Stocks have gone on a tear, with the S&P 500 index up 19% since the start of the year. The rally has some investors optimistic that we could be in a new bull market.
However, investors shouldn't let the recent rally distract from potential risks relating to higher interest rates -- specifically commercial real estate. Concerns center around office properties and high refinancing costs as interest rates hit multi-decade highs.
Wells Fargo (WFC -0.03%) is one of the country's largest commercial real estate (CRE) lenders. It recently bolstered its allowance for credit losses on its CRE portfolio by billions in the second quarter. Here's what investors need to know about this move by the bank.
Commercial real estate headwinds
Commercial real estate has dealt with headwinds, some building for years, causing a slowdown across the industry. CBRE Group, one of the world's largest commercial real estate companies, is well positioned to understand the factors driving the industry slowdown. Company Chief Executive Officer Robert Sulentic pointed to three headwinds in the industry today:
- High inflation and rising interest rates to combat it
- Stress in the banking system
- Falling demand for office space
Since March 2022, the Federal Reserve has increased the federal funds rate from 0% to 5.5%, the fastest pace of interest rate increases in decades. These changes in interest rates contributed to the downfall of SVB Financial's Silicon Valley Bank in March, which was ill-prepared for interest rates going as high as they have.
The bank's failure sent ripple effects across the industry, spreading concerns of possible contagion. In response, banks have pulled back funding, especially in those areas that appear to be more risky. Commercial real estate, specifically office real estate, has been one area of concern.
Data source: YCharts
Remote work for office employees became widespread during the pandemic, and many companies have stuck with it or have gone to a hybrid work arrangement. Many big tech companies have been laying off employees in droves. The result is that companies require less office space, especially in specific regions, and could choose to let the property go.
With more than $154 billion in loans outstanding, Wells Fargo is one of the largest banks when it comes to CRE. Of that amount, $33 billion is in office loans.
Wells Fargo is building up billions of reserves for credit losses
During Wells Fargo's earnings call, Chief Financial Officer Mike Santomassimo told investors "the office market continues to be weak" and that "our CRE teams are focused on surveillance and derisking, which includes reducing exposures and closely monitoring at-risk loans." Santomassimo also pointed out that Wells Fargo's office exposure is just 22% of its total commercial real estate loans and 3% of its whole loan book.
Things weren't too bad in the second quarter; Wells Fargo had net charge-offs of $79 million on its commercial real estate loans, representing 0.2% of its average loans. The bank also increased its allowance for credit losses on CRE loans to $3.6 billion, or 2.35% of its total loans.
Banks build up reserves for credit losses as a precautionary measure to guard against losses from borrowers who could potentially default on their loans. Setting aside reserves gives banks the resources to absorb unexpected credit losses during economic downturns or volatile conditions and help ensure financial stability.
Reserve buildups don't always mean a downturn will happen. For example, during the pandemic, banks built up billions of dollars in reserves to prepare for the uncertain environment. It turned out that those buildups were unnecessary, and their earnings got a boost in the quarters that followed as they released those reserves. However, it's a prudent measure to ensure banks prepare for economic turbulence that could happen.
Image source: Getty Images.
The impact of rising interest rates hasn't yet been felt
We haven't begun to see the full impact of the Federal Reserve's interest rate hikes, which as economists sometimes note, have "long and variable lags." According to Raphael Bostic, president and CEO of the Federal Reserve Bank of Atlanta, interest rates could take 18 months to two years to affect inflation and the economy. The Fed did its first interest rate hike 16 months ago, and the impact of subsequent rate increases could take time over the next year or so to trickle into the economy.
In addition, the Fed recently completed its annual stress tests, where it evaluated banks to ensure they are sufficiently capitalized to absorb losses during a severe recession. This year's test highlighted heightened stress in commercial real estate, including a 40% decline in commercial real estate values.
In the test, the Fed found that Wells Fargo's losses on its commercial real estate portfolio could top 9.7% of its total loan balance is the most severe scenario. This places it in the middle of the pack. Those with the most exposure include Goldman Sachs (which could see losses of 16% of its total loan portfolio), Morgan Stanley (13.7%), and Citizens Financial Group (12.4%).
Wells Fargo should weather the storm, but investors should avoid these stocks
Investors can take away from Wells Fargo's earnings that weakness in commercial real estate markets seems likely to continue. For this reason, I would avoid office-focused REITs for now, including SL Green Realty, Office Properties Income Trust, and Vornado Realty Trust. These stocks will likely face more volatility in the coming months as higher interest rates affect the industry, and office property prices could take years to recover.
For Wells Fargo, its exposure to office properties -- those most at risk -- is a small amount of its overall portfolio. The bank also did well during its stress test and is well capitalized to ride out any potential turbulence in these markets. However, investors should be aware of possible challenges that could be a drag on the bank's earnings in the coming quarters.
