• High interest rates and a growing number of employees in a work-from-home environment have put the spotlight on commercial real estate.
• Domestic banks have substantial financial exposure to commercial real estate and there are concerns for the banking sector, and by extension the broader economy, should default rates become unmanageable.
• Below, we discuss delinquency rates and the risks associated with small and large financial institutions.

Over the past several years, negative headlines concerning banks’ exposure to commercial real estate (CRE) have fueled speculation about the overall risk to the banking system. Following the COVID-19 pandemic, rapidly rising interest rates and a slowdown in demand for office space led to fears that defaults would skyrocket as CRE loans matured. A recent report by the Federal Reserve Bank of New York expressed similar concerns, arguing that banks were delaying loss recognition in commercial real estate loan portfolios through term modifications. 

The study found that banks with weak capitalization were motivated to extend the maturity of existing loans to avoid depleting their capital, and this phenomenon occurred most notably in the post-pandemic era as rising interest rates led to substantial marked-to-market losses in banks’ securities portfolios. Banks’ “extend-and-pretend,” as the study refers to it, has created a rapidly expanding maturity wall of CRE loans set to expire in the near future. Data from the Federal Reserve (Fed) appears to support these findings, as both delinquency and net loss rates have been slow to materialize, despite recurrent headlines regarding elevated vacancy rates and pressure on lease rates, particularly in office properties.

The following chart illustrates the delinquency rate across all CRE loans for all U.S. commercial banks from the end of the first quarter of 1991 (the first available data point) through the end of the second quarter of 2024. 

Relative to the Savings & Loan Crisis in the 1990’s and the Global Financial Crisis period, delinquencies remain low despite a national office vacancy rate approaching 20%. Net CRE charge-offs are similarly contained, although the following chart graphically highlights that losses in CRE can materialize suddenly and violently after extended periods of stability.

The Fed’s study addressed the roughly 51% of the $5.8 trillion in CRE loans outstanding at the end of Q4 2023 held by commercial banks (the right-hand side of the pie chart). Bank share of the exposure is not distributed evenly across the system, with the U.S. global systemically important banks (G-SIBs) and banks with total assets exceeding $100 billion owning 17.8% of total CRE exposure. The largest aggregate exposure is held by community banks and regional banks with less than $100 million in total assets at 33% of total CRE and 65% of aggregate banking system exposure.

The absolute size of small bank (assets < $100 billion) exposure versus large banks is depicted in the following chart. Large bank exposure to CRE has been optically flat since pre-COVID, while small bank exposure continued to increase through the end of September 2024, albeit at a slower pace.

In addition to being large on an absolute basis, CRE loans dwarf balance sheet equity at small banks despite some recent improvement, while exposure as a percentage of equity at large banks has remained stable since 2015. 

Although granular disclosures are lacking, the relative levels of established loan loss reserves at smaller banks appears to be inadequate from a high level. Loan loss reserves totaling $69.3 billion at small banks was equivalent to 1.5% of total gross loans at small banks at the end of Q3 2024. A spike in CRE loan losses to the 3.28% level hit in Q4 2009 would consume 96% of small banks’ total loan loss reserve. In a scenario where losses hit 3.5%, small banks’ entire loss reserve would be wiped out along with $1.7 billion in balance sheet equity. Large banks by contrast can absorb a 5% loss rate that would consume 33% of available loan loss reserves.. 

The New York Fed’s concerns appear to be justified accordingly, although the real reckoning looks to be with small banks that are outside of our investable cohort. As large banks generally have more manageable levels of exposure to CRE and are better reserved against potential losses, we expect our approved issuers to emerge on the other side of this particularly noisy credit cycle with credit fundamentals and ratings intact. 

Sources

Federal Reserve Bank https://www.federalreserve.gov/data.htm

Federal Reserve Bank of NY “Extend-and-Pretend in the U.S. CRE Market” Publication No. 1130 10/24 

https://www.commercialedge.com/blog/national-office-report/