In a recent interview, Pacific Investment Management Co. (Pimco) has issued a warning about potential regional bank failures in the United States. The firm cites a "very high" concentration of troubled commercial real estate (CRE) loans as the primary reason behind this concern.

According to John Murray, Head of Global Private Commercial Real Estate Team at Pimco, the wave of distress in the CRE sector is just beginning for lenders with exposure to properties ranging from malls to offices. The uncertainty surrounding potential interest rate cuts by the Federal Reserve has only exacerbated the challenges faced by the sector. High borrowing costs have led to plummeting valuations and increased defaults, leaving lenders burdened with assets that are difficult to sell.

Contrary to market expectations, larger banks have been offloading some of their higher-quality assets to minimize potential losses. However, as stressed loans grow due to maturities, it is anticipated that these banks will be compelled to sell the more challenged loans to reduce their troubled loan exposures. Pimco's private commercial real estate team has been acquiring such loans from large U.S. banks over the past 18 months.

The impact of the turmoil has been particularly severe for regional banks, which significantly increased their exposure to CRE loans. In many cases, these loans are now worth only a fraction of their peak value. Smaller banks have also contributed to investor worries since the collapse of a few banks last year. New York Community Bancorp, for example, shocked investors by slashing its dividend and increased cash reserves for potentially bad loans, resulting in a capital injection. US Bancorp, the largest regional bank by assets, has also increased its provisions for credit losses in the first quarter.

One factor that further exposes regional banks is their lack of requirement for extra down payments from commercial-property borrowers in recent years. This vulnerability is underlined by a March report released by MSCI Real Assets, which stated that regional banks were the only lenders that did not demand additional down payments. Additionally, deposit-taking institutions face an estimated $441 billion of maturing property debt this year.

While Pimco believes that the property exposures of larger banks are not likely to cause systemic failures due to reduced CRE lending after the 2008 crisis, the failure of borrowers to repay has resulted in even further reduced lending compared to 2021 and 2022.

In addition to the concerns with banks, mortgage real estate investment trusts (REITs) are also experiencing their own problems, limiting their ability to underwrite new investments. Starwood Real Estate Income Trust recently implemented measures to preserve liquidity, and Blackstone Inc.'s $59 billion property trust has faced increased withdrawal requests.

According to Murray, another area that requires attention is the over $200 billion of loans made by debt funds in the US, set to mature through 2025. Many of these loans were originated during the peak pricing era of 2021 and have a three-year term and a three-year rate cap. As interest rates rise, assets may struggle to meet extension tests, creating stress at the asset level.

Pimco, based in Newport Beach, California, is also keeping an eye on how German banks handle their commercial real estate exposure. Murray highlights that the combination of rising rates and recessionary pressures poses significant challenges for commercial real estate, from both capital markets and fundamentals perspectives.

As the distressed commercial real estate market continues to unfold, the impact on regional banks and other lending institutions remains a cause for concern. The future performance and stability of the sector will heavily depend on how these entities navigate the challenges posed by troubled CRE loans and the broader economic landscape.