As CRE Office Vacancies Rise, So Do CFI Credit Risks

In the early 1930s, the Great Plains began to report what outsiders assumed was just bad weather. A combination of drought, high winds, and over-farming created enormous dust storms that swallowed fields, homes, and entire towns. At first, it seemed like a regional problem — affecting only a handful of farming communities already used to tough conditions.Yet, as crops failed and fields became unfit for farming, families were forced to leave. The migration of displaced workers upended local economies across state lines. Food prices soared, unemployment deepened, and the crisis became national in scope. What started as a local environmental issue soon evolved into one of the largest economic and social disruptions of the decade.The Dust Bowl’s legacy reminds us that small, localized stressors — if left unchecked — can become far-reaching systemic risks. For community financial institutions (CFIs) today, a different kind of storm is brewing: rising commercial real estate (CRE) vacancies in major urban markets. While the consequences of these vacancies appear isolated to cities for now, the structural shifts underway in how businesses use office space may not stop at the city limits. CFIs in suburban and even rural areas may soon be affected.Urban Office CRE Vacancies: A Lingering DragIn cities like San Francisco, New York, Chicago, and Washington, D.C., office attendance still hasn’t bounced back from pre-pandemic norms. San Francisco’s return-to-office (RTO) rate remains below 42% of pre-pandemic levels, while the Big Apple is at 54%.In fact, according to the Atlanta Fed’s CREMI index, office CRE performance across the US remains below its long-term average, signaling this is more than a local issue.

Source: Atlanta Federal Reserve

Hybrid Work and a Flight to QualityRTO mandates have largely given way to national hybrid work flexibility. Outside of a few stalwart sectors like finance, most companies are no longer pushing for rigid in-office policies. To attract and retain top talent, they’re redesigning floor plans, downsizing footprints, and prioritizing amenities. Simply put, businesses want less office space, more flexibility, and better locations. This “flight to quality” is driving demand for Class A buildings in central business districts, while older and less desirable office spaces struggle. Many tenants are moving toward shared or coworking spaces, and the average lease size continues to shrink. In Q4 2024, tenants renewing office leases reduced space by an average of 2.9% — a major gain for CRE landlords, who had seen an average footprint reduction of 11.7% just a year earlier.Suburban Markets Face Growing PressureSuburban markets initially benefited from the shift away from dense urban cores, but that trend is leveling off. After all, hybrid work models reduce overall office demand, whether urban or suburban. Sublease availability is rising in secondary markets, and signs of CRE softening are beginning to appear in places previously seen as insulated.For CFIs with significant exposure to suburban or rural commercial properties, this is a critical inflection point. Office demand may not disappear, but it’s certainly shifting — and early post-pandemic assumptions about local office resilience in suburbia may no longer hold true.What This Means for CFIs: A New CECL LandscapeTo manage CRE exposure and maintain robust current expected credit losses (CECL) compliance, CFIs should take a more nuanced and forward-looking approach to managing CRE loans, especially as urban distress threatens to ripple outward from city centers.1. Watch for Shadow VacanciesMany of these unoccupied buildings are still technically “occupied.” Leases signed before the pandemic continue to generate rental income for now. However, as those leases approach expiration, landlords face a stark reality: actual occupancy is low, and tenant needs have fundamentally changed — maybe for good.These “shadow vacancies” are part of the larger “extend and pretend” strategy larger banks are using to beautify their balance sheets, and can mislead lenders about true property performance and future rent potential.CFIs should:

2. Don’t Assume Suburban Is SafeSuburban markets have definitely benefited from post-pandemic urban migration, but they aren’t immune to CECL ripple effects. The popularity of hybrid work is likely to continue reducing office space demand, and not just in big cities. As leases mature, suburban landlords could face the same challenges urban ones are experiencing today.CFIs should:

3. Reevaluate CRE Loan AssumptionsMany CRE loans were underwritten during a vastly different environment — low rates, strong occupancy, and stable rent growth. Those assumptions may no longer apply.CFIs should:

4. Adjust CECL Q-Factors for Emerging TrendsThe CECL ripple effect means that CFIs should take a forward-looking view, incorporating not only recent performance data but also anticipated economic conditions, like the current administration’s tariffs. As CRE headwinds shift office and mixed-use segments, qualitative considerations must change accordingly.CFIs should:

Looking AheadThe challenges in urban commercial real estate may seem distant from the communities CFIs serve — but as with dominoes, stress in one market can easily tip into another. With careful analysis and timely CECL adjustments, CFIs can stay ahead of the problem, protecting their portfolios while continuing to support the communities they know best.