Title: The Unequal Burden of Commercial Real Estate Loans: Why Smaller Regional Banks are More Vulnerable
The commercial real estate (CRE) sector has emerged as a significant source of stress for banks in the wake of the pandemic. Had banks been privy to the upcoming disruption that would drastically alter where people work, they might have exercised more caution while extending loans to clients dealing in office buildings. However, with an impending deadline, over the next three years, a staggering $2.2 trillion in commercial real estate loan payments are due, according to data firm Trepp.
The predicament for office building landlords is dire as vacancy rates remain at historic highs with the continued remote work trend. Consequently, many landlords have resorted to drastic measures such as reducing rent or selling off properties at a loss. This situation potentially implies substantial missed loan payments when they come due. Nevertheless, the stress is not evenly distributed among banks.
Although large national banks hold a significant portion of commercial real estate loans, it is the smaller, regional banks that bear the brunt of the stress. These institutions represent approximately 80% of the total loans US banks have granted to commercial real estate firms. According to Goldman Sachs economists, across all US banks with over $100 billion in assets, commercial real estate constitutes 12.5% of their aggregate loan portfolios. However, for banks with less than $10 billion in assets, the sector represents a much more substantial 38%.
This disparity could potentially lead to significant losses for smaller banks, causing potential collapse, as Fitch Ratings noted in a December report. Regional banks have been on high alert following New York Community Bancorp (NYCB)’s recent announcement of steep future losses on commercial real estate loans.
BankRegData analysis revealed that Flagstar Bank, NYCB’s subsidiary, has the second-highest concentration (470%) of commercial real estate loans to tier-one capital plus its allowance for loan and lease losses. Valley National Bank, based in Morristown, New Jersey, reported the highest exposure with loans in the sector accounting for 475% of its tier-one capital including its allowance for loan and lease losses.
The FDIC jointly released guidance in 2006 that institutions with concentrated CRE exposures may be vulnerable to real estate downturns, and having exposure above 300% is a significant risk factor. In its December advisory note, the agency expressed concerns about institutions with high CRE concentrations. By contrast, JPMorgan Chase, which is currently the leading lender to commercial real estate clients, has a much lower exposure to the sector at just 61%.
Why do smaller regional banks carry a larger share of commercial real estate loans? To differentiate themselves from larger banks, smaller institutions prioritize building relationships with local businesses and customers. This “community-based lending model,” as Fitch calls it, plays a part in their high exposure to commercial real estate.
Valley National Bank CEO Ira Robbins told CNN that the bank “has been a relationship-focused commercial real estate lender for many decades.” He added, “The sector serves as a critical component for supporting the economic vitality of the local community.”
After the Great Recession, banks with assets under $250 billion shifted their lending activities from construction and land development, which led to substantial losses at that time, to commercial real estate. Additionally, as certain lending products like residential mortgages or credit cards moved towards scale players, smaller banks were left with commercial and industrial (C&I) and CRE lending as their core products.
It’s crucial to note that commercial real estate encompasses more than just office space; it includes multi-family housing, rental properties, and retail spaces, among other components. While all these subsectors have their challenges, the most significant concern arises from office real estate as vacancies rise at an unprecedented rate. In Q4 2021, the national office vacancy rate reached a record-breaking 19.6%, according to Moody’s Analytics—the largest quarterly increase since the first quarter of 2021 and higher than the 19.3% level reached twice in the past four decades.
To mitigate risks, banks with high CRE lending portfolios can benefit from diversification across property types. The FDIC advised in 2007 that banks with significant exposures to CRE could lessen their risks if they have “portfolio diversification across property types.” In other words, a bank whose CRE lending portfolio is more evenly distributed among the subsectors, rather than heavily skewed towards one, could be less vulnerable to a downturn.
Valley National Bank’s $28.2 billion commercial real estate portfolio is well-diversified, with no subcomponent accounting for more than 25%. Office real estate is among the smaller commercial real estate subcomponents. Robbins of Valley National Bank told CNN, “We remain comfortable with our diverse and granular commercial real estate portfolio.”
Additionally, Fitch found that although smaller banks are more exposed to CRE lending, they’re experiencing fewer late-stage delinquencies and nonpayments compared to larger banks. Smaller banks tend to lend more to owner-occupied properties, whose loan payments are typically made on time, while office building owners may face more challenges in making timely payments.
Despite this trend, the FDIC strongly advises banks with high commercial real estate exposures to set aside more capital “to provide ample protection from unexpected losses if market conditions deteriorate further.”
