Analysis: Small U.S. banks imperiled by big office loans

Dime Commercial Bancshares

24/03/2023 17:45

By Saeed Azhar and Matt Tracy
       NEW YORK, March 24 (Reuters) - Small U.S. lenders that
have outsized exposure to office loans could become the next
group to face strains after bank failures roiled financial
markets this month, according to analysts.
    Rising interest rates, a slowdown in the commercial real
estate (CRE) market and the proliferation of remote work pose
challenges for smaller firms that made risky loans to finance
office buildings, the analysts said. 
    For banks with assets between $1 billion to $10 billion, CRE
loans comprised about 33% of the total held on their books,
according to estimates by ratings agency Fitch. At the end of
last year, CRE only made up about 6% of loans held by larger
banks that had total assets of more than $250 billion, it said. 
    Goldman Sachs economists estimate the combined share of
small and mid-sized banks, including lenders with less than $250
billion in assets, is 80% of the overall stock of commercial
mortgage loans, it said in a note.
       Both Goldman and Fitch did not specify which small
lenders were most vulnerable. 
        Julie Solar, a credit officer at Fitch Ratings, said the
office sector faces asset quality deterioration, putting smaller
banks at risk due their relatively larger exposure as a
percentage of their assets.
  
        "Banks will be primarily exposed to CRE through bank
loans on the balance sheet," she said. The total exposure of the
U.S. banking system to CRE loans was $2.5 trillion at the end of
December, Fitch said.
    CRE leases tend to be long-term, which give lenders time to
deal with any potential problem loans, but a wall of maturities
are due for both loans and commercial-backed mortgage securities
in coming months, investors and analysts said. 
        "Coupled with higher funding costs, elevated funding
needs, and tighter lending standards, this implies a challenging
fundamental backdrop in upcoming months," Vinay Viswanathan, an
analyst at Goldman Sachs Group Inc  GS.N  wrote in a note. 
  
       The S&P 1500 Regional bank index  .SPCOMBNKS  is down 30%
month to date.
    
    HEADWINDS     
    The CRE market faces headwinds that could hobble small
banks. After the global pandemic sent droves of employees to
work from home, many have returned on hybrid arrangements or not
at all, spurring vacancies in office buildings. 
    Rising interest rates have also depressed demand for CRE
loans, while weighing on real estate investment trusts (REITs).
    Goldman's Viswanathan cited several indicators that
reflected a weakening market for office real estate: declining
occupancy rates, falling appraisal values and rising defaults.
    Last month, a subsidiary of asset manager Brookfield Corp
defaulted on loans linked to two buildings in Los Angeles,
according to a regulatory filing.
    More cautious underwriting will probably lead to a further
slowdown in real estate markets, Wells Fargo & Co  WFC.N 
analysts wrote, citing Federal Reserve data that showed
tightening lending standards for CRE in the first quarter.
    CRE borrowers are grappling with higher costs for
refinancing and hedging at a time where it's also getting more
expensive to pay back their debts, said Viswanathan at Goldman.
   Declining occupancy rates will probably force office
landlords to cut rents for tenants who are also seeking less
space as they negotiate new leases, he said.
    Morgan Stanley expressed a more bleak outlook for CRE
lenders this week.
    "Don't roll the riskiest loans when they come due," Morgan
Stanley analysts led by Betsy Graseck wrote in a note. "Banks
should tread carefully as they can be left with the keys" of
properties they don't want.
    Big cities will bear the brunt of the CRE woes.
    "You’re looking at the larger metro areas - LA (Los
Angeles), New York, Chicago - where there is an abundance of
office space that is now being severely challenged,” said
Michael Donelan, senior managing director and portfolio manager
at SLC Management. 
    CRE "is the next shoe to drop," said Edward Campbell,
co-head of the multi-asset team at PGIM Quantitative Solutions,
a unit of insurer Prudential Financial Inc  PRU.N . 
    "The smaller banks are especially vulnerable," he said.     

 (Reporting by Saeed Azhar in New York and Matt Tracy in
Washington; Editing by Lananh Nguyen and Nick Zieminski)
 ((Saeed.Azhar@thomsonreuters.com ; +1 347 908-6341; Reuters
Messaging: saeed.azhar.reuters.com@reuters.net))