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U.S. Financial Institutions CRE Asset Quality Is Resilient: Long-Term Risks Remain

U.S. banks' credit quality, including commercial real estate (CRE), remained pristine in second-quarter 2022 relative to historical levels. Overall net charge-offs in the second quarter totaled 22 basis points (bps), compared with 26 bps a year ago, while delinquency rates also remained low. Our base-case expectations are for bank provisions across all loan categories to total about $40 billion to $50 billion in 2022, versus reserve releases of $31 billion last year. The increase is from loan growth, modestly higher charge-offs (30 bps-35 bps), and increased concern about the economy decelerating.

The only signs of weakness regarding overall asset quality stem from lower-credit-quality consumers. However, the data so far is not damning, but largely points to declining deposit balances and a slight increase in delinquencies. Still, we expect credit quality to worsen in the quarters ahead, but we don't expect outsize losses, assuming a shallow recession.

Banks Are Likely To Maintain Capital Positions Even If CRE Losses Tick Up

U.S. banks' exposure to loans collateralized by nonresidential CRE properties (including office buildings)--where the borrower relies primarily on rental income to repay the loan--was roughly $1.1 trillion, about 9% of total loans, in the second quarter of 2022. The portion of past due and nonaccrual loans for such "non-owner-occupied" CRE (at least 30 days past due) ticked up modestly since 2020, from roughly a benign 0.8% of loans to a little over 1% in 2020, but dropped again in the second quarter to 0.8%, with a very low level of write-downs. For the largest U.S. banks, such CRE loans account for less than 10% of loans. (Total CRE, including multifamily and construction loans, pushes that ratio somewhat higher.) Even if pockets of CRE (and office, in particular) were to have additional stress, it is unlikely that such losses would materially hurt banks' capital positions.

Chart 1

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We also rate several regional banks where CRE exposures, including on non-owner-occupied properties, are much higher (sometimes more than 30% of loans for total CRE). A severe decline in CRE prices and credit quality has the potential to affect these banks more significantly. However, most rated regional banks diversify their exposure across several categories of CRE and geographic regions, as well as underwrite loans at relatively conservative loan-to-value ratios, often 60% or lower. By contrast, the greatest proportional exposures to CRE is typically within the country's smallest regional and community banks, most of which we don't rate.

Precise estimates of U.S. bank CRE lending to the office subsector are hard to glean as banks' disclosures by property type are usually neither granular nor standardized, so exposure to office space needs to be estimated or gathered privately. Our best estimate is that office exposure for the median banks is roughly 15% -25% of total non-owner-occupied CRE exposure of $1.1 trillion, making up less than 5% of loans in the banking system.

Given the manageable exposure, a run-up in delinquency rates on bank loans for office space does not automatically signal a spike in charge-offs. Office leases are typically long term, and sometimes backed by sponsors with deep pockets who can offer banks protection and possibly withstand a stress cycle. The timing and path from delinquency to charge-offs on bank balance sheets can vary significantly across institutions.

Chart 2

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Assessing The Impact Of Hypothetical CRE Loss Rates

Another way to evaluate banks' potential exposure to a downturn in CRE is to measure the effect on bank capital assuming various hypothetical CRE loss rates. This analysis is not just office specific. Our analysis shows that CRE loss rates would need to rise to at least 10% to have a meaningful impact on industry capital levels. In dollar terms, a 10% CRE loss rate would generate $239 billion of losses, representing 12% of industrywide bank capital. Because banks' balance sheets are well fortified overall, a hypothetical loss of this magnitude could be absorbed, although the ratings impact could vary by institution. Nevertheless, our base-case expectation for CRE losses is currently in the low single digits, well below the stylized scenario.

Chart 3

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Higher CRE Loss Rate In The Fed's Latest Stress Test

We also use results from the Federal Reserve's stress test to evaluate loss rates across asset classes, including CRE. This year's test assumed real GDP declines by more than 3.5% and unemployment increases to 10.0%. The Fed's stress on CRE seemed to be more severe than last year. With this backdrop, the median CRE loss rate for the 33 banks tested was 9.8%, higher than the 6.4% loss rate on total loans across all bank loans. The only category with a higher loss rate than CRE was credit cards, which are unsecured and where the loss rates totaled 15.6%. Notwithstanding more severe loss assumptions on CRE in this year's stress test, all banks performed well, with most banks' current capital levels above the minimum required, even post-stress, indicating ample buffer across most banks.

For Nonbank Lenders, Larger CRE Exposures Could Pose Issues

Nonbank lenders are a growing source of capital for commercial real estate and the CRE lenders we rate tend to have significantly higher exposure to office loans, often 20%-40% of their loan portfolios. We expect those lenders, all of which are rated speculative grade, to face challenges on some of those loans as leases mature and tenants reduce their space. However, some CRE lenders repositioned their office portfolios since the start of the pandemic, by reducing exposure in metropolitan cities and increasing exposure to smaller cities with growing populations, which should alleviate some of the asset quality concerns stemming from office exposure.

The expertise those lenders tend to have in CRE and the diversification and underwriting of their portfolios should allow them to generally work through challenges, albeit with some loan losses.

Overall, our base case is that CRE losses will be manageable for bank and nonbank lenders. But those institutions with more significant exposure, particularly to office, that underwrote these loans with more aggressive loan to value ratios (>75%), could face higher stress in the coming years.

This report does not constitute a rating action.

Primary Credit Analysts:Stuart Plesser, New York + 1 (212) 438 6870;
stuart.plesser@spglobal.com
Brendan Browne, CFA, New York + 1 (212) 438 7399;
brendan.browne@spglobal.com
Secondary Contact:Devi Aurora, New York + 1 (212) 438 3055;
devi.aurora@spglobal.com

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