Investor-owned office buildings, where delinquencies have risen to 5% of all loans, constitute the most stressed sector within commercial real estate lending. But with about $750 billion in total loans, investor-owned offices only represent roughly 13% of the commercial real estate market (see figure below).

For mutual fund and ETF investors, office building mortgages are typically pooled in commercial mortgage-backed securities (CMBS) along with other commercial loans diversified across geographies, property types, and industries. “That diversification in CMBS,” said Bob Behal, Vanguard’s head of structured product research, “should mitigate the potential impact of trouble in the office building space on publicly traded investments, including our mutual funds and ETFs.”

Plenty could go wrong if the economy were to drop into a deep recession. We ran an internal analysis that considered an economic scenario comparable with the global financial crisis of 2008 (GFC) and the savings and loan (S&L) crisis in the late 1980s. In such a scenario, our research found:

• Property values could decline by as much as 40% on average.
• Net operating income in many commercial property sectors could decline for as long as three years.
• Among defaults, it could take up to two years to liquidate the property, and recoveries could be less than two-thirds of loan value.

But even in such a worst-case scenario, we see potential for around $100 billion of losses in office real estate, and only a quarter of that would hit publicly traded securities. Moreover, this dire scenario is unlikely given our current expectation of a modest recession within the next 18 months.

Banks could be impacted, but they’ve been building reserves to prepare for potential losses. Based on our stress scenario of U.S. banks, we believe that commercial real estate losses could be stressful for many small banks, defined as those outside the top 25 banks by size. However, the average asset size of an impacted bank is very low, at $1 billion, and the number of banks that would face capital challenges is a small fraction of those that failed in the GFC or the S&L crisis.

“When banks of this size fail, typically they are closed and sold by the FDIC to larger banks that assume all deposits,” said Brian Monteleone, Vanguard’s co-head of U.S. investment-grade credit research. “As a result, we believe this would not pose a systemic risk to the banking system overall.”

One major reason for optimism is the embedded appreciation in properties, even after market valuations have come down. Nationally, commercial real estate loans issued in 2013 have risen in value by 120% on average, and even office properties are still up 40%, according to Real Capital Analytics as of June 30, 2023.

That equity—and a staggered maturity schedule for both leases on properties and loans coming due—will give owners and lenders flexibility to work on loan modifications. That process has worked in past down cycles, and we believe it will work again. Accordingly, we expect modifications to increase. 

“Despite our belief that commercial real estate will remain resilient, we do not believe bond prices reflect the stress to come,” said Behal. “We have therefore reduced our CMBS holdings from around $5 billion a few years ago to about $500 million now, which is less than 1% of net assets in any of our active funds that invest in credit.”

In our funds that include such structured products, we currently hold mostly AAA paper as a safeguard against potential default losses.

Regarding bank risk, small banks have very low amounts of corporate debt outstanding, and it’s an area where we have little exposure.

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