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Credit FAQ: What Declining Commercial Real Estate Values Could Mean For U.S. Banks

In the wake of the failures of three sizable U.S. banks, market sentiment toward the banking industry is somewhat fragile. The steep increase in interest rates has also raised concern about the health of banks' commercial real estate (CRE) exposures. So far, bank credit costs have remained relatively benign, with only a modest uptick in provisions and allowance for loan losses in the first quarter. We expect credit costs to rise throughout this year--by how much will depend on the depth and duration of a potential recession. Our economists expect a shallow recession in the second half of the year but have also raised the chances of a harder landing.

For the U.S. banks we rate, we believe that most have manageable exposures to CRE (meaning they're not outsize compared to capital) and have sought to lower their exposure to the most vulnerable segments, such as office. For most rated banks, we believe it would take a broader asset class decline, with charge-offs rising well above normal levels, to put pressure on banks' credit quality.

However, if CRE losses were to rise significantly, the rated banks with heavier exposure to CRE could face downgrades. (We have taken actions owing to deposit and liquidity strains and unrealized losses in the securities portfolio.) So far, asset quality metrics have not been an issue for the banking industry. That said, as billions of dollars of CRE debt come due for refinancing this year, classified or criticized assets and debt restructuring could increase more for some of our rated banks that are more exposed to CRE than peers--which could hurt ratings if CRE prices were to fall precipitously.

Here we discuss various CRE topics, including U.S. bank exposure, refinancing risk, and the extent of possible losses that banks can withstand from a capital standpoint.

Frequently Asked Questions

What is the size of the U.S. CRE debt market and who are the participants?

The size of the U.S. CRE debt market as of year-end 2022 was roughly $6 trillion, according to Fed data (through its Financial Accounts of the United States survey). This amount is almost double the size of where the market stood in 2007 (see chart 1), as the period of prolonged low interest rates up until 2022 spurred demand. The debt outstanding includes loans and debt held by banks, insurance companies, government-sponsored enterprises, other nonbank financial institutions, and the trusts of commercial mortgage-backed securities (CMBS). Including bank owner-occupied CRE loans, banks hold about half of the CRE debt outstanding, according to the Fed data, although other third-party measures of the CRE market differ somewhat. For more details, see the Appendix.

Chart 1


What types of loans are within bank CRE and what are the demand and pricing for them?

CRE is a diverse asset category that can be broken down into a few major subsectors--namely, retail, office, multifamily, hospitality, industrial, and loans to REITs. Each performs differently under various economic scenarios. CRE portfolios of the largest banks typically tend to be geographically dispersed and thus minimize exposure to the performance of one state or city. Banks that have smaller geographical footprints may have higher concentrations by geography but can diversify by managing exposures by subsector.

CRE loans tend to be secured with collateral, with the exception of loans to REITs that are generally rated investment grade ('BBB-' and higher). The loan-to-value estimates for CRE vary by bank, but typically are 50%-65% on average. In addition, the lender has recourse for some CRE loans above the value of the collateral.

Within CRE, the loans most problematic today are office loans. The dwindling need for office space spurred by a hybrid work model in place since the pandemic has raised vacancy rates in major urban areas, or "gateway cities," as many employees continue to work from home, at least for part of the week. In response to higher vacancy rates, several companies have reduced their office space over the last couple of years. Whether the hybrid work model will persist remains to be seen. Lately, some companies have mandated that employees return to the office, a trend that could gain further traction over time.

Transparency and granularity on CRE disclosure vary by bank. We estimate that for rated banks, the median exposure to CRE (including owner occupied) is roughly 20% of loans, and office loans are approximately 20%-25% of CRE loans at the median. Within office, the type of property can be an important consideration for a bank's CRE portfolio. Of the three types of class A, B, and C buildings, class A buildings are the most modern in terms of amenities and year of construction. Demand for leasing space in class A buildings generally is holding up better than class B or C buildings.

Another differentiator in office space is that the performance of small city/suburban office space has held up better than large city offices in gateway cities. That's because prices for suburban office space did not rise in the same way prices for large city office did during the years of low interest rates.

Other asset classes within CRE are holding up better than office from a demand standpoint, but higher interest rates and inflation raise property operating expenses across the board. Nevertheless, we believe multifamily exposure may be less vulnerable as the run-up in housing prices in 2020 and 2021 and limited housing construction and supply have made it less affordable to own a home. Household formation is also supporting the demand for rental housing, which may remain resilient even in a recession. We expect demand for rental housing to remain robust over the next one to two years as rising borrowing costs, tightening lending conditions, and elevated inflation continue to weigh on the affordability of home ownership (see "Real Estate Monitor: Rising Rates Driving Rental Housing Resiliency," March 30, 2023). Still, some multifamily properties have come under pressure because of landlords' inability to raise rents enough to compensate for the higher costs of servicing a building.

Positively, retail and hotels, which performed poorly during the pandemic, have rebounded significantly, while demand for industrial space remains strong as the need for warehouses to accommodate the growth of online activity continues.

How significant are the declines in CRE pricing?

Higher real interest rates have weighed on the pricing of all CRE asset classes as cap rates have risen, with office the most significantly affected because of a decline in demand as well. CRE prices are down 5.2% through March 2023, from the peak in June 2022, and office is down 6.6%, according to RCA core CPPI data (Real Capital Analytics Commercial Property Price Indices) (see chart 2).

Chart 2


We believe the RCA data may understate the CRE price declines, given the low frequency of transactions in CRE, particularly in office. An alternative way to gauge price decline is to look at the value of public equity REITs relative to their net asset value (NAV). Looking at the CRE industry from this perspective suggests a much more pessimistic view. The median discount to NAV for all U.S. equity REITs was about 20%, with the median discount for office properties down over 50% (see chart 3). This method of gauging CRE prices could overstate the downside because it relies on market sentiment (stock price of REITs), which is out of favor right now.

Another CRE pricing index is the Commercial Property Price Indices (CPPI) from Green Street. According to this index, overall office values have declined by about 25% since last year. All in all, we think valuation declines could vary greatly and will be very asset specific, based on the quality of the property, tenant roster, remaining lease term, capital structure of the asset, and market location.

Chart 3


Which rated banks have the largest exposure to CRE?

For the banks we rate, the median exposure to CRE (including owner occupied) is roughly 20% of loans and 130% of Tier 1 capital. For all banks, exposures to CRE as a percentage of loans vary by bank, with the smaller banks having the largest percentage of CRE loans to total loans (see the table).

Banks' commercial real estate loans to total loans
--% of total loans--
Construction Multifamily Non-owner Farm CRE not secured by RE Total CRE
Large banks (> $100 bil.) 1.8 3.6 4.8 0.1 2.4 12.8
Midsize banks ($10 bil.-$100 bil.) 7.5 7.0 17.0 0.7 1.1 33.2
Small banks (< $10 bil.) 8.0 7.3 18.5 3.9 0.4 38.1
Data as of March 31, 2023. Note: Excludes owner-occupied. Source: S&P Global Ratings.

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 (see chart 4).

Chart 4


Since office is one of the riskier CRE segments, we also looked at office loans as a percent of total CRE loans for banks with over 30% of CRE loan exposure (see chart 5). For these banks, at the median, office is only about 15% of their total CRE exposure. And these banks tend to have exposure to CRE in smaller cities or suburban areas, which haven't had the run-up in prices that larger cities have had.

Chart 5


How has the credit quality of bank CRE loans held up so far?

Delinquencies and charge-offs for CRE owner-occupied loans have remained low so far. But the delinquency rate on non-owner-occupied nonresidential property loans has increased for the past three quarters. The 24-basis-point rise in the March quarter was the largest sequential increase since the 20-basis-point rise in the fourth quarter of 2020. Although delinquencies for non-owner-occupied properties have ticked up, the levels are still not troubling. This is likely because CRE price discovery can be slow, plus many property owners are still paying relatively low interest rates for outstanding loans. As price discovery progresses and loans refinance to higher rates, we expect more significant CRE write-offs to materialize over the next two years.

Banks have been building loan reserves for CRE and have been speaking publicly about possible troubles on the horizon. But the reserve builds have not been large. Allowance to loans for all asset classes edged up to 1.67% at the end of first-quarter 2023 from 1.61% the quarter before. Criticized CRE loans have risen in recent quarters as well, likely triggered by the portion of CRE loans that are up for refinancing over the next two years. (A bank denotes a loan as being criticized if it has an elevated chance of default.)

Chart 6


What amount of CRE losses would affect bank capital more significantly?

We performed 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 $2.5 trillion of bank CRE loans outstanding according to Fed Z.1 data, versus roughly $2.0 trillion of Tier 1 capital (see chart 7). A CRE loss rate of 10% equates to a loss of 12% of bank capital.

To put the 10% loss rate in our stress scenario analysis into perspective, it's about equal to the 9.8% median CRE loss rate in the Fed's 2022 stress test, which assumes a significant recession with unemployment reaching 10% and CRE prices declining 40%. Another yardstick is the roughly 9% charge-off rate for CRE loans (excluding multifamily and construction loans) cumulatively from 2008-2010.

In our view, a 10% CRE loss rate --assuming no other asset class are under significant stress-- should be manageable for rated banks without heavy CRE exposure, especially since they could absorb some of those losses with preprovision revenue. That said, a significant rise in CRE losses could lead to heightened confidence sensitivity and deposit outflows.

If we applied the same stress to just the banks in our rated portfolio with over 30% CRE exposure, a 10% loss rate would equate to 29% of capital. This is a much more significant hit versus the 12% for all banks (see chart 8) and could lead to downgrades for some.

Chart 7


Chart 8


How much of banks' CRE loans is due to be refinanced this year and what are the credit implications ?

We estimate that of the CRE loans outstanding for our rated U.S. banks, roughly 15%-30% are due to be refinanced this year. As the pipeline for refinancing comes due, criticized loans are likely to rise, but not necessarily charge-offs, because a charge-off will depend on the ultimate valuation of a distressed property and the loan to value at origination.

In general, when a loan comes due for refinancing, the bank that owns the loan will assess the value of the property and determine whether additional equity or mezzanine financing is required from the owner of the property (typically the sponsor), to help protect the bank in case there is default connected to the property. If the loan is fixed rate, refinancing could pressure the economics of the property because the offering rate will likely be significantly higher than when the loan was first taken out. But even some CRE loans that have a variable rate could pressure borrowers when they come due for refinancing. That's because some lenders of variable-rate debt require borrowers to buy an interest-rate cap that limits their exposure to rising rates. Rates have gone up significantly since these have been taken out, and replacing these hedges once they expire is now very expensive.

In any event, the sponsor may look to replace the financing, if better terms can be found elsewhere. If there are no alternatives, the sponsor can either:

  • Try to negotiate better terms with the bank in an attempt to limit the additional capital needed, or
  • Walk away from the property if the sponsor believes that the economic value of the property has been impaired such that a further equity investment is unwarranted.

In the second case, the sponsor is willing to lose its initial investment.

Recent high-profile defaults point to stress. For example, a large asset manager defaulted on office properties in Los Angeles and Washington, D.C., while another large asset manager defaulted on properties in San Francisco, New York, Boston, and Jersey City.

As relationship lenders, banks may not view foreclosing on CRE property as their best course of action if extending the terms of a CRE loan or restructuring the debt would offer better long-term prospects. Also, with funding costs rising, banks will do their best to maintain or add to earning assets so as to preserve net interest income and profitability. As long as a CRE loan makes economic sense, a bank with balance sheet capacity is likely willing to extend a loan.

In some cases, foreclosure may be unavoidable. But widespread foreclosures could lead to fire sales and CRE losses, which could then affect the collateral valuations across the rest of the CRE portfolio and could result in a significant increase in criticized and nonperforming assets. Expectations on interest rates could also provide an incentive for a bank to consider forbearance (such as extending a CRE loan) in lieu of foreclosure, since a future decline in interest rates could alleviate credit pressures.

We believe many bank CRE loans will likely be restructured. We capture restructured loans as part of our credit analysis as we look at nonperforming assets, including troubled debt restructurings, and gauge loan loss reserves accordingly.

Have banks become more conservative in terms of new CRE lending?

Banks have generally become more selective in terms of new CRE lending because there is concern about potential credit quality issues. Banks have also become more circumspect regarding the use of their balance sheets as most banks' deposits have declined amid the recent turmoil in the regional bank sector. CRE loan growth in first-quarter 2023 was basically flat from the prior quarter.

According to the April 2023 Senior Loan Officer Opinion Survey, in first-quarter 2023, banks reported tightening standards for all types of CRE loans (see chart 9). Such tightening was more widely reported by midsize banks than by the largest banks or other banks. However, the tightening was not outsize versus the previous quarter, before the March bank volatility.

Chart 9


According to the Federal Reserve's survey, banks' most frequently cited reasons for an expected tightening of lending standards in the rest of 2023 are:

  • An expected deterioration in the credit quality of their loan portfolios and in customers' collateral values;
  • A reduction in risk tolerance; and
  • Concerns about banks' funding costs, liquidity positions, and deposit outflows.
Given the recent turmoil in the banking industry, do U.S. banks have the balance sheet capacity to lend further?

In the first quarter of 2023, systemwide deposits declined about 2.5% (see chart 10). But the deposit outflow has not been even across the industry, with deposit trends at the larger banks faring better than at the smaller banks.

Chart 10


As such, larger banks seem to have more capacity to fund CRE loans than smaller banks. According to our analysis, the largest banks (with over $50 billion in assets) hold about 45% of systemwide bank CRE loans (see chart 11). These banks had a loan-to-deposit ratio of 59% at the end of the first quarter versus 58% at the end of the fourth quarter. They also seem to have the capacity to continue extending CRE loans--assuming the loans continue to make economic sense.

Smaller banks (with less than $50 billion in assets), which represent roughly 55% of CRE loans, are not as well placed as the larger banks. Their loans to deposits were 80% at the end of the first quarter versus 79% at the end of fourth-quarter 2022. When looking at securities and loans to deposits, the ratio gets tighter. Said another way, these banks could have funding issues sooner than the large banks if they grow their loans quickly.

Chart 11


If banks are unable or unwilling to refinance CRE loans, could other players step in?

We believe others could step in, but the economics of the property in question would need to make sense. (See Appendix for details on CRE debt market participants.) While CMBS issuance has dropped off recently, one sector that may have some capacity to pick up CRE loans is private credit. Six of the largest alternative asset managers we rate (have roughly doubled assets under management devoted to credit since the end of 2019, reaching approximately $1.4 trillion.

That said, small bank CRE lending--should the banks pull back--may be more difficult to replace. That's because small banks use their expertise in their locales to compete more effectively than other types of lenders. The terms of these deals may not meet the credit standards of a larger lender that is not as familiar with the local community as a smaller bank. Also, the loan may be too small to interest private credit, which lately has taken on larger loans. But private credit providers may be willing to partner with smaller banks. For example, Blackstone has been talking to small banks about stepping in to lend alongside them as more look to slim down their balance sheets.

Appendix: U.S. CRE Debt Market Size And Participants

Although banks and nonbanks often compete for CRE assets, the nature of the loans they offer can be quite different. 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 and require significant equity and guarantees from borrowers.

Finance companies and other originators that sell loans into CMBS, including the large banks, also make loans on cash-flowing, stabilized properties, but they may not require recourse to the borrower. In the past, CMBS financings were longer term and fixed rate. But more recently, these have become shorter-term/single-borrower deals and mostly floating rate.

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

Higher-risk CRE may be found on the balance sheets of finance companies. These companies often make loans on "transitional" properties, typically holding those on balance sheet. Transitional properties may be undergoing some level of construction or improvements or may have lower occupancy rates and be undergoing efforts to improve leasing.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Stuart Plesser, New York + 1 (212) 438 6870;
Secondary Contacts:Devi Aurora, New York + 1 (212) 438 3055;
Brendan Browne, CFA, New York + 1 (212) 438 7399;
Research Assistants:Nick Nelson, Englewood
Jake McAlister, Englewood

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