Capital Ideas: Why the Fed’s Still Worried About CRE

While the industry is looking to see what the Fed will do on interest rates next week, a recent report shows the Fed is closely watching banks’ exposure to commercial real estate, especially to office loans.

Twice a year, the Fed zeroes in on U.S. banking conditions and regulations and its own bank monitoring practices. The system is generally healthy, according to the latest Supervision and Regulation report released on Dec. 1: Ninety-nine percent of banks maintained capital levels exceeding the regulated capital requirements, and stress tests show that large banks are “well positioned to withstand a severe recession” while maintaining capital requirements and their ability to lend. Deposits reached a historical high of $18.3 billion in August, and overall loan growth has been strong.

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Nevertheless, there are still some risks in the system, and most of them seem to be in banks’ CRE assets and activities, particularly office loans.

In the Fed report, CRE loans grew “modestly” in the first half of the year but at a higher rate compared with the last quarter of 2024. Meanwhile, delinquencies rates for CRE declined to about 1.5 percent in the second quarter of 2025. That’s less than the highest quarterly rate over the last decade but double the average over that period.

At large banks, the delinquency rate for office loans fell slightly but was still near 10 percent in the second quarter, the report found. The delinquency rate for multifamily at large banks remains elevated while generally speaking it has declined from the 10-year high.

The report also highlighted banks’ increased association with nondepository financial institutions as they lend to these entities and partner with them while noting that there have been “limited delinquencies” for loans to nonbank lenders. Citing some recent defaults, however, the Fed is increasing its monitoring of banks’ exposure to these entities and extending its supervision.

Smaller banks’ high exposure

The Fed found that most community banks organizations (with assets less than $100 billion) and regionals banking organizations (with assets between $10 billion and $100 billion) were “broadly stable” with lower levels of past due and “classified” loans than the 10-year average. But supervisors remain focused on CBOs and RBOs that are heavily involved in CRE lending, particularly office and multifamily.

Borrowers, the report notes, may struggle to refinance or pay off loans due to higher interest rates, tighter underwriting and lower commercial property values. And the Fed is closely watching trends in loan modification, underwriting, classifications and credit loss reserves.

CRE was not the only cause for concern identified by the report. The Fed also noted that about half of large institutions showed weaknesses in capital planning and liquidity risk management practices.

The state of the banking industry has little bearing on whether the Fed raises or lowers the Fed Funds rate next week. Inflation and jobs are their north stars when deciding what to do about rates. But a lowering of the Fed rate—a 25 percent cut is widely anticipated at next week’s FOMC meeting—would have a positive impact on Treasury and SOFR rates, the typical measures of CRE capital costs, and relieve some of the pressure on banks and borrowers.