Rising interest rates and a shift toward remote work have participants cautious about the outlook in the commercial real estate industry in the coming quarters. Earlier this year, CBRE Group, the world's largest commercial real estate firm, pointed out several headwinds that could affect valuations of commercial real estate properties.

Last month, Goldman Sachs (GS 2.50%) CEO David Solomon acknowledged that his firm would have to markdown some of its real estate holdings in its second-quarter earnings. Here's why commercial real estate valuations could be under pressure and how it may affect Goldman Sachs.

The current state of commercial real estate

For the better part of this year, market participants have sounded alarm bells around the commercial real estate industry. In May, the Federal Reserve released its Financial Stability Report. In that report, the Fed warned that trouble in the commercial real estate sector could pose a risk to the U.S. financial system. 

Stress in commercial real estate began during the pandemic, when employees shifted from working in the office to working from home. Many employees have returned to the office on a full-time or hybrid basis, but there remains less demand for commercial office properties than before the pandemic.

Fueling the fire are rapidly rising interest rates and a pullback in bank lending. Since March 2022, the Federal Reserve has raised its benchmark interest rate at its fastest pace since the 1980s, bringing its benchmark federal funds rate from near zero to 5.25%.

According to data from MSCI, nearly $900 billion in U.S. commercial property loans will mature in the next two years. As these loans come due, borrowers will face a decision: Refinance at much higher borrowing costs, or allow the leases to expire and walk away from their properties.

In addition to higher interest rates, banks have pulled back on funding commercial real estate loans. According to the Wall Street Journal, regional banks hold about 67% of commercial real estate loans. Following the collapse of SVB Financial's Silicon Valley Bank and Signature Bank, regional banks have been reconsidering the composition of their balance sheets. They have become much more selective about the loans they are willing to extend, making it more difficult for those in commercial real estate to secure funding.

Two professionals walking outside while looking at a commercial real estate property.

Image source: Getty Images.

Goldman Sachs CEO David Solomon said the firm would markdown some holdings in Q2

During an interview with CNBC last month, Goldman Sachs CEO David Solomon acknowledged that the firm would have to markdown some of its commercial real estate holdings in its second-quarter earnings as the industry adapts to higher interest rates.

Solomon said the firm already posted $400 million in impairment losses in the first quarter, and that defaults are just now showing up in the bank's results. He said the markdowns are "definitely a headwind" for the business, but they are manageable in the grand scheme of things for the firm. At the end of Q1, Goldman Sachs' loan portfolio totaled $183 billion. Of this total, nearly $29 billion is in commercial real estate loans. 

While Solomon says the commercial real estate markdowns are manageable for Goldman Sachs, he did preach caution for small and mid-sized banks. Solomon said that the writedowns are "something that we're going to have to work through" and that "[t]here'll probably be some bumps and some pain along the way for a number of participants." 

The investment bank faces several headwinds

Investors shouldn't ignore Goldman Sachs' exposure to commercial real estate compared with its peers. The Federal Reserve recently released results from its annual stress tests, where it analyzes how major banks would perform in a severe recession. One extreme scenario tested was a 40% decline in commercial real estate values. In that scenario, Goldman Sachs would have the highest commercial real estate loan loss rate, at 16% of its average loan values. Morgan Stanley and Citizens Financial Group were the next highest, at 13.7% and 12.4%, respectively.

Goldman has had its share of headwinds affecting its business in recent years. After a record year in 2021, its investment banking division has taken a hit due to fewer companies going public and fewer mergers and acquisitions deals during the rising interest rate environment.

Earlier this year, it also announced it would be scaling back its consumer banking efforts, which it initiated in 2016. Now the company faces further markdowns on its commercial real estate business, which could take several quarters to play out. For those reasons, I'll be avoiding the stock for the time being until the headwinds die down.