The Office Real Estate Collapse Isn't Over, It's Just Getting Started
The idea that commercial real estate (CRE) is over the worst is a narrative that Wall Street has been clinging onto for months. Headlines suggest that the real estate downturn, especially in the office sector, may be stabilizing due to scattered signs of interest in Class A properties from investors. However, below the positive surface lies a bigger issue, one that isn’t necessarily visible in leasing reports or vacancy charts.
The commercial office property sector remains somewhat of a slow-motion disaster. Offices particularly within urban areas are still struggling with secular demand destruction and disappearing valuations, while industrial and residential assets have shown more resilience.
The real problem isn’t really the buildings themselves, however. It lies in the balance sheets of insurance portfolios, regional banks, and pension funds, right where overpriced office loans and securities are declining in value. When that does happen, the collateral damage could extend far past real estate.
Empty Offices, Full Prices
When the pandemic hit, it exposed and accelerated the deep underlying issues of the office real estate crisis, and didn’t necessarily create the problem in 2020. Even before then, a lot of urban office markets were already indicating signs of saturation. The general shift to remote and hybrid work simply enabled companies to justify abandoning excess square footage with no return in sight.
In San Francisco, the situation escalated to historical extremes. Office vacancy is the highest it’s ever been on record, with a surge of 35.8% of offices being vacant in Q1 2025, according to CBRE. Although New York has experienced an increase in demand for top-tier spaces, the wider market remains pressured from long-term lease exits and elevated vacancies. While Chicago’s industrial sector has outperformed, office vacancy statistics for Q1 2025 were not explicitly reported. Although older office buildings, like many across the U.S., are experiencing the same struggles with high vacancies and declining lease values while tenants continue to opt for more efficient, newer spaces.
Despite vacancies increasing and the demand weakening, a number of office buildings remain valued as if nothing had changed. This is because their valuations are based on dated financial projections rather than real market transactions, most are marked-to-model, not marked-to-market. With fewer buildings being sold, these assumptions have largely not been tested. However, it’s becoming harder to ignore the imbalance between book value and real-world pricing as more loans mature.
Behind the Balance Sheet
The commercial office space crisis doesn’t only apply to landlords and is embedded within the financial system, which places huge risk on regional banks, municipal budgets, and pension funds.
Particularly vulnerable are regional banks. Recent analysis shows that commercial real estate (CRE) loans make up around 18-30% of total assets at smaller and regional banks, with some of these holding as much as 44% in certain cases. In contrast, larger banks only hold about 13% of their assets in CRE loans. This disparity means that the balance sheets of smaller banks are facing disproportionately bigger risks, while office spaces lose their value.
As the value of properties drops, many of these loans are leaning towards negative equity territory, with loan-to-value (LTV) ratios reaching past 100%, particularly regarding Class B and Class C buildings in cities with high vacancies. Still, the financial system has yet to fully reflect this risk. This is because instead of depending on actual market data, institutions still rely on marked-to-model valuations, causing these assets to show dated assumptions and not current revenue potential or current buyer interest.
During the years of near-zero interest rates, pension funds and insurance companies also chased yield by channeling billions into office-backed commercial mortgage bonds and REITs. As more assets deteriorate, the value of investments also erodes, which threatens funds required to meet long-term promises to policyholders and retirees.
This risk becomes aggravated by held-to-maturity accounting, which, regardless of market conditions, enables banks and funds to report loans and bonds at their original value. Unless the asset has been sold or marked down, the loss doesn’t appear on statements. However, as more loans mature and refinancing isn’t an option, the real numbers will be much harder to hide.
The Derivatives Nobody’s Watching
Reminiscent of 2008, underlying loans are not the sole problem with commercial mortgage-backed securities (CMBS), but rather how the loans are bundled, split into tranches, and then distributed. In lower-rated office tranches, losses can quickly spread through the financial system when defaults rise. It’s evident that there’s growing stress present in the CMBS market, with Fitch Ratings reporting that in March 2025 the average U.S. CMBS average delinquency rate has climbed by seven basis points, which is being driven by office and retail sectors. All the while concerns are growing over weakening collateral values and debt service coverage ratios are increasing stress on ratings across the sector.
While investors are reassessing risks tied to structured office debt, it’s becoming harder to ignore the instability of the CMBS market, making it more at risk to not only affect property owners and lenders.
Budget Shortfalls and the Urban Doom Loop
The downturn of commercial real estate goes beyond Wall Street which poses considerable risks to urban stability and city finances. Municipal tax bases are eroding due to the office property values that are declining, leading to potential cuts in public service and budget deficits.
Mostly due to underused office spaces and decreased property tax revenues, the city of San Francisco is facing a projected budget deficit which could potentially reach $1.4 billion by 2027. There have been slow efforts to convert vacant office buildings into residential units, with only one project having been completed since 2020, emphasizing the challenges of such projects.
Initiatives like tax abatements and zoning changes have been implemented by Washington D.C. in order to try to encourage office-to-residential conversions. However, the effectiveness becomes reduced as high conversion costs and regulatory complexities complicate matters.
The decline in property values causing reduced tax revenues, the diminishing of public services from forced budget cuts, which also contributes to residents and businesses leaving, all adds to the urban doom loop. All these factors further exacerbate the city’s financial worries, it would require strategic investments and policy reforms to break this cycle in the hopes to revitalize city centers and to stabilize municipal finances.
Why the Worst Is Still Ahead
Estimated by Jones Lang LaSalle (JLL), the commercial real estate industry has around $1.5 trillion debt maturing by the end of this year, posing significant challenges. This also presents a considerable refinancing burden for property owners, especially in an environment where interest rates are heightened and property valuations are quickly declining.
Adding to the complexity of the refinancing outlook, borrowers that took on loans when interest rates were low, are now in a position to refinance at considerably higher rates. This can place pressure on cash flows and make projects unaffordable. Declining property values have also put increased pressure on loan-to-value ratios, making refinancing even more complicated.
In response to refinancing difficulties, some banks may opt to “extend and pretend,” which involves extending loan terms without resolving difficulties of repayment. While extending and pretending can put off problems in the short term, it can also delay loss recognition and risks further exacerbating financial instability. Finally, regional banks are the most heavily exposed to CRE debt. Widespread loan defaults would have a significant impact on these institutions and larger consequences for the financial system.
These factors of large debt maturities, higher refinancing costs and falling property values, looks like it will lead to increasing pressures on the CRE sector over the next two years. This is likely to cause further strain at financial institutions with high exposure to struggling real estate ventures, with potential knock-on effects for the broader economy.
A Slow-Moving Detonation
What we’re seeing in commercial real estate currently is not a short-term correction, but a slow-moving detonation. The risks are unfolding across three fronts: regional banks heavily exposed to commercial debt, pension funds and insurance companies dependent on yield from unstable assets, and municipalities struggling with shrinking tax bases and rising deficits.
Despite the mounting evidence, these dangers are still not fully reflected in broader market optimism. The narrative continues to underestimate the scale and slow-motion nature of the damage.
Readers should keep an eye out for key signals: an increase in distressed property sales, a rise in office loan delinquencies, and new downgrades in regional bank credit ratings. These will be the early markers of deeper cracks in the financial system, cracks that won't remain hidden forever.