Of about 4,000 U.S. banks analyzed by the Klaros Group, 282 banks face stress from commercial real estate exposure and higher interest rates. The majority of those banks are categorized as small banks with less than $10 billion in assets. “Most of these banks aren’t insolvent or even close to insolvent. They’re just stressed,” Brian Graham, Klaros co-founder and partner at Klaros. “That means there’ll be fewer bank failures. But it doesn’t mean that communities and customers don’t get hurt.”
With the Federal Reserve expected to pause its rate-hiking campaign at this week’s meeting, regional banks stocks have made a comeback, but that doesn’t mean all the trouble is in the rearview mirror. “This banking situation was certainly, in large part, caused by the Fed and their aggressive rate-hiking policy,” said Jack Ablin, chief investment officer at Cresset Capital. With a likely pause ahead, it “takes one of those big challenges off the table.” Ablin said he expects the central bank to keep rates high for the moment, which means there will still be “a fair amount” of rate pressure on banks trying to keep deposits. Heading into this week, bank shares had logged a four-week-long advance. But the stocks swooned on Monday after several banks warned that net interest income would come in lower than expected. Still, the upward march resumed on Tuesday, begging the question of what’s ahead for bank stocks. The group is still far below from where it traded in March, when a banking crisis was set off by the collapse of Silvergate Capital, Silicon Valley Bank and Signature Bank in quick succession. The KBW Regional Banking Index has gained about 20% over the past month, but it remains down more than 18% since the year began. Over the past month, PacWest Bancorp , the gauge’s worst performer, has gained 88%. But its shares remain down nearly 63% year to date. A sharp eye on deposits Investors have been carefully watching deposits, and the news there has been good, according to Federal Reserve’s data. Deposits rose $29.5 billion at large and small U.S. banks in the week ended May 31. It was the third weekly gain for deposits, and it likely helped drive a $33.1 billion increase in commercial bank assets during that same period, on a seasonally adjusted basis. “While deposits might start to decline again if the Fed ends up hiking further, recent data suggest that the rapid pace of outflows immediately after the failure of SVB was a short-lived phenomenon,” Bank of America economist Aditya Bhave wrote in a research note Monday. “The 13-week annualized change in deposits at large and small banks was -2.5% and -14.1%, respectively.” While credit conditions still could tighten, the balance sheet data suggests the bank failures earlier in the year didn’t cause a “significant economic shock” and trends are “encouraging,” Bhave said. That said, Morgan Stanley analyst Betsy Graseck warned Monday that the Treasury General Account (TGA) will need to be refilled now that the debt ceiling issue has been resolved. As the Treasury sells tens of billions of dollars in Treasury bills, it could pressure bank deposits. Graseck predicts that a reacceleration of deposit outflows would snuff out the bank stock rally. “Last month, we suggested that the post-earnings decline in bank stocks was overdone given that there was no evidence that deposit outflows had re-accelerated in 2Q23,” Graseck wrote in a research note. “Following evidence in the Fed H.8 data that deposits have indeed stabilized through the month of May, the group is up ~15%+ from their troughs.” But gains are limited from here, she said, as the market waits for more clarity on the deposit outlook amid the TGA restocking. According to Morgan Stanley, the average TGA balance in June 2022 was $750 billion, but the Treasury’s cash bottomed out at $23 billion on June 1. The restocking has begun, but the firm anticipates the Treasury needs to issue an estimated $600 billion in T-bills by the end of the third quarter to always keep five days of spending on hand. Morgan Stanley is predicting a $525 billion drain from bank reserves by September. This is because quantitative tightening is still draining bank reserves, it said. Valuations are low Still, it may take some time for this trend to play out. More immediate headlines may influence stocks on a day-to-day basis. During last week’s rally, Nicholas Colas, co-founder of DataTrek Research, noted that even with stocks’ gains, valuations were quite low and dividend yields were above average. In addition, regional bank earnings estimates, which had been cut severely in March and April, had leveled off in May. “With earnings expectations now stable and valuations still at a deep discount to the overall U.S. equity market, bank stocks should be able to claw back more of their YTD losses,” he wrote on Thursday. “In fact, this process appears to already be underway.” But then came warnings Monday from Citizens Financial Group , KeyCorp, Huntington Bancshares and Truist Financial about net interest income being weaker than expected. All the banks presented at a Morgan Stanley U.S. Financials, Payments and CRE Conference in New York. Deutsche Bank analyst Matt O’Connor said the banks were likely hurt by a combination of higher rates, higher deposit betas and continued deposit remixing. Consolidation ahead? Ablin expects the difficult environment for banks will result in some consolidation. “If we see the big banks gobbling up the smaller banks, that should really put a floor on banks’ valuation and likely create opportunities for them,” he said. KEY YTD mountain Key has recovered some of the losses that occured during the banking crisis that began in March, but the stock is still down more than 42% since the start of the year. He named KeyCorp and Truist as examples of two well-run banks in “decent-sized markets” that could likely benefit from getting larger. TFC YTD mountain Truist shares are off their lows for the year but the stock is still down 27% year to date. Meanwhile, investors who want exposure to financial stocks could also consider names that aren’t regarded as being in the traditional retail banking business, such as Capital One , Albin said. “We have it in our large-cap portfolio,” he said. “It’s a high quality company.”
Only two months ago, SL Green & Co. chief executive Marc Holliday was sounding happy. The head of New York’s biggest commercial landlord firm told Wall Street analysts that traffic to the company’s buildings was picking up, and more than 1 million square feet of space was either recently leased or in negotiations. The company’s debt was down, it had finished the structure for its 1 Madison Avenue tower in Manhattan, and local officials had just completed an extension of commuter rail service from Long Island to Green’s flagship tower near Grand Central Station.
“We are full guns blazing,” Holliday said on the quarterly earnings call, with workers headed back to offices after a pandemic that rocked developers as more people worked from home, raising the question of how much office space companies really need any more. “We can hopefully …continue on a path to what we think will be a pivot year for us in 2023.”
Then Silicon Valley Bank failed, and Wall Street panicked.
Shares of developers, and the banks that lend to them, dropped sharply, and bank shares have stayed low. Analysts raised concerns that developers might default on a big chunk of $3.1 trillion of U.S. commercial real estate loans Goldman Sachs says are outstanding. Almost a quarter of mortgages on office buildings must be refinanced in 2023, according to Mortgage Bankers’ Association data, with higher interest rates than the 3 percent paper that stuffs banks’ portfolios now. Other analysts wondered how landlords could find new tenants as old leases expire this year, with office vacancy rates at record highs.
How much an office crash could hurt the economy
There are reasons to think the road ahead will be rocky for the real estate industry and banks that depend on it. And the stakes, according to Goldman, are high, especially if there is a recession: a credit squeeze equal to as much as half a percentage point of growth in the overall economy. But credit in commercial real estate has performed well until now, and it’s far from clear that U.S. credit issues spreading outward from real estate is likely.
“There’s a lot of headaches about calamity in commercial real estate,” said Kevin Fagan, director of commercial real estate analysis at Moody’s Analytics. “There likely will be issues but it’s more of a typical down cycle.”
The vacancy rate for office buildings rose to a record high 18.2% by late 2022, according to brokerage giant Cushman & Wakefield, topping 20 percent in key markets like Manhattan, Silicon Valley and even Atlanta.
But this year’s refinancing cliff is the real rub, says Scott Rechler, CEO of RXR, a closely-held Manhattan development firm. Loans that come due will have to be financed at higher interest rates, which will mean higher payments even as vacancy rates rise or remain high. Higher vacancies mean some buildings are worth less, so banks are less willing to touch them without tougher terms. That’s especially true for older, so-called Class B buildings that are losing out to newer buildings as tenants renew leases, he said. And the shortage of recent sales makes it hard for banks to decide how much more cash collateral to demand.
“No one knows what is a fair price,” Rechler said. “Buyers and sellers have different views.”
What the Fed has said about commercial real estate
Federal Reserve officials up to and including Chair Jerome Powell have stressed that the collapse of Silicon Valley Bank and Signature Bank were outliers whose failures had nothing to do with real estate – Silicon Valley Bank had barely 1 percent of assets in commercial real estate. Other banks’ exposure to the sector is well under control.
“We’re well aware of the concentrations people have in commercial real estate,” Powell said at a March22 press conference. “I really don’t think it’s comparable to this. The banking system is strong, it is sound, it is resilient, it’s well capitalized.”
The commercial real estate market is a bigger issue than a few banks which mismanaged risk in bond portfolios, and the deterioration in conditions for Class B office space will have wide-reaching economic impacts, including the tax base of municipalities across the country where empty offices remain a significant source of concern.
But there are reasons to believe lending issues in commercial real estate will be contained, Fagan said.
The first is that the office sector is only one part of commercial real estate, albeit a large one, and the others are in unusually good shape.
Vacancy rates in warehouse and industrial space nationally are low, according to Cushman and Wakefield. The national retail vacancy rates, despite the migration of shoppers to online shopping, is only 5.7%. And hotels are garnering record revenue per available room as both occupancy and prices surged post-Covid, according to research firm STR. Banks’ commercial real estate lending also includes apartment complexes, with rental vacancies rates at 5.8 percent in Federal Reserve data.
“Market conditions are fine today, but what develops over the next two to three years could be pretty challenging for some properties,” said Ken Leon, who follows REITs for CFRA Research.
Still, most debt coming due in the next two years looks like it can be refinanced, Fagan said.
That’s one of the reasons Rechler has been drawing attention to the issues. It shouldn’t sneak up on the market or economy, and it should be manageable with the loans spread out across their own maturity ladder.
About three-fourths of commercial real estate debt generates enough income to pass banks’ recent refinancing standards without major changes, Fagan said. Banks have been extending credit using a rule of thumb that a property’s operating income will be at least 8% of the loan every year, though other experts claim a 10% test is being applied to some newer loans.
To date, banks have had virtually no losses on commercial real estate, and companies are showing little need to default either on loans to banks or rent payments to office building owners. Even as companies lay off workers, the concentration of job losses among big tech employers, in Manhattan, at least, means that tenants have no trouble paying their rent, S.L. Green said.
Bank commercial mortgage books
Take Pittsburgh-based PNC Financial, or Cincinnati-based Fifth Third, two of the biggest regional banks.
At PNC, the $36 billion in commercial mortgages on the books of the bank is a small fraction of its $557 billion in total assets, including $321.9 billion in loans. Only about $9 billion of loans are secured by office buildings. At Fifth Third, commercial real estate represents $10.3 billion of $207.5 billion in assets, including $119.3 billion in loans.
And those loans are being paid as agreed. Only 0.6% of PNC’s loans are past due, with delinquencies lower among commercial loans. The proportion of delinquent loans fell by almost a third during 2022, the bank said in federal filings. At Fifth Third, only $10 million of commercial real estate loans were delinquent at year-end.
Or take Wells Fargo, the nation’s largest commercial real estate lender, where credit metrics are excellent. Last year, Wells Fargo’s chargeoffs for commercial loans were .01 of 1 percent of the bank’s portfolio, according to the bank’s annual report. Writeoffs on consumer loans were 39 times higher. The bank’s internal assessment of each commercial mortgage’s loan’s quality improved in 2022, with the amount of debt classified as “criticized,” or with a higher-than-average risk of default even if borrowers haven’t missed payments, dropping by $1.8 billion to $11.3 billion
“Delinquencies are still lower than pre-pandemic,” said Alexander Yokum, banking analyst at CFRA Research. “Any credit metric is still stronger than pre-pandemic.”
Wall Street is worried
The riposte from Wall Street is that the good news on loan performance can’t last – especially if there is a broader recession.
In a March 24 report, JPMorganChase bank analyst Kabir Caprihan warned that 21% of office loans are destined to go bad, with lenders losing an average of 41% of the loan principal on the failures. That produces potential writedowns of 8.6%, Caprihan said, with banks losing $38 billion on office mortgages. But it is far from certain that so many projects would fail, or why value declines would be so steep.
RXR’s Rechler says that market softness is showing in refinancings already, in ways banks’ public reports don’t yet reveal. The real damage is showing up less in late loans than in the declining value of bonds backed by commercial mortgages, he said.
One sign of the tightening: RXR itself, which is financially strong, has advanced $1 billion to other developers whose banks are making them post more collateral as part of refinancing applications. Rechler dismissed rating agencies’ relatively sanguine view of commercial mortgage backed securities, arguing that markets for new CMBS issues have locked up in recent weeks and ratings agencies missed early signs of housing-market problems before 2008’s financial crisis.
The commercial mortgage-backed bond market is relatively small, so its short-term issues are not major drivers of the economy. Issuance of new bonds is down sharply – but that began last year, when fourth-quarter deal volume fell 88 percent, without causing a recession.
CMBS issuance
Loan type
Q1 2022
Q1 2023
Conduit
$7.9B
$2.3B
SASB
$19.1B
$2.7B
Large loan
$442.6M
$13.1M
CRE CLO
$15.3B
$1.5B
Total
$42.8B
$6.5B
Source: Trepp
“The statistics don’t reflect where it’s going to come out as regulators take a harder look,” Rechler said. “You’re going to have to rebalance loans on even good properties.”
Wells Fargo has tightened standards, saying it is demanding that payments on refinanced loans take up a smaller percentage of a building’s projected rent and that only “limited” exceptions will be made to the bank’s credit standards on new loans.
Without a deep recession, though, it’s not clear how banks’ and insurance companies’ relatively diversified loan portfolios get into serious trouble.
The primary way real estate could cause problems for the economy is if an extended decline in the value of commercial mortgages made deposits flow out of banks, forcing them to crimp lending not just to developers but to all customers. In extreme cases, that could threaten the banks themselves. But if developers continue to pay their loans on time and manage refinancing risk, MBS owners and banks will simply get paid as loans mature.
Markets are split on whether any version of this will happen. The S&P United State REIT Index, which dropped almost 11% in the two weeks after Silicon Valley Bank failed, has recovered most of its losses, down 2% over the past month and remains barely positive for the year. But the KBW Regional Banking Index is down 14% in the last month, even though deposit loss has slowed to a trickle.
The solution will lie in a combination of factors. The amount of loans that come up for refinancing drops sharply after this year, and new construction is already slowing as it does in most real estate downturns, and loan to value ratios in the industry are lower than in 2006 or 2007, before the last recession.
“We feel like there’s going to be pain in the next year,” Fagan said. “2025 is where we see our pivot toward a [recovery] for office.”
