For regional banks, the CRE bark could be worse than its bite

It is more than a year since the regional banking failures of 2023 sparked fears of new vulnerabilities in the U.S. banking system. Concerns about its health tend to ebb and flow, but the declining fortune of commercial real estate (CRE) has stayed in investors’ minds for many quarters now. The markets and financial press often paint CRE with a broad brush, but the worry resides primarily in the office sector. The focus is on regional banks, primarily those with assets between $10 billion and $100 billion, though some midsized banks with assets larger than the $100 billion mark are included.

With vacancies at all-time highs, office buildings—especially in the downtowns of U.S. cities, are facing secular and cyclical questions. Of course, the shift to a hybrid work model sparked by the pandemic has been the main impact on occupied space. It remains to be seen how long the work-from-home movement will continue; for most businesses, it appears here to stay. The consequence is that the vacancy and structural demand imbalance likely will continue to weigh on cash flows and valuations. The prospect of the Federal Reserve remaining in a higher-for-longer rate environment only adds headwinds to borrowers and many commercial mortgage lenders alike, whose financial health would benefit from lower interest rates.

Against this backdrop, office “doom and gloom” headlines have been plentiful. Most of the eye-catching valuation declines and bank-specific asset concerns also have been idiosyncratic, unique to a company. But for that very reason they are worrisome to an investor portfolio with concentrated exposure to the sector. We anticipate negative press reports will continue as the ultimate financial impact will likely stretch over a period of years, giving banks and other lenders time to address underlying issues. For reference, the bursting of the real estate bubble and the ensuing Global Financial Crisis (GFC) took place from roughly 2007-09, but CMBS delinquencies did not peak until mid-2012.

Despite the loud and negative rhetoric, we think office real-estate issues are neither a systemic challenge to the U.S. banking system nor destructive to most banks in the investment-grade credit universe. Exposure among the largest systemically important banks in the country is limited—less than 2-3% of total loans, on average. Additionally, one benefit of the spotlight being trained on this part of the larger loan book is it has encouraged bank management teams to thoroughly review their exposure to that area. Operationally, this has given banks time to proactively engage with concerning borrowers, execute loan sales and prepare for a range of outcomes.

The financial result, we believe, should be an increase in office CRE-related loan-loss reserves. That would mean banks are recognizing the potential for losses in advance of actual ones—certainly a good development. Lastly, the Fed stress-tests banks with balance sheets greater than $100 billion annually or biannually. The assessment scenario assumes an approximately 40% decline in CRE values peak-to-trough, resulting in loss-rates worse than those experienced in the GFC. This leads us to believe the largest U.S. banks are relatively well-protected against office building related stress.

This is not to say that all U.S. banks will skate through unscathed. There are always outliers, both less vigilant or simply unlucky. And the office CRE environment is more challenging for some assets than others. Factors such as geography and age/type of debt unfortunately saddle some deposit institutions with a significant exposure to distressed assets or inadequate reserves to ameliorate the situation.

With a potentially long road ahead amid more negative news, security selection will be crucial for investors. Banks that emphasize diversification and seek out management teams with conservative underwriting standards and defensive balance sheets should avoid floundering—or foundering.