(Bloomberg) — Big U.S. banks may have more exposure to commercial real estate than regulators realize because of credit lines and long-term loans they offer to real estate investment trusts, according to a new study.
Adding indirect lending to REITs increases big banks' exposure to CRE lending by about 40%, say researchers including New York University economics professor Bilal Acharya, a point they argue has been largely overlooked in discussions of the risks the troubled industry poses to lenders.
“Everybody is looking at banks' on-balance-sheet lending,” Mr. Acharya, a former deputy governor at the Reserve Bank of India, said in an interview. “We shouldn't fall into the blind spot that the large banks' exposure is relatively small compared to the smaller banks.”
REITs have faced challenges since the pandemic began, as working from home has threatened the long-term value of offices while rising borrowing costs have hurt many multifamily investments. Some investors responded by pulling money from trusts over the past two years, including those managed by Starwood Capital Group Inc. and Blackstone Inc., which have limited redemptions to preserve liquidity.
High Stress
REITs are companies that own, operate or rent out income-generating real estate. They are relatively cash-poor because they are obligated to pay large dividends every year. As a result, they worry about redemptions and tend to withdraw loans from banks during periods of general economic stress, which is a concern for researchers.
That could cause a “sudden capital or liquidity squeeze,” the report said, adding that regulators should better take into account lenders' exposure to real estate investment trusts when conducting bank capital stress tests.
The report said that because borrowers decide when to draw down loans, it's hard for banks to manage the risks associated with them, which “may exaggerate banks' cyclical risk.” In some cases, the funds appear to have been used to buy additional real estate, the researchers noted.
“The collateral damage to large banks from large credit drawdowns means that the systemic risk from overall CRE exposure is probably much greater than if we looked at just the direct exposures,” said Manasa Gopal, an assistant professor of finance at the Georgia Institute of Technology and one of the report's authors.
So far, the risk to the financial system from more people working from home has been most noticed by regional banks, which have increased their CRE exposure in recent years. In the U.S., office non-performing loans exceeded $38 billion as of the end of the first quarter, with another $50.3 billion in potential non-performing loans, according to data compiled by MSCI Real Assets.
Of the five largest U.S. banks by market capitalization, Morgan Stanley has the highest percentage of its own credit lines in REITs, said co-author Max Jaeger, an assistant professor at the Frankfurt University School of Finance and Management. Still, in absolute terms, Morgan Stanley's exposure is smaller than its peers. A company spokesman declined to comment.
The Fed examines banks' exposure to REITs and shadow lenders, tracking the debt relationships between the two. In its April Financial Stability Report, it said bank credit to REITs declined from a year earlier.
Rising fees
Still, credit facilities to REITs have grown at a much faster pace than other borrowers in recent years, the researchers said, adding that lenders should charge higher fees on REIT products to compensate them for the risk they take on.
Months before Blackstone REIT limited redemptions toward the end of 2022, it secured increased credit facilities at spreads that were largely unchanged or unchanged “despite clearly increased credit and drawdown risks,” according to the report.
“BREIT takes an active and disciplined approach to managing its liquidity,” a representative for Blackstone said in a statement. “The company has maintained ample liquidity throughout economic cycles, operates its business efficiently and has a strong balance sheet.”
The analysis found that large U.S. banks had $345 billion in indirect exposure to commercial real estate in the fourth quarter of 2022, up from $109 billion in the same period in 2013.
Despite this, REITs' leverage ratios remain low: According to research by representative firm NAREIT, REITs' debt-to-market asset ratio was 33.8% at the end of the first quarter, meaning they are “less stressed” than their more heavily debt-burdened counterparts.
Acharya said much of the risk for banks from lending to distressed REITs has been mitigated by the Fed's backstop measures to ensure banks have enough liquidity to meet demand during the pandemic. But that hasn't always been the case.
“There's an episodic aspect to Line of Credit, and we don't know exactly when that event is going to happen,” he said. “There's a risk that we won't know exactly how the episode will unfold.”
–With assistance from David Scheer.
(An earlier version of this story corrected a statement about reimbursement in the second paragraph under the subheading “Rising Fees.”)
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