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U.S. Banks Face Long-Term Risks To Their Commercial Real Estate Asset Quality

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Rating Component Scores For U.S., Canadian, And Bermudian Banks (December 2020)


U.S. Banks Face Long-Term Risks To Their Commercial Real Estate Asset Quality

Amid the coronavirus pandemic, how banks' credit quality will hold up remains a big question. Although many asset classes face risks, topping the list, in our opinion, is commercial real estate (CRE)--in particular, to what extent credit quality will deteriorate in the sector and how heavily will it weigh on banks' stability. Given the many variables that could disrupt CRE, this question is difficult to answer with any certainty.

We expect pandemic-triggered losses on bank CRE loans to exceed the roughly 2% that banks charged off in 2009 and 2010, excluding construction loans. We have set our base-case expectation at 3% (about half of the Fed's 6.3% aggregate CRE loss rate for the 33 banks in the 2020 stress test's severely adverse scenario). If this turns out to be the case, losses should be manageable for most of the banks we rate, particularly given that at the median their exposure to CRE is less than 20% of loans. In addition, banks:

  • Are largely diversified across the subsectors of CRE loans (office, multifamily, retail, etc.);
  • Have already built an allowance specifically for CRE losses of roughly 1.5% of CRE loans;
  • Remain profitable; and
  • Have been increasing capital ratios due to temporary limitations on share buybacks.

But not all banks have limited CRE exposure. Among the banks we rate, 11 have more concentrated loan exposure to CRE (greater than 30%). Looking at the industry more broadly, for smaller commercial banks with less than $5 billion in assets (such as community banks), the median exposure to CRE is also about 30%. These banks with higher exposure will likely have a tougher time if the asset class deteriorates further. This is particularly the case for banks that have weaker underwriting standards on CRE loans.

In addition, losses could exceed our base case, particularly if the economic rebound stalls or if structural changes within CRE in the aftermath of the pandemic are long-lasting and significant. Notably, the stock prices of publicly traded REITs are down roughly 25% for most of the CRE subsectors, signaling that investors believe the CRE market is likely to have some difficulties down the road.

With this in mind, we did a sensitivity analysis to attempt to size up the banking industry's ability to handle more significant CRE losses. Excluding owner-occupied CRE loans, which typically perform better than other types of CRE, there is roughly $2.1 trillion of bank CRE loans outstanding, versus roughly $1.8 trillion of Tier 1 capital. A CRE loss rate of only 3% equates to 4% of bank capital--certainly manageable for banks without heavy CRE exposure (see chart 1), especially since they could absorb some of those losses with preprovision revenue. But if loss rates rose to 10% or higher, that would equate to at least 12% of industry capital, a much more significant dent to the banking sector that would likely lead to downgrades for many banks.

Chart 1

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What Could Lead CRE Loss Rates To Surpass Our Base Case

Notably, although the average loss rate was 6.3%, the Fed shows that some banks' CRE loss rates under stress could surpass 10% even for some of the largest banks (see "The Fed's Latest Stress Test Points To Limited Bank Capital Returns," June 30, 2020). If loss rates were to reach these levels, no doubt the smaller banks with more exposure would feel substantial pain.

The loss rates the Fed derives from its stress test are largely attributable to rising unemployment and lower economic output. We don't believe the Fed's stress test takes into account some of the structural dynamics that may play out in the CRE market in the aftermath of the pandemic.

For example, even after the pandemic is over, companies may rethink the traditional workplace, allowing for more liberal work-from-home policies. If this is the case, it would likely reduce the need for office space, potentially lowering prices for office properties. In turn, this could lead to lower demand for multifamily dwellings, particularly in pricier major cities like New York and San Francisco, together resulting in much higher loss rates for these subsectors within CRE.

In addition, certain sectors within CRE--lodging, retail, and health care--are already experiencing large losses, largely driven by the pandemic, that were not factored into the Fed's original stress test. As such, CRE loss rates could run higher than the Fed's scenario.

Also, still unclear is the full economic fallout from the pandemic. Although the economy sharply rebounded in the third quarter, COVID-19 cases are on the rise across the U.S., which could hamper economic growth and lead to higher levels of unemployment. The Fed is currently evaluating how the largest banks would fare under a more extreme stress scenario, adding "U" and "W" shaped economic recoveries to its more traditional "V" shaped recovery. The results, which are expected in December, will likely show much higher aggregate loss rates than the 6.3% CRE loss rate it showed in its traditional "V" shaped recovery.

An Overview Of The CRE Market And Its Participants

Total U.S. CRE debt outstanding as of June 30, 2020, was $5.0 trillion--a record despite the onset of the COVID-19 pandemic earlier in the year. This included loans and debt held by banks, insurance companies, government-sponsored enterprises, and other nonbank financial institutions. Prior to the pandemic, a prolonged period of low interest rates and a benign credit environment promoted strong growth for CRE lending.

Total CRE loans grew at a compound annual growth rate (CAGR) of 6.4% from 2014-2019, a five-year CAGR not seen since 2004-2009, when it averaged 8.2%. CRE loan growth prior to the Great Recession stemmed largely from construction and development. But in recent years, growth in CRE loans has been driven increasingly by higher levels of residential multifamily lending. Multifamily loans now make up about 34% of total CRE loans, versus 24% in 2007, spurred by lower home ownership trends.

Although banks and nonbanks often compete for CRE assets, the nature of the loans they offer can be quite different (see "As The Pandemic Persists, U.S. Nonbank Lenders Will Likely Find Their Commercial Real Estate Assets Challenging," Nov. 16, 2020). Interest rates, down payment requirements, and the guarantees required can differ for bank and nonbank lenders. Banks most often hold three- to five-year floating-rate loans on "stabilized" commercial and multifamily properties (those with adequate cash flows relative to their debt service requirements and not in need of much additional leasing, sales, or renovation) and require significant equity and guarantees from borrowers.

Chart 2

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Finance companies and other originators that sell loans into commercial mortgage-backed securities (CMBS), including the large banks, also make loans on cash-flowing, stabilized properties, but they do not require recourse to the borrower. These loans most often have roughly 10-year maturities and somewhat higher loan-to-value (LTV) ratios, on average, than most CRE loans that banks hold. Most are fixed rate, but variable-rate loans also make up a portion of the CMBS market.

Insurance companies, led by life insurers, often make nonrecourse, fixed-rate, longer-term loans on stabilized properties, probably at lower LTVs than CMBS lenders in general. Such loans historically have performed well.

We think CMBS probably have the greatest exposure to the riskiest asset classes, lodging and retail, as evidenced, in part, by the higher forbearance and delinquency rates than CRE loans held by banks and insurers.

Assessing The Dynamics Of The CRE Subsectors

CRE is broken down into a few major subsectors that each performs differently under various economic scenarios. In the heat map table, we provide our views on the severity of the impact of COVID-19, in terms of loss rates, and when credit deterioration may occur for the major subsectors within CRE. (See the section "Our Views On Some CRE Subsectors' Credit Quality Trends" for more details.)

Besides the possibility of structural changes to the CRE market in the aftermath of the pandemic, unemployment levels will also play a big role in CRE performance. Although the unemployment rate fell to 6.9% as of October 2020--after spiking in April--it is still above the historical average. Persistently high unemployment leaves both the office and multifamily sectors vulnerable, absent additional government intervention or relief efforts for individuals and families.

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Bank Exposure To CRE

The participants in the CRE lending market have remained fairly similar over the past several years. We estimate that banks continue to hold roughly 50% of CRE loans outstanding. We think banks have maintained this percentage of loans within CRE due to a few variables, including that CRE loans are typically local, meaning regional bank lenders can use their expertise to compete more effectively than other types of lenders.

Federal Deposit Insurance Corp. (FDIC) data shows the breakdown of banks' CRE exposure (see charts 3-4). What's noticeable is the increase in bank exposure to multifamily loans (23% in 2020 versus 14% in 2007) and the drop in construction and development loans (18% versus 43%).

Chart 3

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Chart 4

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The categories in charts 3-4 constitute our definition of CRE. We exclude real estate loans held in foreign offices from our definition, which are concentrated at a limited number of banks. In addition, U.S. banks hold another $561 billion of owner-occupied CRE loans, which we also exclude from our CRE statistics because we think they have a credit profile more similar to commercial and industrial loans. Borrowers on these loans typically use the loan proceeds to purchase properties for specific business purposes or simply to help fund their operations. They use cash flows from their businesses, rather than rental income, to repay the loans. This differs from other CRE loans used to finance properties purchased for investment, which are repaid typically with cash flows from rental income.

Owner-occupied loans hit a peak quarterly charge-off rate of 1.14% in the last financial crisis, versus 1.69% for non-owner occupied (see chart 5). However, this time around, with many commercial and industrial loans under pressure, we think that owner-occupied CRE will perform worse than they did in previous cycles but still better than non-owner-occupied CRE loans.

Chart 5

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In terms of which size banks own CRE, the larger banks (more than $50 billion in assets) own about 45% of bank CRE loans, while smaller banks (those with assets below $5 billion) own 25% of bank CRE loans outstanding (see chart 6). Banks with $5 billion to $50 billion asset size also hold about 30% of the bank CRE loans market.

Chart 6

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The Rated Banks With The Highest Exposure To CRE

For the banks we rate, the median exposure to CRE is roughly 19% of loans and 139% of Tier 1 capital. Positively, for all our rated banks, despite current record levels of investor-owned CRE and multifamily loans held by U.S. banks, construction loans remain about 40% below the 2008 peak of $631 billion. We view this as a favorable trend for the industry, as construction lending recorded the highest rate of net charge-offs for an FDIC loan category during the previous economic downturn. That being said, the dynamics of the COVID-19 pandemic raise concerns about different loan categories than previous downturns.

A portion of the banks we rate, particularly smaller regional banks and those with specialty CRE product lines, tends to have the highest CRE concentrations. In chart 7, we show the rated banks with CRE exposure that is over 30% of total loans and represents greater than 200% of Tier 1 capital. When disclosure is available, we also show the allowance these banks have taken for CRE through the first half of the year and the deferral rate through the third quarter, which have come down sharply (see chart 8).

Chart 7

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Chart 8

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Disclosures on which subsectors within CRE these banks are exposed to are, for the most part, lacking. Indeed, a large portion of the CRE loans falls into a bucket called "Other," which includes industrial/warehouse, mixed-use property, health care/health services, and farmland/agriculture, and could also include hotels and retail. This type of opaque disclosure makes it difficult for investors to determine the percent of bank loans that are exposed to subsectors of most immediate concern--retail, hospitality, and health care.

Notably, eight of the 11 banks we rate with over 30% exposure to CRE loans have negative outlooks, partially reflecting their large CRE exposure. First Commonwealth Financial Corp., Umpqua Holdings Corp., and BancorpSouth Bank currently have stable outlooks, which reflects a combination of their higher relative capital levels, lower exposure to local economies severely affected by the pandemic, and peer comparisons within their rating categories.

Banks' CRE Asset Quality Has Held Up, But Some Cracks Have Appeared

Banks' net charge-offs for CRE have been rather benign so far through the pandemic--just as in other asset classes. But this is not surprising given our expectation that asset quality deterioration in CRE will take some time to play out.

Chart 9

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Although some leading indicators are showing signs of stress, it is still difficult to make a clear determination of the ultimate path for CRE. For example, in second-quarter 2020, deferral rates for CRE were 12% at the median but, along with other sectors, came down sharply in the third quarter. Another positive trend is that according to data collected from publicly traded REITs, rent is still being paid (above 90%) for most CRE sectors, with malls and strip shopping centers showing the most stress, with rent payments below 60% (see "COVID-19 Accelerates Structural Shifts In Global Office Real Estate And REITs," June 9, 2020).

Other leading indicators also show mixed signals. For example, nonperforming loans--after spiking in the first quarter--came down somewhat in the second quarter, and stayed relatively low in the third quarter, but CRE criticized loans, which also spiked in the second quarter, seemed to move higher for some banks in the third.

Chart 10

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Chart 11

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Pricing trends for CRE have not shown significant stress as of yet, except for the retail sector. That said, we believe lenders are working with borrowers to modify loans, rather than taking over a nonperforming property and encountering the uncertainty of a sale. Still, CRE pricing rose significantly the last few years, spurred by optimistic rental assumptions and the low interest rate (see chart 12). As such, price declines could be precipitous if net operating income were to decline--as a result of, for example, secular changes in rent expectations, or if the gap between entry and exit capitalization rates was to widen.

Chart 12

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CMBS data quality offers some insights into the state of bank CRE loans, but bank loan performance is typically better

Within CMBS, forbearance rates are high, at 7.27% as of the end of October. But they are declining, albeit modestly, from the peak of 8.1% at the end of July. The subsectors contributing the most to CMBS forbearance, not surprisingly, are retail and lodging, which account for 49.46% and 33.85%, respectively, of all CMBS loans currently in forbearance or requesting forbearance.

Chart 13

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Chart 14

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Delinquency trends are also high, but trending down. Specifically, CMBS delinquencies--which are separate from loans on forbearance--were 7.5% in October, down from a high of 9% in June. Although, the share of loans that are delinquent more than 30 days is on the rise. In terms of CRE asset categories, again, not surprisingly, the amount of lodging properties that are delinquent increased significantly year over year, with retail also remaining high.

Chart 15

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Chart 16

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Although we consider CMBS trends a potential indicator of the performance of bank CRE loans, the loan performances of the two sectors vary. For starters, CMBS is made up of an amalgam of loans packaged into securities, all of varying credit quality. Conversely, CRE on bank balance sheet is generally of a higher credit quality. In addition, banks can more easily negotiate loan terms with CRE borrowers given the more limited parties involved in the transaction.

Our Views On Some CRE Subsectors' Credit Quality Trends

Retail

With the growing demand for online shopping, the retail subsector, along with its real estate, was already struggling prior to the pandemic. The onset of the pandemic, though, exacerbated the decline of the retail subsector, as the shift to online shopping has accelerated. Shopping malls have been hit particularly hard.

Some retailers with brick-and-mortar stores also have strong online presence, which helps their financial condition. In addition, the retail CRE subsector includes pharmacies and supermarkets, which have performed well during the pandemic.

Hospitality

Given travel restrictions, hospitality, including lodging and restaurants, has been one of the hardest-hit sectors. Since the coronavirus outbreak earlier in March, hotel vacancies have increased and revenue per available room has plummeted, weighing heavily on hotel properties. We think hotels in "drive-to" locations have fared better than hotels in "fly-to" locations dependent on air travel, which has also been heavily affected by COVID-19.

Within restaurants, fast food establishments seem to be performing well. Government-imposed capacity restrictions and shifting consumer behavior have sharply reduced income for dine-in restaurants, although they are learning to pivot to other sources of cash flow, such as takeout.

Health care

Portions of this subsector, which include nursing homes and assisted living, are facing pressure brought on by the pandemic. Until a vaccine is in place, vacancy will likely remain constrained. Meanwhile, weighing on hospitals is that more lucrative, elective surgeries, are being delayed.

Office

Office space is possibly the biggest wildcard within CRE (see "Rent Pressure And Development Delays Heighten Risks For U.S. Office REITs," July 2, 2020). Still unclear are corporations' ultimate plans for workforce needs and whether employees will be required to work in offices on a regular basis once the pandemic is over. In addition, with corporate revenues under pressure, another wave of layoffs may be around the bend. As a result of these two factors, office space needs may be sharply reduced, which could lower prices for office buildings.

Offsetting these negatives is the likelihood of an extended low interest rate environment, which typically leads to more favorable cap rates, helping to bolster CRE prices.

In terms of timeframe, based on public REIT data, only about 20% of office leases come due by 2022, and roughly 51% of office leases are due after 2025. As such, the dynamics of declining demand for office space may take a while to fully play out.

Multifamily

Multifamily was a large growth area pre-pandemic for banks because of changing preferences in urbanization and home ownership trends. Prices for multifamily structures rose precipitously before the pandemic, particularly in major cities, reflecting elevated rent levels and low cap rates. But rent is being pressured--more so in major cities--exacerbated by more flexible work from home policies that allow people to live further from city centers. Whether rents remain depressed will likely hinge on corporations' responses to their workforce requirements and public health and safety developments.

Positively, rent in some areas of the country that didn't see growth pre-pandemic remains stable. In addition, prices of home ownership is on the rise, which could spur rental demand. Separately, in some cities, rent-stabilized buildings also make up a portion of the multifamily sector. These buildings also didn't see a large increase in prices before the pandemic. However, this subsector could get hurt if unemployment levels for lower-income individuals remains high.

Industrial (including storage facilities, online distributors, and data centers)

This is one of the few bright spots within CRE as many of these businesses have flourished lately. Indeed, unlike many other publicly traded REIT sectors, the industrial subsector still trades at a premium to net asset value. Notably, it's possible that other types of CRE (office space, for example) could be repurposed to further meet industrial demand.

Unsecured CRE loans

Although most CRE loans are secured, a portion of CRE loans is unsecured. These are typically lent to REITs that have investment-grade credit quality and portfolios that are well-diversified both by types of property and the location of the properties. Nevertheless, the pandemic has hit REITs hard. Equity prices for publicly traded REITS are down roughly 25% year to date. In addition, unsecured loans reflect construction and land development activities as well.

Chart 17

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Positive Factors That Should Help Allay Bank CRE Losses

Diversification

The CRE category is made up of many subcategories, and even within a category, there are different types of businesses. For example, office CRE comprises many industries, each of which will fare differently in the aftermath of the pandemic. In addition, for the larger banks, CRE typically has a wide geographical dispersion that won't rely on the performance of one state or city. That said, some banks, particularly smaller ones, have much higher concentration risk within a region.

Collateral

Banks typically hold significant collateral for CRE loans. Many of the banks we rate extend CRE loans at loan-to-value ratios of roughly 50%-65%, depending on the property type and other loan characteristics. As such, banks have some cushion even if CRE prices were to decline. Still, some CRE loans are made with a much higher LTV, and the underwriting is not equally conservative across all banks. Some banks were fairly aggressive over the years as they attempted to gain market share.

Debt yield

A higher debt yield, defined as the net operating income (NOI) of a property over the loan committed, helps protect banks from unexpected declines in NOI. Many banks have weighted average debt yields at 10% or higher, a level we view as relatively conservative. That said, a portion of these banks' CRE loan portfolios has debt yields lower than 8%, which could run into trouble if NOI for these loans declines.

Low interest rate

The low interest rate environment may help support commercial real estate prices and, perhaps, mitigate price declines on some properties. In addition, debt servicing requirements will be eased. But at the end of the day, a property's NOI over the long term will probably be the biggest determinant of its value.

Financial condition of property owners/landlords

Most banks are selective in terms of which sponsors or property owners they lend to, relying not only on their assessments of the financial health of these companies or individuals, but also on their savvy in property selection. Landlords with strong balance sheets should be able to weather short-term negative developments. And, rather than sell a property in distress, they should have the financial capacity to hold on to the property while waiting for a real estate turnaround. If, however, in the long term, the NOI of a property remains unfavorable, these same owners could hand the property back to the bank.

Related Research

This report does not constitute a rating action.

Primary Credit Analysts:Stuart Plesser, New York + 1 (212) 438 6870;
stuart.plesser@spglobal.com
Nicholas J Wetzel, CFA, Centennial + 303-721-4448;
nicholas.wetzel@spglobal.com
Secondary Contacts:Brendan Browne, CFA, New York (1) 212-438-7399;
brendan.browne@spglobal.com
Devi Aurora, New York (1) 212-438-3055;
devi.aurora@spglobal.com
Research Assistant:Jason He, New York

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