FinLogic FinLogic Quantitative Think Tank Center|A lot of offices are still empty — and it's becoming a major risk for the economy

The FinLogic FinLogic Quantitative Think Tank Centernext big potential risk to the U.S. economy may be lurking in corporate towers across the country's downtown districts.

With many people still working from home, companies are cutting back on so much office space that it threatens to unleash even more headwinds for the U.S. economy.

An unraveling of the office sector spells trouble not only for banks that are owed an estimated $1.2 trillion in outstanding office loan debt, but also for countless small businesses that depend on white-collar customers as well as cities that benefit from the property taxes tied to office buildings.

It's a troubling development for the commercial real estate industry at a time when the U.S. economy is already showing signs of stress and maybe even a recession.

Here are some of the ways America's empty offices could further hurt the economy:

Landlord defaults and foreclosures

Nearly 20% of office spaces are currently empty across the United States. It's a milestone that exceeds the vacancy rate during the 2008 global financial crisis, and it's worse in places like San Francisco and downtown Los Angeles, where more than a quarter of offices are sitting empty.

If companies continue to give up their leases and if demand for office space remains sluggish, office landlords won't be able to collect the rents needed to keep up with mortgage payments to pay off commercial loans, according to analysts.

Many of those loans are coming due in the next year, and building owners will need to refinance their debts at a time when low occupancy has eroded building values and interest rates have shot up.

That means many landlords could soon be saddled with significantly steeper payments.

Analysts say it could end badly.

"I'd say the number one implication is going to be defaults and foreclosures," says Kenneth Rosen, chair of real estate research firm Rosen Consulting Group.

Banks will also feel the pain

Increased defaults and foreclosures would likely send tremors across the U.S. banking system.

The bulk of the $1.2 trillion in office space debt is owed to smaller regional banks, which are already in turmoil from depositors fleeing to bigger banks.

Over the past two months, three smaller banks have failed. That trouble has continued to spread as shares for PacWest Bancorp took a hit last week.

If office landlords can't make good on their loans and ultimately hand over the keys, banks would need to find new buyers, a tough task when interest rates are high, credit is tightening and concerns about the economy grow.

All this has caught the attention of policymakers.

In a report published Monday last week, the Federal Reserve said it has increased and expanded its scrutiny of commercial real estate loans and the banks that commonly issue them.

The fallout could upend city centers

Soaring vacancies are already upending the ecosystems of downtown city centers.

Dry cleaners, shoeshiners, restaurants and convenience stores that have long depended on heavy five-day-a-week foot traffic are struggling to survive.

"Right now I'm maybe getting four or five customers a day," says James Wallace Sears, owner of a shoe repair shop in downtown Los Angeles, adding that his monthly sales are down 85% from before the COVID-19 pandemic. "I'm here now starting up again to see if it's still going to work, but I don't know.

For public transit systems, fewer commuters and the end of pandemic-related aid are contributing to budget deficits and massive projected shortfalls.

And for local governments, high office vacancies will mean a drop in property tax revenues, which will burn a hole in city finances.

Landlords are desperately searching for solutions

The commercial real estate market has few good options.

Some landlords are exploring ways to convert their office buildings into apartments, which would help relieve housing shortages, but not all buildings can transform seamlessly without significant retrofitting and expensive reconstruction, and that's a major undertaking, given the tightened lending conditions and greater borrowing costs.

Brokerage firms and landlords are pulling out all the stops to score new occupants for their higher-end buildings.

Cushman & Wakefield is offering helicopter tours of new offices in downtown Los Angeles, built on a very expensive bet that high-amenity spaces with edgy restaurants, luxe fitness centers, on-site child care and breezy workspaces will be enough to lure companies and workers back.

So far, demand for those higher-end spaces appears promising, but committing to them at a time of great economic uncertainty is a gamble, one that analysts don't believe will be enough to save the office sector at large.

A more surefire solution is one that many workers seem unwilling to consider: an end to remote work and an aggressive full-bore return to the office.

Barring that, the cities and businesses that once flourished because of white-collar workers stand to flounder — and even fail — without them.