Commercial real estate portfolios largely continued to hold up during the second quarter, but banks started proactively taking measures to brace for a feared downturn.
Concerns over commercial real estate (CRE) have been growing in recent months as cautious investors looked for weakness in lenders' balance sheets following the recent bank failures. Office has emerged as an area of intense focus as occupancy in office properties has not recovered from the COVID-19 pandemic that led to a rise of working from home. Healthcare property owners are also seeing stress as labor-related expenses remain high in a tight job market.
As such, banks are taking proactive steps to address potential problems, including stress testing, portfolio reviews and increasing reserves, executives disclosed on second-quarter earnings calls.
Stress testing
Wells Fargo & Co. conducted both stress testing and a loan-by-loan review of its office CRE portfolio, which largely motivated the $949 million increase in the company's allowance for credit losses during the quarter. The stress scenarios looked at a number of risks, such as refinance risk, the current rate environment and cap rate expectations, according to President and CEO Charlie Scharf.
"Office, that's the place where we're certainly seeing weakness," CFO Michael Santomassimo said on the company's second-quarter earnings call. "We've gone through a number of stress scenarios and feel like at this point, we're appropriately reserved to be able to deal with what could be a number of different scenarios depending on how it plays out over time."
Wells Fargo reported $154.3 billion in total CRE loans at June 30, making up 16% of total loans. Office loans totaled $33.1 billion, or almost 22% of total CRE loans.
United Community Banks Inc. is also engaging in ongoing stress testing to find potential CRE problems.
The first test the company ran looked at fixed-rate borrowers maturing in the next 24 months, but "so far, we haven't seen anything that really identifies as when the rates change, these people aren't going to be able to make payments," Chief Risk Officer Robert Edwards said on the company's second-quarter earnings call.
CRE made up 21% of United Community Bank's total loans at June 30, and office CRE made up 4.2% of total loans. The company's office portfolio is primarily concentrated among small suburban businesses and medical office buildings with an average loan size of $1.3 million, according to the investor presentation.
Comprehensive review
In addition to stress testing, banks are also performing comprehensive, detailed loan-by-loan reviews.
Western Alliance Bancorp.'s special mention loans more than doubled in the quarter to $694 million from $320 million in the first quarter after it conducted a CRE loan review in an attempt to identify loans that could become problems in the future. The increase was largely connected to office and hotel loans.
All the loans are current and paying but have been identified as having "potential weakness" and were moved to special mention to "elevate those within our credit architecture and make the appropriate changes before those become problems," Chief Credit Officer Timothy Bruckner said on the company's second-quarter call. The action is intended to head off missed payments or default.
At June 30, CRE made up $9.9 billion, or 21% of total loans. Hotel made up the largest portion of the company's CRE book at 45%, while office came in second at 23%.
Truist Financial Corp. had an "intentional focus" on office CRE during the quarter, leading to an "intense" loan-by-loan review of almost that entire book, Chief Risk Officer Clark Starnes said on the company's second-quarter earnings call.
"We work really, really hard to make sure we're not kicking the can down the road and we understand where we are," Starnes said.
As a result of that effort, Truist moved some loans to nonaccrual status, leading to a total of $1.52 billion in total nonaccruing loans and leases, up from $1.19 billion in the first quarter. Nonaccruing CRE loans jumped to $275 million from $117 million quarter over quarter.
Reserving for potential losses
Some banks increased their loan loss reserves now to prepare for whatever lies ahead for CRE.
With an allowance-to-loans ratio of 7.4%, PNC Financial Services Group Inc. feels it is "reserved for whatever happens" in its office CRE portfolio, Chairman, President and CEO William Demchak said on a second-quarter earnings call.
"A large amount of the reserves we have appropriately are focused towards commercial real estate in office specifically. And I think even with the soft landing, that asset category is going to have trouble," Demchak said. "We'll need those reserves because we do think there's going to be problems."
PNC's office loans totaled $8.7 billion, making up 2.7% of total loans, at June 30.
Losses start to materialize
Some banks, like M&T Bank Corp. and Citizens Financial Group Inc., recorded net charge-offs (NCOs) related to CRE in the second quarter.
Citizens Financial's reported $56 million in NCOs related to office loans in the quarter, contributing to the quarter-over-quarter increase in total NCOs. As a result, the company increased its allowance ratio for its office portfolio to 8% during the quarter, a level it feels comfortable with.
"While we continue to see increases in criticized assets and charge-offs in this particular portfolio, we believe losses are manageable and readily absorbed by reserves and our strong capital position," Chairman and CEO Bruce Van Saun said on the company's second-quarter earnings call.
The 8% allowance ratio is "effectively higher" than the 1.5% of losses the company saw in the second quarter, Van Saun said. General office loans totaled $3.9 billion in the quarter.
M&T also saw a jump in its NCOs in the quarter to $127 million, driven by four large credits: three office buildings in New York City and Washington, DC, and one large healthcare company in New York, CFO Daryl Bible said on a call to discuss second-quarter earnings. CRE loans totaled $44.9 billion, or 33.6% of average loans, at June 30.
When it comes to charging off a CRE loan, "you have to look at it on a case-by-case basis just because of the unique quality and pieces of how it is. Each borrower has different implications," Bible said. Factors relate to tenants, market conditions and interest rates.
Location also plays a big role.
"New York City is a big marketplace, and every place is a little bit different," Bible said. "Right now, it seems like the downtown area might be a little weaker than the middle part of Manhattan. So the charge-off that we took in Manhattan was in the downtown district there."
