FYI: An Update on Emerging Issues in Banking

How Long Can Bank Portfolios Withstand Problems in 

Commercial Real Estate?

June 23, 2003 

Overview

Fundamental measures of commercial real estate (CRE) market activity, such as vacancies, rents and 

absorption levels, have deteriorated significantly over the past two years.1 Faced with diminished demand 

and flat job growth in a slower-growth economy, many office property owners are confronted by tenants 

demanding lower rents as they also pare back their holdings of space. In contrast to the CRE downturn of 

the late 1980s and early 1990s, the present situation is more the result of rapidly diminished demand 

rather than excessive volumes of new construction. Still, just as in the last cycle, the resulting imbalance 

between supply and demand has caused market fundamentals to deteriorate and threatens to impair the 

future performance of banks' CRE loan portfolios. Surprisingly, measures of problem CRE loans at 

commercial banks, including past due loans and loan charge-offs, remain near historically low levels.2

This FYI reviews the declining fundamentals in U.S. office markets and offers reasons why CRE loan 

performance has remained strong at FDIC commercial banks. The key question going forward is how 

long will bank CRE portfolios remain strong in the face of weak market fundamentals.

Demand for Office Space Continues to Decline

Performance in most U.S. office markets continues to deteriorate by almost all measures. During eight of 

the last nine quarters, U.S. office markets have experienced negative net absorption, a situation where 

the amount of space given up by existing tenants exceeds the amount of space occupied by new tenants. 

This development is unprecedented in the sense that, prior to 2001, U.S. office markets had never 

experienced negative net absorption in the 20 years for which comparable data are available. (See chart 

1). In the face of retrenching demand by business tenants, office vacancies have shot up to levels not 

seen since the last cycle in the late 1980s and early 1990s, while rents are down by as much as one-half 

in some markets. 
D

Rapid rises in space available for sublease are also contributing to declining office fundamentals. Space 

available for sublease is estimated to account for up to 50 percent of vacant office space in some cities, 

creating special problems for landlords. Seeking to cut expenses and losses in any way possible, many 

companies solicit new tenants to assume their existing leases by offering enticements such as rental 

rates far below market levels. Depending on the severity of the rental rate cuts and the pervasiveness of 

the practice in a given city, subleasing has been a major contributor to downward pressure on market 

rental rates over the past two years. 

In addition to pressures in the sublease market, the problems associated with "shadow space" are likely 

to put further downward pressure on rents and upward pressure on vacancy rates. Shadow space is the 

unused but still-leased office space that a company retains after cutting back on staffing levels, prior to 

the point of lease renewal. Tenants have tended to retain this space only until the lease comes up for 

renewal, when it is carved out of the total square footage requirements in the renewed lease. 

In addition to the sublease and shadow space factors, landlords are also seeing declines in market rental 

rates at lease renewal time. This is particularly the case for leases that were executed at higher prevailing 

rates when market conditions were considerably tighter in 1999 and 2000. Declining lease rates are 

another factor that could impair the cash flows associated with office properties and make it more difficult 

for borrowers to service their debt. 

Office Vacancy Rates are Nearing Highs of Last Cycle

The nation's office vacancy rate last peaked at 19.2 percent of available space in 1991, during the height 

of the last major U.S. commercial real estate downturn. Thereafter, vacancies gradually declined; 

however, the national vacancy rate remained in double digit territory through 1997 before bottoming out at 

8.6 percent in 2000.3 Since the turning point in 2001, the office vacancy rate has risen at an 

unprecedented pace, nearly doubling to 16.9 percent as of the first quarter of 2003. 
The increase in office vacancy rates has occurred in every major U.S. market. New York City is the only 

major U.S. market still registering a single digit office vacancy rate--9.6 percent as of March 2003. In 

contrast, as recently as 2000, nearly one-half of the 55 office markets tracked by Torto Wheaton had 

single digit office vacancy rates. 

A number of cities with very low office vacancy rates at year-end 2000 have now experienced sudden and 

sharp increases in vacancies. Six cities that had office vacancy rates below 5 percent at year-end 2000 

have each now climbed to at least 15 percent. The largest increase has taken place in Austin, Texas, 

where the office vacancy rate has climbed from 5 percent to 25.7 percent over the last 9 quarters. (See 

Table 1). 

Table 1

U.S. Metro Areas with the Highest Office Vacancy Increases 

in Past Two Years

City

Net Increase in 

Office Vacancy 

Rate, 

December 2000 

- March 2003

Office Vacancy 

Rate, March 

2003

Office Vacancy 

Rate, 

December 2000

Austin 20.7 25.7 5.0

San Jose 18.6 20.0 1.4

San Francisco 16.1 20.3 4.2

Atlanta 12.4 22.3 9.9

Oakland 12.4 15.6 3.2

Denver 12.0 21.0 9.0

Portland 11.8 18.9 7.1

Boston 11.8 15.7 3.9

Seattle 11.2 15.6 4.4

Kansas City 10.5 19.2 8.7

Northern New 

Jersey 10.3 17.6 7.3

Nation 8.3 16.9 8.6

Source: Torto Wheaton Research.

Rental Rates are also Under Pressure

Rental rates are also suffering in predictable fashion, as office vacancy rates have risen. During the last 

cycle, office rental rates declined for just two years, 1992 and 1993 at -3.9 and -8.1 percent, respectively. 

Similarly, in this cycle, rents began falling in 2002 when they dropped by 6.7 percent. Through March 

2003, rents nationwide had fallen by 1.5 percent from year-end 2002.4 Some markets in this cycle have 

had extreme rental declines that followed rapid rises from just a year or two earlier. Downtown San 

Francisco, for example, had office rental growth of 44 percent in 2000. Since then, the San Francisco 

market has experienced a 50 percent plunge in rental rates in 2001, followed by another drop of 27 

percent in 2002. 
Problems in CRE Fundamentals Extend to Other CRE Property Types

Vacancies for industrial properties as of first quarter 2003 climbed to 11.3 percent, a record level eclipsing 

a previous high of 10.7 percent reached in 1992. Industrial fundamentals have nearly paralleled office 

property performance with negative absorption occurring for the first time on a national scale for industrial 

properties in 2001 and continuing through first quarter 2003. Concerns in the retail sector include 

bankruptcies of many large and small companies and falling profits extending even to the discount 

operators. Hotel properties still have not recovered from the sharp drop in demand since the September 

11th terrorist attacks and rates have stayed low as operators seek to attract lodgers. Formerly thought to 

be a safe harbor in any CRE downturn, apartment managers are experiencing falling demand as lower 

interest rates enable more individuals to afford home ownership. 

Demand for all CRE property types has suffered and is expected to remain weak for sometime due to 

general economic conditions. At least for an uncertain period, office and industrial absorptions are 

expected to be lower, even as recovery gains momentum, as employers have shifted strategies to get by 

with fewer workers. 

Bank CRE Loans Continue to Perform Well

Despite declining CRE market fundamentals, there has been to this point only minimal effect on bank 

CRE portfolios. A repeat of the large-scale losses experienced in commercial bank CRE portfolios in the 

last cycle does not appear likely at present. (See chart 2). Still, the nation's commercial banks registered 

increases in their non-current CRE loan portfolios of $530 million, or 7 percent, during the first quarter of 

2003 and charge-offs are trending upwards. As a percentage of total outstanding commercial bank CRE 

loans, however, the non-current portion is still at a low 0.95 percent, a moderate increase from 0.90 

percent at year-end 2002 and 0.94 percent at year-end 2001. Charged-off CRE loans have steadily 

increased from a low of $38 million in 1997 to $1.17 billion in 2002 and as a percent of average CRE 

loans outstanding, net charge-offs increased in the same period from 0.01 percent in 1997 to 0.14 

percent at year-end 2002. Even with these upward movements, in percentage terms, CRE delinquencies 

and charge-offs at commercial banks have remained near historical lows during the past two years. 
D

Commercial Banks' CRE Portfolios are Performing Better than Commercial Mortgage Backed 

Securities

Commercial mortgage backed securities (CMBS) defaults are rising faster and higher than non-current 

levels for commercial banks' CRE portfolios. A recent study performed by FitchRatings on fixed-rate 

CMBS transactions reports on the growing level of CMBS defaults and found that the cumulative default 

level on mortgage loans securing CMBS pools were 2.66 percent as of year-end 2002. The study noted 

that the default rate by loan balance "...has increased steadily since year-end 2000, growing from 1.07 

percent at the end of 2000, to 1.75 percent as of year-end 2001, to the current 2.66 percent rate at yearend 2002."5

One possible explanation for the relative CMBS weaker performance compared to banks' CRE portfolios 

is that the CMBS market often provides funding for CRE projects that might not meet the stringent 

underwriting standards for bank CRE loans. As such, these properties are likely to be much more 

vulnerable to underlying real estate market weakness. As a result, the performance of CMBS can be 

viewed as a leading indicator for the future direction, but not necessarily the severity, of performance for 

bank CRE portfolios. 

A Buffer is Shielding Bank CRE Loans - For Now

A "buffer" comprised of at least three major components has helped to insulate banks' CRE portfolios 

from the effects of the deteriorating office market fundamentals in this recent cycle. These factors are: 1) 

this cycle's low interest rate environment; 2) the tremendous growth in public, non-government mortgage 

securitization; and 3) the greater degree of regulator oversight and more stringent CRE lending 

standards.

Lowest Interest Rates in Decades Have Been a Boon for Cash Flows
The low interest rate environment during this cycle has allowed bank borrowers to more easily service 

their total debt payments. Additionally, in this cycle, CRE borrowers have not encountered difficulty in 

refinancing properties.6 In the last cycle, the national office vacancy rate was reaching its peak of 19 

percent at year end 1991, just when the prime rate and the targeted federal funds rate were 7.21 and 

4.00 percent, respectively. In contrast, at 16.9 percent, the nation's office vacancy rate is fast approaching 

the high point of the past cycle, yet the current interest rate environment is far more favorable for 

borrowers with the prime rate and targeted federal funds rate now at 4.25 and 1.25 percent respectively. 

With this cycle's favorable interest rate environment, many borrowers have reamortized or refinanced 

their existing debt loads at lower interest rates and reduced their loan payments. To date, reductions in 

payments have been enough for many borrowers to offset cash flow shortfalls resulting from declining 

rents. Additionally, the lower interest rate environment, conceptually, enables business owners to 

restructure all of their outstanding debts to "tighten up" their balance sheet to help weather the current 

downturn. Certainly, CRE borrowers are better able to endure the current downturn by refinancing and 

reamortizing their loans. However, to the extent that cash-out refinancing of CRE occurs, there are 

concerns that one result may be the depletion of the remaining equity cushion. 

Low Interest Rates Spawn Low Capitalization Rates

Today's low interest rate environment is partly responsible for exceptionally low capitalization rates as 

shown by recent CRE property sales.7 Perhaps the more surprising aspect of the lower capitalization 

rates is that they have been falling for most property types, while market fundamentals have declined. 

Fueling the lowered capitalization rates, beyond just lower interest rates, has been the perception by 

many investors of a lack of viable investment alternatives to CRE. This has kept demand levels high for 

purchasing good, positive cash-flowing CRE properties, particularly as investors shift money from the 

stock market in search of higher returns. However, should office property values begin to suffer, as some 

analysts have predicted, investors may change strategies once again and bypass further office 

purchases.8

Increased Role of Capital Markets in CRE Ownership

The second component of the buffer contributing to the sustained performance of bank CRE loans in this 

cycle is the tremendous growth in public market, non-government mortgage securitization occurring since 

the last cycle and the enhanced transparency that comes with the public scrutiny of CRE markets. 

Along with the increase in credit availability by public market funding sources such as commercial 

mortgage backed securities and Real Estate Investment Trusts (REITs), there has been a significant 

increase in the volume of public and private information on real estate supply, demand and project 

performance. 9,10 As a result of the greater monitoring and coverage of CRE conditions, both lenders and 

developers can more thoroughly and easily evaluate the feasibility of proposed projects.

The public appetite for holding CRE debt has shown remarkable growth since the last cycle. To a great 

extent, a large acceleration in the volume and marketing of securitized assets is attributable to the asset 

disposition strategies of the Resolution Trust Corporation (RTC) in the early 1990s.11 Since that time, 

many private institutions have entered the market, implementing procedures to serve as "conduits." 

These institutions originate and package CRE loans for a fee. As a result, many CRE loans now bypass 

the balance sheets of financial institutions entirely and are instead held by the public market in the form of 

CMBS. Additionally, the readily available CRE securities market provides banks with the ability to make 

CRE loans and then choose to retain them within their own portfolios or to sell them through the 

securitization process. 

Chart 3 shows both the large growth in CRE debt (from $1.1 trillion in 1990 to $1.9 trillion in 2002) and the 

shifts in shares of the holdings between the two periods. Financial institutions (commercial banks and 

savings and loans) held 54 percent of the debt in 1990, while CMBS represented only 2 percent of the 
market. In comparison, financial institutions still held about 50 percent of the debt in 2002 while the public 

market CMBS share increased to 18 percent. 

D

Public Market Scrutiny 

As the volume of public investments in CRE has grown, so has the need for information on CRE markets. 

The demand for CMBS and REIT-related information has led to a large number of Wall Street analysts 

who track and provide complete reporting on industry trends, CRE conditions and operating performance. 

In addition, Torto Wheaton Research (TWR), Property & Portfolio Research (PPR), REIS, Cushman 

Wakefield, Grubb & Ellis, and Costar are among the largest private vendors of CRE data. 
Tighter CRE Lending Requirements and a Greater Degree of Regulator Oversight 

The third major component of the buffer results from this cycle's tighter CRE lending requirements and a 

greater degree of regulator oversight. As an outgrowth of more liberal real estate lending practices of the 

last cycle and the heavy toll the resulting losses took on financial institutions, the FDIC Improvement Act 

of 1991 (FDICIA) became law. Section 304 of FDICIA requires federal banking agencies to establish 

maximum lending limits for different real estate categories.12 Other tightened underwriting standards since 

the last cycle are requirements for higher debt service coverage ratios along with pre-leasing 

commitments.

A 1999 FDIC study titled "Recent Trends in Construction Lending Practices" found that with few 

exceptions, banks in the early years of this cycle were complying with the lending limits established by 

FDICIA.13 In this study, over 400 real estate construction loans were reviewed at 29 institutions to assess 

underwriting standards and practices. The study found that equity levels in real estate loans were 

markedly improved from the last cycle. For example, the review of commercial construction loans found 

that 81 percent possessed equity investments of 10 percent or more of the loan amount and that 91 

percent had loan-to-value ratios of 85 percent or less. The study concluded that lending standards had 

improved substantially since the last real estate cycle. 

How Long Will the Buffer Insulate Banks from the Effects of CRE Problems?

Many analysts believe that recovery for CRE fundamentals is at least a year or more away, and perhaps 

even longer for the hardest hit office markets, such as San Francisco and Austin. There appears to be 

consensus that CRE problems have been mitigated by the improved factors outlined in this report. 

Opinions are divided, however, as to whether high levels of delinquencies will be avoided entirely, or 

perhaps just postponed as a result of the changed conditions in CRE markets. 

Referring to the improved conditions over the past cycle, Dottie Cunningham, CEO of the Commercial 

Mortgage Securities Association, writes that "[Delinquencies] have been kept down by low interest rates, 

the discipline of the rating agencies and the tranching of deals which puts the risk where it belongs."14

At the same time, Moody's Investors Service Vice President and Senior Credit Officer, Sally Gordon, 

predicted recent increases in CMBS delinquencies and stated they will not peak until after the economy 

recovers. She explains "real estate lags the general economy, and mortgage defaults lag the rest of real 

estate. We don't expect delinquencies to peak until after the economy recovers. ... Even if the economy is 

robust in 2003, there will be an increase in delinquencies and defaults, because 2003 delinquencies will 

be the result of the 2002 economy."15

Conclusion

CRE fundamentals such as absorption rates, rents and vacancies have deteriorated nearly in tandem 

with the modest growth performance of the national economy. Unlike the last cycle, a number of other 

forces such as lower interest rates, higher levels of CRE securitization and transparency along with 

greater degrees of regulatory oversight and stricter lending requirements have kept CRE property owners' 

problems from becoming bankers' problems. The length of time that this stand-off will last is uncertain, but 

so far the degree to which the problems have not been transferred to banks in the form of CRE 

delinquencies and charge-offs serves at least as partial testimony to the changes implemented since the 

last cycle. Still, some declines in credit quality as shown by non-current and charge-offs in the nation's 

banks' CRE portfolios appear likely to increase. However, because of the factors previously discussed, it 

appears unlikely that the declines will approach the severity of the last cycle's lows. Although the banking 

industry as a whole is expected to avoid the severity of the last cycle, performance by individual banks 

will not be uniform across the board due to different exposures to specific markets and property types and 

different underwriting practices. Going forward, banks have every reason to continue their diligence in 
evaluating their CRE portfolios and to continue to assess their market and property type exposures. 

1

Absorption refers to office space (existing or new construction) that is newly occupied. "Positive net 

absorption" refers to the net new space that is occupied in any given period over the prior period's 

occupied space level. The reverse occurs with "negative net absorption" when more space is vacated 

than occupied during the new period. Office net absorption, rent and vacancy data are from Torto 

Wheaton Research (TWR). TWR reports that second quarter 2002 was the only quarter of the past nine 

where the nation's office markets had positive net absorption of office space. 

2

Commercial bank CRE referred to in this FYI represents the three loan types of: 1. construction and 

development; 2. nonfarm, nonresidential; and 3. multifamily. It is important to note that construction and 

development loans encompass construction loans for both commercial and residential properties. 

3 Many CRE analysts consider a 10 percent office vacancy rate to represent an equilibrium point between 

supply and demand factors. Different cities are expected to have varying equilibrium levels for their own 

particular demand and supply constraints, but 10 percent is an acceptable benchmark. 

4 Reported rental rates do not truly capture the full extent of real rental declines. CRE journals and 

abstracts report that rental concessions have been rampant in this cycle as landlords offer inducements 

to keep and gain tenants and attempt to avoid lowering their reported rents. 

5 MacNeill, Mary; Stafford, Erin; O'Rourke, Mary, "2003 CMBS Conduit Loan Default Study," FitchRatings 

Structured Finance, Commercial Mortgage Special Report, May 27, 2003. 

6 An argument could be made that, in the last cycle, the market place would have looked less favorably at 

CRE refinancing in light of CRE oversupply conditions, declining bank profits and plummeting CRE 

prices. 

7 Cap rates, short for capitalization rates, are equivalent to the amount of net operating income a property 

generates in a given year, divided by its sales price. Alternatively, and more traditionally, the equation is 

viewed as net operating income divided by the capitalization rate to yield the sales price for a given 

property. 

8 Starkman, Dean. The Wall Street Journal. "Property Values Finally Decline With Office Space Falling 

1.7%," May 28, 2003. 

9 Commercial mortgage-backed securities are backed by the cash flow of a pool of commercial real estate 

mortgages. After the deduction of servicing expenses, principal and interest payments of the mortgage 

are passed through directly to the certificate holder in sequential payment order. 

10REITs enable investors of any size to invest in large-scale, income-producing real estate. For the most 

part, the universe of REITs is comprised of publicly-owned companies that own and in most cases 

operate income-producing CRE property. In order to retain their tax exempt status, REITs are required by 

law to distribute 90 percent of their net taxable income to investors in the form of dividends. 

11See, for example, Freund et al. History of the Eighties: Lessons for the Future, FDIC, 1997. 

12The supervisory maximum loan-to-value limits established through FDICIA are: 65 percent for raw land, 

75 percent for land development, 80 percent for commercial development and 85 percent for 1 - 4 family 

residential development. 

13Burton, Steven K., "Recent Trends in Construction Lending Practices," Bank Trends, July 1999. 
http://www.fdic.gov/bank/analytical/bank//bt9901.pdf.

14 "Uncertainty Reigns, Interest Rates, War Cloud 2003 CMBS Outlook," Commercial Property News, 

January 1, 2003.

15 Ibid.

About FYI

FYI is an electronic bulletin summarizing current information about the trends that are driving change in 

the banking industry, plus links to the wide array of other FDIC publications and data tools. 

Disclaimer 

The views expressed in FYI are those of the authors and do not necessarily reflect official positions of the 

Federal Deposit Insurance Corporation. Some of the information used in the preparation of this 

publication was obtained from publicly available sources that are considered reliable. However, the use of 

this information does not constitute an endorsement of its accuracy by the Federal Deposit Insurance 

Corporation. 

Last Updated 6/23/2003

Chart 1 Negative Net Absorption of Office Space Continues to Drive Vacancy Rates Upward

Date Completions Vacancy Rate (%) Net Absorption 

12/31/90 82 0.1872 52.70

12/31/91 53 0.1904 34.90

12/31/92 32 0.1868 37.30

12/31/93 7 0.1691 54.10

12/31/94 6 0.1530 48.50

12/31/95 8 0.1392 43.10

12/31/96 16 0.1220 61.60

12/31/97 28 0.0993 86.90

12/31/98 56 0.0897 77.00

12/31/99 101 0.0961 72.50

12/31/00 83 0.0865 103.10

12/31/01 83 0.1420 -96.50

12/31/02 61 0.1650 -14.70

3/31/03 9 0.1690 -7.10

Source: Torto Wheaton Research. 2003 results as shown are as of first quarter 
Chart 2 Bank CRE Loan Performance Remains Strong Despite Escalating Office Vacancy Rates

Date

FDIC 

Commercial 

Banks Past 

Due CRE 

Loans as % 

of o/s CRE 

Loans

FDIC 

Commercial 

Banks' 

ChargedOff CRE 

Loans as % 

of o/s CRE 

Loans

Office 

Vacancy 

03/31/03 0.95% 0.09% 16.90%

12/31/02 0.90% 0.14% 16.50%

12/31/01 0.94% 0.12% 14.20%

12/31/00 0.71% 0.05% 8.60%

12/31/99 0.71% 0.03% 9.60%

12/31/98 0.91% 0.01% 9.00%

12/31/97 1.14% 0.01% 9.90%

12/31/96 1.54% 0.11% 12.20%

12/31/95 2.14% 0.30% 13.90%

12/31/94 2.88% 0.57% 15.30%

12/31/93 4.68% 1.23% 16.90%

12/31/92 7.07% 2.00% 18.70%

12/31/91 8.00% 1.88% 19.00%

Source: FDIC, Torto Wheaton Research. 2003 as shown is first quarter, with charge-offs 

annualized. 
Chart 3 CMBS Have Assumed a Much Larger Role in Funding CRE During This Cycle

Total $1.9 Trillion CRE Debt Outstandings 

by Holder - for 2002

2002 

Dollar ($ 

Billion)

Pensions/Other 13% $238 

Banks 42% 799

S&L's 8% 149

Life Co's 12% 232

Fed Mtg's/GSE's 7% 142

CMBS 18% 340

Total $1.1 Trillion CRE Debt Outstandings 

by Holder - for 1990

1990

Dollar ($ 

Billion)

Pensions/Other 17% $193

Banks 36% 402

S&L's 18% 201

Life Co's 23% 251

Fed Mtg's/GSE's 4% 42

CMBS 2% 20

Sources: FDIC, Haver Analytic