The postmodern granite and glass skyscraper at 301 South College Street in Charlotte used to be known as One Wells Fargo Center. Before the pandemic, the building was the megabank’s East Coast headquarters, where it rented almost 700,000 square feet of office space. But since then, Wells Fargo has been reducing its footprint; it now occupies less than half that area, and in January it announced it would leave the 42-story building altogether by the end of 2023.
Few tenants have swooped in to take its place. The building’s occupancy rate has plummeted from 98% at the end of 2021 to 52.9% today, according to data from Fitch Ratings and CoStar; when Wells Fargo fully vacates, it could fall as low as 34%. That drop has made refinancing the skyscraper’s $160 million mortgage a challenge—so much so that the owner, Vision Properties, has had to request a loan extension from a special servicer. The extension talks could be a prelude to loan modifications or even a default process. (Vision confirmed that it was in negotiations but declined to comment further.) Whatever the outcome, it means some real pain for Vision’s management—and its lenders and investors.
The problems at 301 South College are widespread across the commercial real estate (CRE) sector in the wake of the work-from-home shift. And the Federal Reserve’s rate hikes could soon make them much worse. The CRE sector has relied for decades on cheap financing. Unlike residential mortgages, however, commercial mortgages typically have shorter terms of five to 10 years. According to Morgan Stanley Wealth Management, more than half of the country’s $2.9 trillion in commercial mortgages will need to be refinanced in the next 24 months—in a climate of much higher rates.
As those loans get renegotiated, many borrowers will see their loan payments spike sharply. Those elevated costs, combined with languishing tenant revenues resulting from falling occupancy rates, could create a perfect storm for defaults and delinquencies.
Banks, of course, are the bag holders here, and small and midsize banks are particularly heavily exposed: A recent analysis by Goldman Sachs found that lenders with less than $250 billion in assets account for roughly 80% of CRE lending. And while factors other than real estate contributed to their recent failures, the fact that CRE made up such a large share of the loan portfolios at Signature Bank (45%) and First Republic Bank (21%) hardly eased the concerns of those banks’ depositors. For comparison, CRE makes up just 11% of JPMorgan Chase’s enormous loan portfolio. (See the graphic for more examples.)
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These recent bank failures are already exacerbating troubles in the CRE sector—in part by making other lenders skittish. Before the March failure of Silicon Valley Bank, “there was a tightening of credit, but there were still lenders willing to make some loans,” Scott Rechler, CEO of real estate firm RXR, tells Fortune. “Post-SVB, there’s been a very clear contraction of loan availability.”
Rechler, who manages CRE properties and investments worth over $22 billion, says that although the office sector has been hit especially hard by the work-from-home trend, many banks aren’t distinguishing between types of real estate, making it challenging to refinance old projects or get capital for new ones in categories like retail and industrial properties. “You have empty buildings, because there’s sort of zombie buildings that have capital structures where no one’s incentivized to invest in them,” he explains.
The lending freeze-up is putting further downward pressure on property values. Peak to trough, Moody’s Analytics expects U.S. office values to fall 25% this cycle, with the bottom not being reached until 2025. Moody’s also predicts sizable price corrections for multifamily buildings (–12.5%), retail buildings (–11%), and industrial properties (–10.1%).
High CRE exposure isn’t automatically a bad sign for a bank. The smaller the sliver devoted to office space, the better off the bank is likely to be. Frank Schiraldi, a managing director at Piper Sandler, points to M&T Bank as an example. While CRE loans make up around 30% of its portfolio, just 4% of total loans are in the office sector. Schiraldi thinks banks with strong reserves will be able to weather the storm even if their exposure is greater.
Not everyone is so sanguine. Capital Economics’ chief economist Paul Ashworth described how, in a worst-case scenario, a “doom loop” could develop between banks and the CRE sector. If customers fear that smaller banks with exposure to ailing commercial properties are in trouble, it could lead depositors to flee. That, in turn, could force banks to not only stop making CRE loans, but to call in underperforming loans to bolster their balance sheets. Loan calls in turn could force borrowers to sell their properties into a weak market, thereby accelerating a real estate downturn. The resulting instability could lead to even more deposits being pulled—and more bank failures.
“It is a tail risk,” Ashworth says. “Nevertheless, if you’re looking for where things could go wrong, that’s it.”
A version of this article appears in the June/July 2023 issue of Fortune with the headline, "The next banking blowup."
