It has been over a year since the commercial real estate debt maturity scare ensued in the wake of several bank failures in March 2023. While CRE losses in 2023 were not nearly as dire as expected, concerns persist as nearly $650 billion of CRE debt is set to mature in 2024. Gross charge-offs for Federal Deposit Insurance Corp. (FDIC) banks increased 66 percent last year, compared to 2022. Even so, CRE represents only 7 percent of that augmentation — a far cry from the expected crash haunting news headlines for months.

That data raises a question: If the industry was bracing for a crash within the CRE landscape in 2023, but actual CRE charge-offs showed only a modest uptick year over year and remained lower than average over the past decade, then what exposure to CRE deterioration truly exists in the United States, and how detrimental will it be to financial institutions?

The answer unfortunately isn’t clear-cut when taking a bird’s-eye view of the industry. Rather, it depends on the individual portfolio of each financial institution. Two specific areas banks should examine when reviewing their CRE-related assets are geographical concentration risks and the specific subsectors or property types within their portfolio.

Concentration has always been one of the foremost risks institutions are diligent about managing. The FDIC released multiple advisory memos in the past year with specific guidance on how to properly manage CRE concentrations to mitigate safety and soundness concerns. Those dispatches built on the tried-and-true rule from the mid-2000s that requires banks to have heightened risk management practices if their CRE concentration is 300 percent or more of their total capital.

The FDIC also indicated that any institutions that have experienced rapid CRE portfolio growth — defined as a bank’s CRE outstanding balance increasing by 50 percent or more in the past three years — will attract heightened monitoring from regulators. As of December 31, 2023, banks headquartered in California had the most exposure to CRE properties.

A strategy familiar to CRE investment is mezzanine loans, which became popular after the global financial crisis as an alternative source of financing for banks. These loans typically originate through private equity to provide short-term financing at high yields, with the intent to cover shortfalls. In contrast to mortgage loans, which are secured by real property, the collateral for mezzanine loans is the mezzanine borrower’s ownership interest in the entity that owns the property, which can create a faster path to foreclosure. Unlike mortgages, mezzanine loans do not appear on property records, making them difficult to track.

While these loans do not constitute concentration risk by definition, institutions will need to monitor the exposure created by alternative financing competing in the industry investment capital stack.

Rapid growth and alternative financing structures in CRE portfolios aren’t the only considerations for banks assessing their risk exposure, as debts in this space mature. Financial institutions should review their CRE portfolios with an eye on office and multifamily properties, in particular, as both subsectors face challenging trends.

Office property has been by far the most popular topic within CRE subsector discussions, and for good reason. Office occupancy has declined over 2 percent on average across national index markets from Q1 2019 to Q1 2024, according to CoStar data. The distress varies across the country, with significant declines in major commuter cities. San Francisco, for instance, has seen a 15.4 percent decline in office occupancy and Seattle has had an 8.9 percent drop. Austin, Los Angeles, and New York have seen drops of 8.5 percent, 6.1 percent, and 6 percent in office occupancy, respectively.

The 30-day-past-due metric for office space — a leading indicator of decline in a loan’s credit quality — has grown more than six times from a year ago.

While this rapid growth in a deterioration metric is concerning, it’s important to look beyond the top line into the details driving this increase, and to recognize that not all office loans are considered equal. For example, Class A space has been performing well, despite the amplified focus on how interest rates and vacancy rates are hurting office space.

Class C office properties are the real standouts for deterioration. These properties are typically older, in less desirable locations, have a less-than-ideal tenant history, and are often overdue for repairs and renovation. They have not received the upkeep and investment in infrastructure to remain competitive.

Another trend surfacing in 2024 is the localized deterioration of certain multifamily loans for rent-regulated investments. Often deployed in urban environments, limitations set on rent increases not expected by underwriters of the loan investment have driven sub-sufficient cash flows that are not keeping pace with financing costs. Lower cash flows, increased operating costs, and stubbornly elevated interest rates are resulting in lower investment valuations and costly refinancings or restructurings.

The recent news about stress within New York Community Bancorp — which has a large concentration in rent-regulated apartment loans — underscores the risk associated with these properties in the subsector.

The best way for financial institutions to ascertain CRE-related risk is to conduct a detailed credit risk review. An independent evaluation of the CRE portfolio will determine risk exposure and enable the chief credit officer, credit department, and other applicable personnel to make sound and informed decisions related to credit risk management.

While deterioration in certain subsegments of CRE will almost certainly come to fruition, we anticipate the situation will not be as disastrous as speculations. Banks are working to modify or extend CRE loans where possible and are collaborating with borrowers to limit the uptick in charge-offs and other negative performance indicators.