Listen: Street Talk | Episode 130: How threatened are US banks by the wave of commercial real estate maturities

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Nathan Stovall

Welcome to Street Talk S&P Global Market Intelligence podcast that offers listeners a deep dive into issues facing financial institutions and the investment community.

I'm Nathan Stovall. And on this episode, we're talking about commercial real estate and the risk that the asset class poses to banks. The issue is of great interest to us and to many of our listeners since rate hikes by the Fed and changes in post-pandemic behavior have put pressure on borrowers looking to refinance loans that are coming due soon. And as we'll soon hear, that number isn't very small.

Joining me on the episode are three members of the FIG research team here at S&P Global Market Intelligence, who have dug into the issue. I want to first welcome Tom Mason, a senior research analyst on our team, who's used data science techniques to estimate the size of the upcoming CRE maturity wall. Thanks for being here, Tom.

Tom Mason

Nathan, -- good to be here again.

Nathan Stovall

Also joining us is Chris Hutchins, a research analyst and our resident real estate expert on the team. Thanks for being here, Chris.

Chris Hudgins

Of course. Thanks for having me, Nathan.

Nathan Stovall

And lastly, coming on the episode of Zain Tariq, a senior research analyst who also serves as my research partner on our quarterly banking outlook. And he's going to talk about how depositories are looking at the issue as well as the results we've seen from the group. Thanks for being here, Zain.

Zain Tariq

Thanks, Nathan. Excited to be here.

Nathan Stovall

Well, Tom, let's kick off things with you. I referenced the idea of this maturity wall that is looming out there. And we've seen a wide variety of numbers being bandied about, about how much is actually coming due. What is the dollar amount? What dollar amount have you estimated for the amount of CRE loans maturing this year and in the years to come?

Tom Mason

Yes. So it is tough to get a handle on. But based on our model, we estimate $950 billion in 2024, about $1 trillion in 2025. And then we think that number will peak in 2027 at about $1.3 trillion and start to go down a bit in the years after that.

Nathan Stovall

Big numbers. Big numbers. So nothing to needs at by any means. And perhaps that quantifies why we're so laser-focused on this issue because that's a lot of loans that need financing. Can you talk a little bit about how you got there and how you arrived at the number because again, we've got lots of great granular bank data here, but that's not one that people have really been able to get their arms around beyond using surveys.

Tom Mason

Yes. So this was a pretty fun challenge. -- allowed me to use my data science shops. As you said, we have all this great loan level data. So every county, we collect these tax filings where lenders have to list the mortgages that they made. And we get that from CoreLogic. So there's about 5 million rows of loan data already. It's a pretty big chunk of data to start digging into. And you get a lot of granular information like you said. So the size of the mortgage, the interest rate, origination date type of property, all this great information across the nation. But the problem is, the big problem is that a lot of times, they don't fill in the maturity dates. And when I say sometimes, I mean about 60% of the time. So that was a huge challenge that we had to overcome. But luckily, with modern machine learning techniques, we can do what's called imputation. So if we take the 40% of the roads that we do know, we can look at the features of those mortgages, so like mortgages, this size and this type of property and all these characteristics, and we can say, okay, this is probably -- the maturity date is probably this long. So that's what we did. And for the data science wonks out there, we used a random forest model, which is basically just a decision tree that you run like hundreds of times, -- that's where the forest comes from. So kind of like a Monte Carlo simulation, and that's how we came up with our estimates.

Nathan Stovall

And the number you threw out, as I mentioned, is really significant. I mean there's about $12.5 trillion of loans outstanding. So even against the industry's entire loan portfolio, banking initial portfolio, you're talking about 7% other loans. Again, nothing really to sneeze at at all. But I think it makes us to take a step back, some of our fellow bank nerds really understand the concept here of why this maturity wall really matters. It's not even just a lot of loans. But why are we looking at this? And why did you go about the painstaking process to try and to estimate, okay, what's coming due? What's the risk there?

Tom Mason

Yes. Why did I do it. But yes, I would say that just like regular consumers, we know that commercial borrowers are also feeling the pain of interest rates going up so much in such a short period of time since the Fed started hiking in March of 2022. So what we looked at, as I said, we have interest rates on all these loans. They definitely fill that in for most of them. And if you just take the average of those mortgages that are maturing, they were paying 4.3% on average across the U.S. But if you were to take out a mortgage right now, the average is 6.2%. So you're going to get -- if you need to refinance your loan or get a new loan, you're going to get hit with a much higher interest rate. And we just don't know if all the borrowers can afford to do that.

Nathan Stovall

Right, right. And in some cases, not only can they forward to do it, but is the financing there, particularly if they're associated with a property that's of great concern. -- and the poster child, of course, being office. We've made the argument many times that not all CRE is created equal, not everything is office. But office is one that is worth digging into quite a bit. Were you able to break out what it looks like by office subcategory and look at what that maturity wall looks like on itself.

Tom Mason

Yes, definitely. So that is one of the breakouts that we do have, fortunately because as you said, it is an area of concern. So yes, based on our model, we think about $86 billion is going to mature in 2024. And I think what's really kind of alarming for people is sort of the jump from 2023 to 2024. So the number rose by about 38%. And I think that's why people are kind of in a bit of turmoil right now. But the good news is that we estimate that it's only about 10% of the total CRE maturing, and that proportion actually goes down in the years after that. So there is some good news, I think.

Nathan Stovall

Certainly. And we know that banks are providing extensions in some cases, not necessarily in the office case, but just because it was originally set to mature, we know some of this might not mature, but it definitely bears washing because of things like the rise and remote work and it's different from one city to the next, but you look in some cities and clearly, center cities are not what they used to be, particularly on a Monday or a Friday and a Friday in the summer like when we're recording this, quite a different space when you look at some of those office credits and the viability of them.

But I want to transition because Chris, you've done some great work here looking at office in particular. And while it is a great concern for all the reasons we've talked about, I think one of the things that's pretty interesting you found in your research is that not really all offices created equal. We've made the argument that not all CRE is create equal, but would you -- do you think that's a fair statement that that's been one of your takeaways is not all office is created equal.

Chris Hudgins

Yes, absolutely. That's spot on with the research that we've done. We've kind of found this pretty distinct separation between the lower quality, the older office buildings versus those high-quality premier office buildings that have adequate amenities that to try to draw in tenants into their office buildings. Those older office buildings have very much struggled from the current work-from-home situation. They're struggling with higher vacancy rates. They're struggling to get more tenants into the office space, re-leasing that office space, whereas the higher quality office buildings that have lots of amenities to draw in tenants have actually seen an increase in demand in recent months. So there's a pretty stark separation there between the high-quality office buildings versus those older office buildings. Another kind of separation we've seen there is -- just as office landlords are evaluating tenants in the space, tenants are now also evaluating the creditworthiness of the office landlord and they're starting to prefer landlords that have adequate cash on the books and are showing a willingness to deploy that capital into the office buildings to make sure that they have a landlord that's going to be there for the longer future and kind of supply all the needs for the office building in regards to renovations, upkeep, et cetera. Given the current low valuations, there's a variety of landlords out there that are kind of choosing to not throw good money into bad money, if you want to put it that way. And so landlords are our tenants are taking that into account and trying to find a good landlord with good credit worthiness that are adequately throwing capital into these buildings to help renovate them and kind of make them appealing as a way to kind of choose one office property over the other as well.

Nathan Stovall

So the tenants are is doing the underwriting on their own.

Chris Hudgins

They're at least doing their homework. Yes, absolutely.

Nathan Stovall

What have we said -- when I say underwriting, I often go back to bank land, what have we seen when you've dug into this in terms of what the banks have disclosed around their office exposures and the kind of reserves that they've taken and even the assumptions they've taken when trying to look at this asset class?

Chris Hudgins

Yes, certainly. So good and bad news there, I think. So we have seen an increase in both criticized loans and nonperforming loans reported by the banks in recent months in regards to office. But the good news there is they're all doing a pretty good job from what it seems of evaluating the portfolio ahead of time and trying to get ahead of the ball of this mortgage wall coming due. We've seen a number of banks holding loan loss reserves for the office portfolios in the high single digits. We've seen them kind of getting ahead of the ball, and we've seen a lot of the top lenders in the space kind of paring back their office portfolio and kind of separating out of the sector a little bit to try to face the headwinds before they get to the breaking point there.

Nathan Stovall

And just to add one other thing. I think that's well said that I think we saw in the last quarter that was of interest is not only that those reserves were at those levels, but they didn't really go up that much. It doesn't mean that they're perfect and they know exactly what valuations are. But you haven't seen -- you've seen them kind of holding where they were. And the reserve model that banks operate are on are supposed people are forward-looking. So perhaps they're right, but my bigger takeaway is that means at least they're not seeing the situation get worse from one quarter to the next. I want to transition and talk a little bit about other categories away from office -- you've done a lot of work digging into just the broader commercial real estate market. What do valuations look like there? Do we have any idea given the lack of transaction activity in terms of market pricing? What have we seen?

Chris Hudgins

Yes. So as you mentioned, the high interest rate environment have really driven down property transactions overall across all commercial real estate, including office. But one good model that we like to do and a lot of my research is on the publicly traded REITs. So the public traded sector, we have a good chunk of information because they report their quarterly financials, but also because they're publicly traded companies, we can see how investors value these companies on a day-to-day basis and a good valuation model that we use for the public sector as we take their current share price and we compare that to what sell-side research analysts estimate the net asset value would be. So if they were to essentially liquidate their portfolio, what's the underlying fair value of their whole property portfolio. So we can kind of see the valuation gap there between what does the stock market say these portfolios are worth versus what is the underlying fair value of these properties assumed by analyst models based off of NOI of the property and assumed cap rates, that kind of stuff. And so what we've seen there in that situation is valuations across all the public sectors and all real estate overall has been pretty depressed for quite a while now. It has gotten better in recent months, but we're still trading at around an 8% discount for the whole public REIT sector as a whole. But even if you don't deal specifically with the public REITs, a lot of things we'd like to say is that because of the property of trade every day on a daily basis and because there's such low transaction volume in the market, this is a good setout in a way to kind of see where valuation trends are heading. And a lot of times in the past, we've seen these publicly traded REITs kind of lead the private markets and kind of add more property transaction in the market happen. We've seen valuations kind of catch up to where the REIT land is. So good news there is we've kind of seen better valuations in recent months, but we're still trading at a pretty decent discount, 8% for all REITs. We've seen stuff obviously like office trading at the larger discounts. But overall, we've kind of trained upwards and hopefully, off of the good news that the Fed might be cutting rates in the hopefully near future, which would help property transactions as well as valuations within commercial real estate.

Nathan Stovall

And while we often talk about and you hear people talk about how REITs are different and maybe their exposures are different, you just said something I think is interesting that they tend the private valuations and the public market valuations tend to converge kind of over time. So even if it's not perfect in a world where there is a little price discovery that seems to be one marker worth watching. And secondly, the other thing I heard you say, I think, is interesting is that things are getting a little bit better or maybe stabilizing. So wherever we are today, kind of in line with that line about banks' reserves, not necessarily going higher. We maybe are close to where maybe that spread between pricing in the market equals where people are carrying these things or assuming what they were.

Zain, I want to go to you and take this back to the banks. What have we seen in terms of credit quality and particularly just the CRE credit quality at banks. This has been something that I feel like we wake up every day and everybody talking about the huge potential problem here. Have we seen much in the way of deterioration yet?

Zain Tariq

Credit quality, obviously, is a big concern for the industry right now. Just like you said, almost everybody is talking about it specifically when it comes down to CRE and more particularly in the office and multifamily space, as they've been talking about it. A lot of empty office spaces since the pandemic era and higher rates putting pressure on landlords as well as not much renovation going on either something that Chris just briefly mentioned. So that's resulting in weakness as a multifamily portfolios as well. And we did see that with one of the large regional banks earlier this year. But overall, I think credit quality is deteriorating with the excess savings finally running out. But if we wind back to 2023, there were predictions of savings running out at prenup last year. So I think there has been a delay as the consumers have held up pretty strong, but we should be expecting more pressures in the coming quarters, especially in the fourth quarter, which tends to have some seasonal impact as well. However, I think the household debt-to-income ratio is still below 40-year national average, and that's good news. And the delinquencies and charge-offs are coming off a very low base. So while the dollar amount or the percentage increases in some cases, may seem really big, you need to compare the actual ratios going back to the GFC, and you will notice that we are still well below those levels. Considering that and the capital the industry has built over the last decade, I think this would be more of a lending issue rather than safety and soundness issue. So I think the headwinds should be manageable.

Nathan Stovall

Yes, in the comparison, the GFC, I mean if you look at CRE, just zeroed in there, in particular, the we've seen delinquencies come up above 1% around 1.25% or a little bit north of that, whereas in the GFC, they peaked at almost in the double digits. So we've seen them come up, as you said, sort of off of a low base. you've dug into that even a little bit more looking at performance among different subcategories or you just talked about some of that, too. What have we seen there? Has it been uniform across different subcategories or even banks of different asset sizes?

Zain Tariq

Yes, definitely, while you see delinquencies and charge-offs are increasing in CRE, if you dig deeper, you will notice that the majority of this is actually coming from nonowner-occupied CRE. So not all CRE is the same. So you can't paint the entire industry with the broadbrush. Over the last 4 quarters, the average quarterly increase in nonowner-occupied CRE delinquency was 22 basis points, and that's sitting at just above 2% now at the end of the second quarter. While the owner occupied was 0.9% with an average increase of just 4 basis points. So a pretty big difference there. And majority of charge-offs are also in the same non-owner-occupied bucket.

Nathan Stovall

So almost no deterioration in that owner-occupied bucket, which as you and I talk about internally, it's almost like a commercial loan that's just secured by real estate. So it's more like a C&I loan and the properties of it are like that rather than the threat that Tom and Chris talked about and the challenges that landlords are facing.

Zain Tariq

Yes, definitely. And I think that is the key. You want to make sure that you're looking at these subcategories and even in nonowner-occupied as you and Chris were talking about different types of office. I think whenever you can get more granular data, I think you need to continue to dive deeper and see where the actual problem is I was talking about the charge-offs and nonowner-occupied bucket, and I previously mentioned how the dollar amounts or the percentage increases are big, between we need to look at the ratios, the dollar amounts in this bucket for charge-offs in the nonowner-occupied bucket, orbitalarming is we had about 1.6 billion charge-offs, net charge-offs in the second quarter of '24, which is more than what we saw in the entire 2008. But that number actually went to over $8 billion in 2010, but the NCO ratio at that time was 1.6% compared to 20.6% in the second quarter right now. So I think you need to compare those numbers, and then you also need to look at the right period for those comparisons and see where we are headed. So I think directionally, we are headed into the cycle, but there should be enough cushion to absorb the shots there are positives. I believe that we did not have back in or not.

Nathan Stovall

Well, I mean, as you mentioned, the dollar figures might look high, too, but I mean the industry has grown 50-plus percent since then, too. So just comparing the dollar values, you need to stick to those ratios, foot really truly good comps. On the asset size piece, one of the things that I think you've uncovered that I thought was interesting is that it hasn't been the same between small banks. You hear all this talk about community and regional banks owning all the CRE and they are more exposed there. That is true. They do have larger exposures. But what have we seen in terms of delinquencies between large and small, particularly in that nonowner-occupied bucket? Have you seen more from the small banks? Or you have seen more from the big banks?

Zain Tariq

Nonowner occupied definitely, we have seen bigger delinquencies for the bigger banks, compared to the smaller banks, which tend to be more reliant on our occupied anyway. But even for their nonowner-occupied loans, we haven't seen much deterioration. I think in Q1, for less than $3 billion in assets, the delinquency was up 10 basis points compared to the bigger banks about $100 billion in total assets, which was up 32 basis points. And for nonowner-occupied loans for banks above $100 billion in total assets was about 4% compared to just 0.8% for smaller banks.

Nathan Stovall

Right. And the bigger guys are the ones making -- who have the balance sheet capacity to make those big office high-rise credits that we've talked about, both Chris and Tom and yourself have alluded to. Small banks don't have capacity. So it's not really that surprising that you start to see more stress there. I mentioned them being exposed – just how exposed are they? And we look at things like concentrations and so does the regulatory community, what do those numbers look like? What have we seen in terms of number of banks, but elevated concentrations as defined by the 2006 guidance, which, by the way, is a reminder to our listeners, are banks with CRE loans who exceed 300% of our risk-based capital and that those that have also grown those portfolios by 50% or more over a 36-month period or those with C&D loans over 100% of risk-based capital. So how many banks are meeting enter criteria there? What have we seen there? Have we seen that number go down over time as banks are really focused on this issue?

Zain Tariq

Yes, definitely. The number of banks exceeding the 2006 guidance has definitely dropped a lot recently, but that does not necessarily mean that's a good thing. I think that number at the end of the second quarter of 24 was 482 bags that exceed those thresholds, either of those 2 criteria that you mentioned, And these numbers down from, I think, 577 at the end of the first quarter of '23. So just around during the last year that, that number has dropped down almost by 100 banks. It's partly because of greater scrutiny from the regulators in a bigger investor focus in this area. So banks are trimming the CRE exposure or not expanding as much to keep up with the capital requirements or basically just to stay out of the spotlight. Now historically, I would like to add that historically, this has been more of a tool to monitor and would not automatically put any restrictions on your lending. Historically, you have to answer more questions from the regulators about your risk management, your capital levels and type of CRE you have. However, recently, the regulators have started issuing IMCRs, which are individual minimum capital requirements to banks that are heavily exposed to CRE and our leading losses. So basically asking them to increase their capital levels in a certain time period. And it kind of makes sense because the regulators are trying to stay ahead of the curve and make sure no bag stalling their watch, but this is obviously limiting loan growth and some banks would not be able to benefit from high yields that are available out there, especially when your margins are already under pressure as a result of high cost of funds. So I think that is definitely limiting the loan growth right now. Another thing that is impacting us the higher capital requirements for these CRE exposed banks when they are trying to make a deal. So I think that is another area where some of these banks are facing pressure, I also think the regulators will not be limiting their exams to 2006 guidance, which generally excludes on our outlined loans. And also, you mentioned Nathan, the criteria, one of the criterias like if your CRE loans have grown more than 50% over the last 36 months, but considering the loan growth is so muted, there will be a lot of banks that are not exceeding that threshold. So paying that the regulators are pulling out all the tools they have to see where the risk is, even if these guidance these guidelines are not breached. On the flip side, I think these banks moving away from CRE do create an opportunity for some others who could tap into these gaps and benefit from good quality, high-yielding loans. So I'm sure this is on the radar for many banks that have the right risk appetite for -- in this environment.

Nathan Stovall

You mentioned how in great detail how regulators are looking at, how are investors looking at this? And what have we seen from the investor community when it comes to CRE-heavy banks? Have we seen them be treated differently?

Zain Tariq

Yes. We did recently put out an analysis looking at the year-to-date returns through the second week of July and some other price multiples for banks with high CRE exposures. We compare that to the broader appendices. And I think there are really no big surprises there as those banks have significantly underperformed. I think the median for the growth was down 8%, while in comparison, the SMP 500 DMI index was up 15.3%. So clearly, a big difference there. Banks also had a lower price to last 12-month EPS of 9.5% compared to 12.8% for the S&P500 PMI. I think this really shows how much the investors are focused on these exposures. Some banks are really getting caught in the middle of a fire. But I think what you can do in that situation is basically to provide more disclosures around CRE type quality maturities. Tom talked about how difficult that is to collect that data. And it's probably easier said than done, but I think educating the investors could help mitigate some of these issues and also making sure your internal models are accounting for all weaknesses over time rather than the bank having to recognize and announce big provisions or reserve builds on the earnings day, which could obviously lead to more negative yields for the institution?

Nathan Stovall

Sunshine is the best disinfect that whether it's for bearish investors or your regulators scrutinizing your exposures even more. I think that's very well said. And I think that's a great place for us to leave it. We've got a lot of loans coming due. As Tom has outlined. Some of those will get refinanced. Some of those will get extended. But a reminder that -- not all of these loans are created the same and do your homework and you as a lender make sure that you're providing your clarity on the differentiation of your portfolio versus others. Well, Tom, Chris, in, thanks so much for coming on and sharing your views. We appreciate it.

Tom Mason

Thanks.

Chris Hudgins

Thank you, Nathan.

Zain Tariq

Thanks, Nathan.