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.”