Some of the largest U.S. bank commercial real estate (CRE) lenders have substantial exposure to office loans, which are expected to face ongoing pressure due to the staying power of remote work. While loss rates could very well jump significantly and impact earnings, it does seem like the largest bank CRE lenders can manage their exposure.
But the thing to remember is that roughly 80% of CRE lending is done by the community and regional banks, so while the large banks may be able to stomach the losses and avoid some kind of systemic event, this is not the only segment of the banking sector that should be examined. In fact, the market has gotten much more interested in bank CRE exposure since three U.S. banks collapsed in March.
Let's take a look at CRE and office exposure among some of the larger CRE lenders with less than $100 billion in assets, and also try to examine how they might hold up if they start to see higher losses in their CRE portfolios.
More exposure than larger banks
Among larger banks, exposure to CRE and office space does look manageable because these larger banks have de-risked their portfolios a great deal since the Great Recession and significantly built capital. Additionally, Dodd-Frank regulation has really encouraged less lending and more bond investment, which is in part what has led to all of the trouble with banks recently.
But for regional and community banks, CRE lending is really their bread and butter, so they definitely have more exposure, especially when you look at it compared to their capital. Here's where several regional banks with less than $100 billion in assets stood at the end of last year when it comes to CRE exposure and retail and office loans in this portfolio, two segments that investors are worried about.
| Bank | CRE % of Loans | Office % of CRE | Retail % of CRE | CRE Loans Past Due 12/31/2022 | CRE % CET1 Capital |
|---|---|---|---|---|---|
| Zions Bancorporation | 23.4% | 18% | 11.7% | 0.38% | 197% |
| Comerica Bank | 13.7% | 8% | 7% | 0.30% | 91% |
| Webster Bank | 26% | 11.5% | N/A | 0.49% | 224% |
| Western Alliance Bancorp | 21.4% | 16% | N/A | NM | 217% |
| East West Bancorp | 40% | 5% | 8% | 0.12% | 303% |
| Synovus Bank | 29% | 23.8% | 11.1% | NM | 254% |
| Valley National Bancorp | 46% | 10% | 19% | 0.54% | 485% |
Data source: Bank regulatory filings/earnings materials. N/A = Not applicable. NM = nonmaterial
As you can see, most of these banks in the chart have significant exposure to commercial real estate and office and retail lending. When you think about CRE exposure as a percentage of core capital, a key threshold is 300%. Banks can certainly go over this level, but this is when regulators will start to get interested, especially if they've grown faster in recent years. Some of these banks above like Valley National and East West Bancorp are at or well above this 300% threshold.
But so far, credit quality has been extremely benign with all of these banks seeing hardly any loan losses in their CRE portfolios and barely any loans where the borrowers are even past due on their payments.
Additionally, most of these CRE loan portfolios appear to have been underwritten conservatively. At Valley National, the weighted average loan-to-value ratio in the CRE portfolio was 58% at the end of 2022, meaning that the typical borrower equity in a loan is 42% of the appraised property value, giving borrowers significant skin in the game. The weighted average debt-to-service coverage ratio (DSCR), which looks at a borrower's operating income as a percentage of debt payments, was 175% in Valley National's CRE portfolio. That is also quite strong.
In an analysis conducted by J.P. Morgan, analysts looked at how select U.S. banks would be impacted if they suffered an 8.6% cumulative loss rate in office, a 6.4% cumulative loss rate in retail, as well as a similar loss rate among construction and development loans.
The banks mentioned above would be able to sustain strong enough capital ratios to be considered "well capitalized" by regulators. However, the losses would in some cases take a significant bite out of earnings. Projected losses in the stress scenario would equate to roughly 28% of Valley National's pre-provision net revenue.
Is the market right to be concerned?
Given what just happened in the banking sector, I think it is good to see investors paying close attention to all challenges that the banking sector might face. That said, I'm not exactly sure what has changed about bank CRE exposure over the last few weeks. Currently, credit quality is still quite healthy and it does look like banks are underwriting CRE loans fairly conservatively. Banks are also expected to further tighten credit quality to better preserve liquidity.
If the economy falls into a deeper recession that will certainly exacerbate issues among retail CRE and many office leases are also expected to come due this year, which will be a good test. I certainly think losses are going to start to show up and potentially rise fairly significantly. While you never really know what is lurking in a loan portfolio, banks do seem well capitalized enough to sustain high losses, given the information available right now.
Still, this is not the time to get complacent and shareholders of banks should make sure they are getting quarterly updates on CRE loan portfolios.
