For months, the Federal Reserve, Treasury officials, bankers, and commercial real estate leaders have cautioned about potential market volatility as property owners grapple with refinancing debt at higher rates.

In December, top U.S. regulators identified commercial real estate as a primary risk to financial stability for the year ahead. They cited increasing vacancy rates, declining office property values, potential economic slowdown, and elevated interest rates. Since July, the Fed has maintained the benchmark interest rate at a 23-year high in its efforts to curb inflation.

The Financial Stability Oversight Council’s annual report emphasized that commercial real estate (CRE) is the largest loan category for nearly half of U.S. banks. Additionally, more than one-quarter of U.S. banks have CRE loan portfolios that outweigh their capital.

The council highlighted significant challenges facing the office sector due to weak demand for office space, particularly in major U.S. markets.

Over the next three years, approximately $2.2 trillion in commercial real estate debt—previously financed at near-zero rates—will mature.

The primary concern lies with smaller banks, echoing sentiments expressed by Fed Chair Jerome Powell and Treasury Secretary Janet Yellen. These smaller banks lack sufficient reserves and are heavily concentrated in commercial real estate lending, which has drawn regulatory attention.

Powell expressed optimism for commercial real estate owners looking to refinance debt at lower rates later in the year, contingent upon economic developments aligning with expectations. However, he emphasized the uncertain economic outlook and the central bank’s cautious approach in managing policy restraint.

Balancing the need for policy adjustment, Powell cautioned against reducing policy restraint too hastily or too little, underscoring the delicate balance the Fed aims to achieve in supporting economic recovery while mitigating inflationary pressures.