Given the rapid tightening from the Federal Reserve, property values are likely to be marked down in the quarters ahead impacting loan values on bank balance sheets.
We recently wrote about the issues facing regional banks and how tighter lending standards could impact the broader economy. Digging a bit deeper, one area of unease is regional bank exposure to the commercial real estate (CRE) market. Shifts in the economy because of the pandemic are creating headwinds in the CRE market, most acutely in the office and retail space. The widespread adoption of hybrid work patterns and work-from-home arrangements could permanently impact demand for office space. Moreover, the rise of e-commerce presents a headwind for lower class malls and retailers. As such, investors are concerned if a collapse in commercial real estate could further weigh on bank profits and exacerbate the tightening in credit conditions.
These concerns are warranted for a few reasons:
- Office and retail vacancy rates are still elevated at 13% and 8%, respectively.
- Small banks account for roughly 70% of outstanding commercial real estate loans.
- CRE accounts for 43.5% of small bank assets vs. just 13% for large banks, highlighting the outsized exposure to this specific market.
- As shown, roughly 19% of total leased office space by square footage will expire over the next two years and perhaps a more manageable 11% of office debt will mature over that same time frame.
In addition, commercial real estate are typically long duration assets, so their values are sensitive to higher interest rates. Given the rapid tightening from the Federal Reserve, property values are likely to be marked down in the quarters ahead impacting loan values on bank balance sheets.
That said, while there are clear challenges in the market, it’s not all dire. Investors should remember that the office sector is bifurcated. Migration trends suggest difficulties are emerging by geography and differentially affecting property vintages. Newer office builds are seeing much stronger net absorption rates than older builds. Moreover, we suspect lenders are unlikely to repossess commercial properties that they would have to either manage or sell themselves should a borrower be unable to inject additional rescue capital in a refinancing transaction. Instead of foreclosing, banks have the flexibility to either extend a loan’s maturity, take a discounted payoff, accept a “deed in lieu” of foreclosure, and/or offer borrowers short-term forbearance or even modify their loans.
In our view, while challenges in the CRE market persist, banks in general have some flexibility in softening the blow until rates comes down. As such, broad weakness in the CRE market is unlikely to become an acute crisis for regional banks, but rather pose a risk that could become more challenging to manage as time goes on.