It's no secret that investors are keeping a very close eye on commercial real estate (CRE) loans as credit normalizes, and even more so in the office loan space.
The office loans segment is likely to be put under significant stress in the years ahead, largely because of the remote work trend, which the pandemic clearly accelerated. With fewer workers going to the office, vacancy rates are down and many office buildings are expected to see their property values plunge.
With one of the largest CRE franchises, Wells Fargo (WFC -0.03%) certainly has office exposure that it will need to deal with. Here's how the bank is preparing.
Image source: Getty Images.
How things are going for Wells Fargo
Wells Fargo's total office exposure is about $33.1 billion, which is certainly a lot in total dollar terms but only represents about 3.5% of the bank's total loans. However, office loans also represent roughly 21.5% of total CRE loans.
At the end of the second quarter, $1.5 billion of Wells Fargo's office loans were categorized as non-accrual, most of which can be attributed to office loans made in the corporate and investment bank to institutional investors. CEO Charlie Scharf said on the bank's recent earnings call that there haven't been significant losses in the office portfolio just yet, but "our detailed loan-by-loan review of the portfolio has given us a sense of how the next several quarters could play out. We've also considered a number of stressed scenarios, all of which informed our actions this quarter."
At the end of the second quarter, Wells Fargo had set aside enough reserves to cover 8.8% of losses for the office portfolio in its investment bank, which is up from 5.7% just one quarter ago. The coverage ratio for the total CRE office portfolio is 6.6%, up from 4.4% in Q1.
Scharf said that total loss content will be based on a number of factors including property type, location, lease rates, lease renewal notice dates, loan structure, and borrower behavior. Furthermore, Scharf said that investors should be careful about reading too much into geography or individual markets when it comes to assessing loss content. He continued:
We have examples in cities that are struggling where the structure of our loan is quite good. The underlying property has very high lease rates for an extended period of time. And then we can have a loan in a market which is doing well, but for whatever reason, that property -- the specific issue in that property, there are a bunch of potential termination dates in the shorter term.
How bad could things get?
It's difficult to know how bad things could get given that there is still so much uncertainty in the environment. But one area we can look at is the Federal Reserve's recent stress testing results. Stress testing puts the largest and most complex banks through a hypothetical severe recession over a nine-quarter period to see how banks would fare.
In the 2023 exams, the unemployment rate would increase from 3.5% all the way to 10%, while gross domestic product would fall by a whopping 8.75% thanks to a 40% fall in CRE prices, as well as a sharp decline in other asset prices. Ultimately, the Fed used a 20% loss rate assumption for office portfolios, which is triple the peak rate seen during the Great Recession.
Despite the scenario in stress testing, Wells Fargo managed to maintain ample capital well above regulatory capital requirements. The total loss rate in its broader CRE portfolio under the stress test hypothetical scenario was 9.7%.
Are office loans an existential threat?
I think it's fairly obvious at this point that there will be loan losses in bank office portfolios -- and at some banks, those losses may be significant. While uncertainty remains, it does seem like Wells Fargo is preparing adequately.
The bank may need to continue to bolster reserves but a stress test-like doomsday scenario seems unlikely, at least when you look at the assumptions around unemployment and economic growth. Could CRE prices fall by 40%? It's certainly possible, according to some economists and analysts. But this is what happened during the Great Recession and actual loan losses were nowhere near what the Fed is modeling in its stress test this year.
Ultimately, while I think the office space will experience stress and there could be some surprises, Wells Fargo does have the capital to contain the issues to more of a temporary earnings challenge, as opposed to some kind of systemic risk.
