Bancorp. were among those to plunge. If real estate assets lose value there would be "significant repercussions" for bank profitability which in turn would make them less likely to lend, according to the International Monetary Fund.

"The tide of concern is rising about the ailing health of regional US bank portfolios, with many sitting on large unrealized losses, at a time when deposit flight is all the rage," said Susannah Streeter, head of money and markets at Hargreaves Lansdown.

Deposits at small banks were $5.247 trillion in the week ending May 3, down nearly $240 billion since February before the failure of Silicon Valley Bank, and potentially could come under further pressure amid more bad headlines.

A pullback in lending will be a key concern for home builders, who typically use regional banks for financing new ventures — potentially reining in construction activity and slowing economic growth. Much will depend on the health of small bank balance sheets.

"Declines in the value of commercial loan portfolios are just paper losses for now and may stay just that as long as banks are not forced to liquidate their portfolios," analysts at BCA Research said in a March 29 note.

The prospect of a recession in 2023 would place further stress on the commercial real estate market.

"Defaults would go up, rents would go down, and banks would indeed face more stress, but [a recession] is not my base case scenario," Deluard said.