A Significant Share of Banks Are Overexposed to CRE

Article originally posted on Globe St. on February 27, 2024

Anyone in the industry could reasonably be tired of hearing how much trouble banks potentially face over CRE loans — especially the bankers.

It’s not that people are enjoying this. And it’s not as though huge numbers of banks are about to fold.

The concerns are also reasonable, given what happened to Silicon Valley, First Republic, and Signature banks in 2023. The biggest issue then was concentration in other industries and holding long-term assets that would have been marked down sharply if marked to market. Depositors fled with their cash and the banks teetered on the edge of insolvency, at which point the Federal Deposit Insurance Corporation stepped in, as it had to.

However, there are a lot of banks out there — 4,641 that are FDIC insured and supervised — and according to an analysis by two Florida Atlantic University researchers, a disturbing number are in dangerous waters.

With hundreds of billions of dollars in CRE loans maturing and needing either settlement or refinancing, the “combination of rising interest rates, high office vacancies due to remote work, as well as lowering returns on investment in these buildings has exposed vulnerabilities in the banking system,” the school wrote.

Reduction in office use leaves property owners facing the possibility of lowered income, and therefore lowered NOI and debt service coverage ratio. “It’s a problem for the banking system as there are a lot of banks that have extensive exposure to risk,” says Rebel Cole, Lynn Eminent Scholar Chaired Professor of Finance at FAU.

Out of the 4,641 operating banks, 1,522, or nearly 33%, have CRE loan exposures more than 300% of their what the school called “equity capital.”

“Normally, if it just says equity, it means common equity,” says Mayra Rodriguez Valladares, managing principle of banking consultancy MRV Associates. “If they use the term capital, it could mean common equity, retained earnings, diverse assets.” That latter would be Tier 1 capital in banking terminology.

Cole, who responded to an email question from GlobeSt.com, says that he ran the calculations in two different ways: against total equity and Tier 1 capital plus allowance for loan and leases from financial filings. “No matter how you do it, it looks bad,” he writes.

Or, as Rodriguez Valladares says, “When you talk about 300%, there’s only so many ways you can arrange the deck chairs on the Titanic.”

And 300% is the lower level of risk. Beyond that, 732 (15.8%) had exposure of more than 400%; 320 (6.9%) had more than 500% exposure; and 113 (2.4%) had 600% exposure.

“A less favorable rate environment combined with declining rents is affecting the value of commercial office space, worrying banks and bank regulators,”  Ken Johnson, a real estate economist in FAU’s College of Business, says.

Concentrations of risk may be likely in areas like the Northeast and California, with higher office vacancy. However, concern isn’t limited to those areas alone. Michael Cohen, managing partner at Brighton Capital Advisors, recently wrote in a blog post for the company that while there are “doom loop” scenarios — growing danger from upcoming loan maturities and low debt service coverage ratios — in downtown Chicago, there are also rapidly escalating vacancy rates in Chicago suburban office markets.