For months, economists and investors have warned that a meltdown was coming in the commercial office building sector. That’s because vacancy rates remain a lot higher than they were before the pandemic — especially in urban cores.

A few weeks back, those warnings made their way to the Financial Stability Oversight Council — a panel in Washington chaired by Treasury Secretary Janet Yellen that’s charged with spotting icebergs that could sink this economy. 

The council heard that banks may be exposed to serious risk because of loans they’ve made for office projects. And smaller banks are holding an awful lot of those loans.

Commercial real estate loans are different from traditional mortgages. Instead of borrowing at a fixed rate for 30 years, a commercial borrower typically pays the loan back over a shorter period.

“For my bank, we fix commercial loans for five years at a time,” said Brad Bolton, president and CEO of Community Spirit Bank in Red Bay, Alabama.

Bolton said at the end of those five years, a borrower basically has to get a new loan with new terms.

“They get a notice that says, ‘Hey, based on the contract, the rate has been reviewed, and here’s your new rate.’”

In normal times, short-term loans can make it easier for commercial borrowers to sell off buildings if they’ve risen in value. And if borrowers don’t sell, they can refinance those loans on better terms.

But these are not normal times, said Robert James II, CEO of Carver Financial Corp., a minority-owned company with community banks in the South. He said developers can’t refinance on better terms because interest rates are a lot higher than they were five years ago.

“Banks that have a lot of office–centric real estate where they’re expecting those loans to mature in the next 12 to 24 months need to be very concerned about the quality of their loan portfolios,” James said.

The research company Trepp estimates that a record amount of commercial real estate loans are maturing this year, with even more coming due in 2024.

Matt Anderson, Trepp’s managing director, said that means developers are going to be looking at different terms going forward.

“With higher interest rates, they would qualify for only a smaller loan because those payments are going to be higher now,” Anderson said.

Many building owners might have a hard time affording those higher payments because they’re not pulling in as much rent as they were before the pandemic. That’s especially true in New York, Washington, San Francisco and other coastal cities, said Nancy Wallace, a real estate professor at the University of California, Berkeley.

“There could be real pain in some of these markets that have especially problematic vacancy rates,” Wallace said.

The situation’s bad enough that some banks have slammed the brakes on new commercial real estate loans.

“I know several of my friends in the banking sector that have stopped making CRE loans, period,” said Dominik Mjartan, CEO of Optus Bank in South Carolina.

Mjartan said his bank is still making commercial real estate loans, but it’s being a lot more cautious with its borrowers.

“We’re going to work with them and ask them hard questions,” Mjartan said. “‘Who’s going to lease it from you? Do you have someone identified? Do they have the capability? What industry are they in? Have you thought about what happens if they can’t pay for three months? Do you have enough reserve money?’” 

Mjartan said banks are nervous that office building owners might default on their loans. If that happens, the bank has to take over the building. Then it would have to sell it, likely for pennies on the dollar.

“Chances are, a bank that is stuck with an office tower in one of those markets where there’s been a significant decline in occupancy rates — that haircut could be massive,” Mjartan said.

He added that any bank in that situation will probably be pretty flexible with its existing borrowers to ensure that it doesn’t have to take over any buildings in the first place.