Regional banks, already under financial stress and the eye of regulators, now face another potential crisis in the shaky commercial real estate sector
The recent collapse of several regional banks, including Silicon Valley Bank (SVB) and Signature Bank, as well as the troubled acquisitions of both Credit Suisse and First Republic Bank, led to many financial industry observers becoming concerned about the banking sector and about the health of the economy in general. Chief among these concerns is the United States possibly slipping into a recession.
Stress in the commercial real estate sector could be the next big concern for U.S. regional banks and regulators, as losses emanating from higher interest rates manifest over the coming months, analysts and bankers say. A portion of this fear stems from the possibility that each regional bank could be the next to suffer a major loss.
As banks report their first-quarter earnings, investors are scrutinizing the results for signs of stress or weakness following SVB’s collapse last month. So far, the earnings picture has not revealed any hidden bombshells, but experts say the pressures on banks’ financial health are likely to become more pronounced in the months ahead.
Of greatest concern is the banking sector’s exposure to commercial real estate (CRE), particularly the office sector. “Compared to big banks, small banks hold 4.4-times more exposure to U.S. [CRE] loans than their larger peers,” stated a new analysts report from JPMorgan Private Bank. “Within that cohort of small banks, CRE loans make up 28.7% of assets, compared with only 6.5% at big banks,” the report continued. “More worrying, a significant percentage of those loans will require refinancing in the coming years, exacerbating difficulties for borrowers in a rising rate environment.”
A separate Citigroup analysis found that banks represent 54% of the overall $5.7 trillion commercial real estate market, with small lenders holding 70% of CRE loans. More than $1.4 trillion in U.S. CRE loans will mature by 2027, with approximately $270 billion coming due this year, according to real estate data provider Trepp.
High vacancy rates
The office sector faces significant challenges following the COVID-19 pandemic, which forced a potentially permanent shift to remote work for millions of employees. A seismic shift in employee mentality following a period of flexible, remote working has led to a continued acceptance of remote and hybrid opportunities. With this change, office vacancy rates remain high across many U.S. cities. The current overall vacancy rate of 12.5% is comparable to where it was in 2010, one year after the onset of the Global Financial Crisis.
Further, chief executives from some of the largest banks have pointed to risks in the commercial real estate sector. “Weakness continues to develop in commercial real estate office,” said Wells Fargo Chief Executive Charlie Scharf on a recent earnings call with analysts. The bank set aside an additional $643 million in the first quarter for credit losses, mainly driven by expectations of higher CRE loan defaults.
California market in focus
With the tech and venture capital sector having borne the brunt of SVB’s collapse, recent data shows that California’s CRE market is one of the hardest hit in the country. San Francisco and Los Angeles had an average office vacancy rate of 21.6% in the first quarter, according to data from commercial real estate firm Cushman & Wakefield. And loans for San Francisco offices now face the highest risk of default of all U.S. metro areas.
“Difficulties are emerging by geography,” noted the JPMorgan report, adding that “Chicago and San Francisco are much more challenged than Miami, Raleigh, and Columbus, for example.”
CRE weakness is likely to affect banks of all sizes, but small and regional banks have, on a percentage basis, the greatest exposure. “While total exposure to the weakest CRE subsectors varies by bank, those with more than 100% of their capital in these buckets are more likely to be smaller regional entities,” the JPMorgan report stated, noting that Webster Financial Corporation, Valley National Bancorp, and Zions Bancorporation are a few of the banks with exposures exceeding 100% of their capital.
The bank’s base case scenario “assumes that aggregate CRE prices fall approximately 10% to 15% in the current cycle,” although for the office sector, the report revealed that price declines of 30% to 40% in the most stressed markets would be unsurprising.