Commercial real estate: Weathering the storm

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Commercial real estate: Weathering the storm

Expert Perspective


October 5, 2023

Key takeaways

  • Some media outlets and asset managers have raised alarms about the health of the $5.7 trillion commercial real estate lending market, chiefly because of the shift to remote work and the rise in interest rates.
  • These concerns may evoke memories of the 2008 global financial crisis (GFC), when residential defaults overwhelmed bank balance sheets and sank complex bonds such as mortgage-backed securities (MBS) and collateralized debt obligations, pools of loans held in tranches by investors.
  • We do not see a systemic financial threat. Our analysis shows that stress is most concentrated in the office sector. Even in a deep recession scenario, the potential for broad-based defaults on commercial mortgages backed by office properties likely would be limited. Further, there is much less financial leverage in commercial mortgage-backed securities (CMBS) today.
  • We believe a careful approach to security selection can sidestep meaningful impact to investors’ fixed income portfolios.

That there are concerns about the health of the $5.7 trillion commercial real estate market is understandable. Remote work and higher interest rates continue to pressure property owners, particularly of office buildings. Yet despite headlines that have raised the specter of a “doom loop,” we do not see a systemic financial threat, nor do we anticipate broad-based defaults in publicly traded fixed income securities.

We think it’s important for advisors to understand the real size of the problem, what could go wrong even in a bear-case scenario, and the reasons for our relatively balanced views.

Sizing up the problem

The commercial real estate mortgage market is diverse in terms of ownership type, property category, credit quality, and maturity schedule. Because of that diversity, most investors will be insulated from problems as lenders and borrowers work out new terms in today’s higher-rate environment.

Consider where the potential problems lie and how large they may be. According to Mortgage Bankers Association data as of March 31, 2023, banks and savings and loan institutions hold $2.9 trillion in commercial real estate mortgages, just over half of the market. Life insurance companies, which typically purchase only the most creditworthy commercial mortgages, own another $680 billion. Multifamily housing, about half of which is backed by U.S. mortgage-finance agencies, accounts for an additional $957 billion.

This means that most of the stress will be diffused or guaranteed within the system.

The sector facing the most stress is investor-owned office buildings, where the delinquency rate has risen to 5.0%. These properties account for only $750 billion, or 13.1%, of the commercial real estate market. Of that amount, only $161 billion is held in CMBS, most of which are pools of commercial loans diversified across geographies, property types, and industries. Those investments are normally included in bond mutual funds and ETFs, such as our active products.

The bottom line is that most of the recent concern lies in office-related CMBS and any banks exposed to mortgages on office buildings.

Beyond offices, loans on retail buildings remain stressed too, but let’s be clear: This is not a new development. The decline of the local mall and the concurrent rise of internet shopping have been underway for years. We believe the market has priced in these trends, which are limited to a few segments of the retail property landscape. Not all retail is deteriorating; in fact, most is performing as expected given the strength of the consumer.


Real estate stress is likely to be concentrated in a portion of the market

A graphic of the $5.7 trillion U.S. commercial real estate market showing the types of institutions that hold loans and the kinds of properties they hold. The graphic shows that investor-owned offices account for $750 billion worth of loans, only 13.1% of the market. Of that, $339 billion is held by banks and thrifts, $161 billion is held by commercial mortgage-backed or asset-backed securities, $131 billion by life insurance companies, and $119 billion by other investors.   In Vanguard’s analysis, only $98 billion, or 13%, of this portion of the commercial real estate market would be subject to default in the event of a severe recession.

Sources: Vanguard and the Mortgage Bankers Association, as of March 31, 2023.

A bear-case scenario

Plenty could go wrong for commercial real estate from here.

Commercial loans typically have terms of 10 years but are amortized over 25 or 30 years, and most are paid on an interest-only basis, which means borrowers will face a balloon payment at the end.

With today’s higher rates, we see many property owners refinancing at rates 250 to 400 basis points higher than their current loans, which has led to lower debt-service coverage ratios. (A basis point is one-hundredth of a percentage point). Combined with more conservative lending terms, borrowers may face pressure.

If the economy were to drop into a recession, the situation would get worse. We ran an internal analysis that considered a recessionary scenario comparable with the GFC and the savings and loan (S&L) crisis in the late 1980s. In such a scenario, we found:

  • Property values could decline by as much as 40% on average, with some property types meaningfully higher or lower.
  • Net operating income in many commercial property sectors could decline for as long as three years.
  • In the event of default, it could take up to two years to liquidate a property, and recoveries could be less than two-thirds of loan value.

Even in such a bear-case scenario, we project some $100 billion of losses in office real estate, with only a quarter of that hitting publicly traded securities. This situation is unlikely given current expectations for the economy, but even if it did play out, the losses would not be catastrophic in the market.

Banks could get hit, too. Most likely to be affected would be small banks, defined as those outside the top 25 banks by size. Federal Reserve data as of September 6, 2023, show that commercial real estate makes up 44% of small banks’ loan portfolios on average, compared with 13% at the top 25 banks.

Banks have been building reserves to prepare for potential losses. Still, based on our stress scenario of U.S. banks, we believe that commercial real estate losses could be stressful for many small banks, but 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 and S&L crisis. When banks of this size fail, they are closed and sold by the FDIC to larger banks that typically assume all deposits. As a result, we believe this would not pose a systemic risk to the banking system overall.

Notably for us, small banks have very low amounts of corporate debt outstanding, and it is an area where we have little exposure.

Reasons for optimism

One major reason for optimism is the appreciation in properties even as values have come down. Nationally, commercial real estate loans issued in 2013 have risen in value by 120% on average, and even office properties are 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.

Some brighter signs have been evident of late:

  • Data from Kastle Systems as of September 13, 2023, show that office attendance has stabilized at about 50% of pre-pandemic levels, and employers are pressing employees harder to come back to work in person.
  • Leasing activity has perked up in recent months, and except for tech-heavy cities such as San Francisco, most regions have not seen a dire drop in office occupancy.

Layers of defense

For investors of publicly traded securities, choosing higher-rated bonds, particularly AAA rated CMBS, offers layers of defense.

In the typical structure of bonds attached to a pool of mortgages, various tranches offer trade-offs between the income received and exposure to risk. Investors in lower-rated tranches receive higher coupon payments but are earliest in line to absorb losses in the event of default, while investors in higher-rated tranches receive less income from payments but are last in line to absorb losses.

One of the unfortunate legacies of the GFC was that such defenses within bond structures proved to be ineffective because residential mortgage loans were later shown to be poorly underwritten and structured.

But the lessons from that time have not been forgotten, and we believe current CMBS will perform as expected. Loss levels would need to exceed 30% in most cases before AAA tranches would suffer in a default.

In our funds that include such structured products, we currently hold mostly AAA paper as a safeguard against potential default losses. While credit spreads on AAA rated CMBS have nudged up this year, much of the change in prices and spread levels has occurred among lower-rated securities.

Current holdings

Despite our belief that commercial real estate will remain resilient, we do not believe bond prices reflect the stress to come. We have reduced our CMBS holdings from some $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.

Because our investors are our owners1, we keep costs low, which means we do not face the pressure to take risks no matter the market environment. For now, we are content to hold the high-quality bonds that we have. In the meantime, we are waiting for the market to fully price in the fundamental risk we see before there is a better entry point to buy more CMBS.

Vanguard active taxable funds include:

Core Bond (VCOBX)

Core-Plus Bond (VCPAX)

Global Credit Bond (VGCAX)


1 Vanguard is owned by its funds, which are owned by Vanguard’s fund shareholder clients.


For more information about Vanguard funds or Vanguard ETFs, visit to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

Past performance is no guarantee of future results. All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.

Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.

Investments in bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk. These risks are especially high in emerging markets.

High-yield bonds generally have medium- and lower-range credit-quality ratings and are therefore subject to a higher level of credit risk than bonds with higher credit-quality ratings.

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