Big Banks Are Taking Hits From Commercial Real Estate

　　Commercial real estate is often talked about as a problem for smaller banks, but big banks are emerging with the most evident scars so far.

　　That isnt how the stock market has behaved. Declining values for offices, apartment complexes or other commercial properties have been a factor weighing on the shares of all banks, but particularly smaller ones. The KBW Regional Banking Index is down around 12% this year, while the KBW (^BKX) Nasdaq Bank Index of larger lenders is up nearly 9%.

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　　Regional, community and smaller banks do represent more than a quarter of commercial real estate and multifamily property debt in the U.S., which is more than twice the share for the top 25 biggest banks, according to a recent Moodys analysis. Not all so-called CRE loans are created equal, though.

　　Such things as credit-card loans are pretty standardized, but real estate is fuzzier. Is it a new-construction loan or one on an existing building？ Is the borrower the propertys main tenant or is it looking to lease the building out？ Is it an office tower, a medical facility, a strip mall or a warehouse？ Is it a big loan split between banks, or a smaller one held by one bank？ And so on.

　　So it is important to drill down into performance, not just exposure. Based on available data for the banking system, figures recently compiled by S&P Global Market Intelligence from regulatory filings for the first quarter are showing a significant disparity in the percentage of loans marked as either delinquent or nonaccrual, which the bank doesnt expect to pay off in full at maturity.

　　The trouble is at big banks and their loans to properties that are intended to be leased to third parties. For CRE loans involving properties that aren‘t owner-occupied and are held by banks with over $100 billion in assets, more than 4.4% were delinquent or in nonaccrual status in the first quarter. That was up over 0.3 percentage point from the prior quarter. Meanwhile, in each of the size categories of banks below $100 billion in assets, as well as for those bigger banks’ owner-occupied loans, the rate was below 1% in the first quarter.

　　The difference can come down to higher interest rates. Owner-occupied CRE loans tend to perform as long as the business doing the borrowing itself is healthy and able to make payments, according to Nathan Stovall, director of financial-institutions research at S&P Global Market Intelligence. Properties for lease, though, are far more sensitive to the level of interest rates. If the property‘s income—affected either by the occupancy rate, or what the latest rents are—isn’t keeping up with what it now costs to pay the loan, or to refinance a loan coming due, then the loan can be problematic.

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　　San Francisco has been contending with rising office-vacancy rates. - Jason Henry/Bloomberg News

　　The split might also reflect differences in geography, such as cities versus suburbs, though it isn‘t only big banks that lend into downtowns. Larger banks might also face more- immediate maturities in key categories. According to a March analysis from MSCI Real Assets, national banks held 29% of the value of the tracked office debt that matured last year and have 20% of the debt due this year. The regional and local banks’ share was 16% last year and 13% this year.

　　CRE loans are often structured with balloon repayments of principal at the end of their terms. Banks with closer payoff dates should be taking a harder look at the likelihood of those loans repaying.

　　Many larger banks have already taken sizable provisions in anticipation of office-loan losses. The median first-quarter reserve ratio for office loans at banks tracked by Morgan Stanley analysts that disclosed this ratio was 8%. That is well above the sub-2% loss allowance ratio across all insured banks and all loan categories, according to Federal Deposit Insurance Corp. data.

　　The net charge-off rate at $100 billion-plus asset banks for non-owner-occupied CRE lending exceeded 1.1% in the first quarter, which was about a percentage point or more above smaller categories of banks, according to S&P Global Market Intelligences figures—though the rate was down more than a quarter point from the previous quarter.

　　To be sure, today‘s problems are also yesterday’s risks, so the question is where the balance of risk might live now. If a property downturn were to more sharply affect smaller or suburban properties, or to more widely hit businesses, then it might be that the most unpleasant surprises are with the smaller or regional banks that hold such loans.

　　On the flip side, a higher-for-longer interest-rates scenario with a steady economy could favor those smaller banks. In that case, there might be some value in those stocks lurking behind the headline worries.