After the collapse of three U.S. banks in less than a week's time in March, the banking sector has found itself under a microscope. Problems that were being ignored by investors or that the market elected to kick down the road are now front and center.
In addition to deposit outflows and unrealized bond losses, two issues that ultimately led to the downfall of SVB Financial, investors are now taking a very hard look at commercial real estate (CRE), which many believe could be another looming issue. Embedded within CRE are office loans, which are an even more worrying loan segment. This is because of the popularity of working from home, which exploded after the onset of the pandemic and is a trend that does not look to be going away anytime soon.
Let's take a look at some of the largest CRE lenders in the U.S. and whether they are prepared for the incoming stress to their office loan portfolios.
Large bank exposure
While the office world is yet another casualty of the advent of the internet and digital tools that allow people to work remotely, office loans have always been a staple of commercial real estate. Here's a look at some of the largest U.S. bank CRE lenders and their exposure to office space at the end of 2022.
| Bank | Office Loans | Office Loans, % CRE | CRE % CET1 Capital |
|---|---|---|---|
| Bank of America (BAC -0.21%) | $18.2 billion | 26% | 39% |
| JPMorgan Chase (JPM 0.06%) | $14.9 billion | 13.8% | 49% |
| Wells Fargo (WFC -0.03%) | $40.8 billion | 22% | 139% |
| US Bancorp (USB 0.32%) | $7.2 billion | 13.1% | 134% |
| PNC Financial (PNC -0.12%) | $9.1 billion | 25% | 91% |
| Citizens Financial Group (CFG 0.43%) | $6.3 billion | 22% | 155% |
| M&T Bank (MTB -0.35%) | $5.2 billion | 11.5% | 291% |
Data source: Bank regulatory filings
As you can see, many of these lenders have about one-fifth or more of their CRE portfolios tied up in office space. The column on the right shows a bank's total CRE exposure as a percentage of core capital that banks set aside for unexpected loan losses. This is an important number because regulators typically don't want to see banks exceed a CRE-to-core capital ratio of 300%.
It's not illegal to go above this range, and plenty of banks have, but doing so will start to get regulators interested in that bank. Most of these banks, aside from M&T Bank, are well below this range.
What level of losses are large banks looking at?
The market is watching office space because vacancy rates have surged in recent years, simply because more people are working from home, and companies have too much office space and are not appropriately sized for a hybrid work setup, where employees only work a few days in the office.
The national U.S. office vacancy rate as of March hit 16.5%, which is up about 0.7% year over year, according to CommercialEdge. Furthermore, there are reports of office rent prices and demand coming down in major cities and work hubs and among class-A office space, which are considered very prestigious buildings with above-average rents and strong companies in them.
Companies sign longer-term leases for office space, so the losses don't all pile up at once. According to Trepp, there will be $270 billion worth of CRE mortgages with banks that come due this year.
There are a few ways to think about the losses that banks could be facing in their office loan portfolios. One way is to look at the Federal Reserve's recent bank stress testing, which models bank balance sheets based on a severely adverse hypothetical economic scenario. In this scenario, gross domestic product falls sharply and unemployment jumps over a two-year period.
Specifically, in the Fed's 2022 stress testing scenario, while there is no specific focus on office space, the Fed assumes a 40% drop in CRE prices. The largest 33 banks with a U.S. presence would suffer more than $75 billion of CRE loan losses, or the equivalent of a 9.8% loss rate. In the scenario, which includes heavy loan losses in other loan portfolios, the 33 banks maintain strong aggregate capital levels that are well above regulatory requirements.
In another analysis of CRE and office space by analysts at JPMorgan, the team assumes a cumulative loss rate of 8.6% specifically in bank office portfolios that are applied over a three- to five-year period, and the hits to bank capital levels are quite manageable, although they do take a bite out of pre-provision net revenue.
Many banks have underwritten office loans fairly conservatively. For instance, the loan-to-value (LTV) ratio in Bank of America's office portfolio at origination is 55%, meaning these borrowers had down payments equivalent to 45% of the appraised property value. For M&T Bank, LTVs in their office portfolio are below 60%.
Likely more of an earnings story
As the team at JPMorgan noted, the stress that large banks are likely to experience in their office portfolios will probably be more of an earnings story. It is certainly something to be concerned about because there could be potentially high loss rates in office loan portfolios that put added stress on banks at a bad time and impact earnings.
But the potential losses do not look high enough to erode a bank's capital levels enough to the point where there is some kind of systemic event. There also might be ways to restructure the loans or still realize value from the properties that reduce the overall loss rate.
While most CRE lending is done by smaller and regional banks, large banks do look well-capitalized enough to weather the hit they may experience from stressed office loans. I'll soon take a closer look at how community and regional banks are positioned.
Correction: The original version of this report had an incorrect office loan dollar amount and office loans as a percentage of commercial real estate for US Bancorp.
