U.S. banks incur losses in their commercial real estate (CRE) portfolios that are manageable through our insurance coverage.
We believe New York Community Bancorp NYCB is particularly high risk and would have been highlighted as such by our risk screen.
Rather than a collapse in the real estate industry, we expect to see small to medium revenue declines at some of the banks we cover, with possibly larger declines at Zions ZION in particular, but we believe all of our banks will emerge from this pressure unscathed.
As CRE risks remain a concern for some market participants, understanding how to categorize and size these risks is paramount. We believe that growing pessimism, based at least in part on the nature of CRE losses, could present an opportunity for patient investors.
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How big will commercial real estate losses be?
The four main sectors of commercial real estate include industrial (mainly warehouses and manufacturing facilities), multifamily (multiple family housing units, primarily apartments), retail, and office.
According to our analysis,
Industrial property fundamentals are good with strong demand and low vacancy rates, so we don't expect much stress. Retail is not as strong as industrial, but it has seen less of a steep decline in demand and supply has been correcting for over a decade, so it should remain relatively stable. We are keeping an eye on multifamily in particular in the Southeast, as we believe overbuilding and rising interest rates (i.e. higher financing costs/lower property values) will stress some properties. However, we expect the pain here to be limited due to the lack of a dramatic shock in demand.
The office is the real pain area, and we believe it will get worse before it gets better. There is a structural demand shock happening that will take years to permeate the system. We are probably in year four of a six- to seven-year process.
The pandemic has exponentially accelerated the remote work trend and structurally reduced demand for office real estate. A significant percentage of the U.S. workforce has been working remotely for more than three years and is unlikely to return to pre-pandemic status quo. Hybrid work has become the norm in U.S. companies, with most U.S. employers offering it in some form.
The impact of hybrid work-related disruptions is showing up in office real estate fundamentals such as vacancy rates, net absorption and rent rates. All are worsening and are expected to get worse as more companies scale back their overall office space in the U.S. Average quarterly office leasing is estimated to decline by more than 30% to about 39 million square feet, compared to 59 million square feet pre-pandemic.
After falling sharply in the early stages of the pandemic, office leasing volumes recovered steadily through the second quarter of 2022, but the recovery has reversed over the past year as more companies began to rethink their long-term office requirements.
The decline in office leasing volumes has been seen across a wide range of industries over the past year, with even sectors such as technology, which performed well in 2021 and early 2022, worsening and seeing the biggest declines in office leasing volumes in recent times.
Demand has fallen as office occupancy rates have fallen by around 50%, and as businesses need less floor space, rentals have fallen and vacancy rates have risen. Supply has responded, with new office construction falling to almost zero.
We believe that slow supply-side growth will allow the office sector to reach a more stable equilibrium in the distant future, but for now the demand-side shock is the key driver. When demand falls so sharply, there is simply no way for the supply side to adjust. Property prices will remain under pressure for the next few years.
What this means for the banking industry
That being said, what can we expect from the banking sector, which is the largest holder of CRE-related debt?
Banks have already built up significant reserves, especially for their riskiest portfolios (often 8% or more for office loans). Public investors often overlook that this has already caused significant stress in the sector (default rates of 20% or more, property value declines of 50% or more). Not all banks are equally exposed to CRE. New York Commercial Bank is a good example. Its relative CRE exposure was nearly twice as high as the most exposed bank we cover (Zions) and more than 10 times higher than the least exposed bank. Much of this exposure was to rent-controlled multifamily in New York City, one of the worst multifamily markets since the 2019 regulatory changes. None of the banks we cover can match this. Investors need to know how to screen for these risks. CRE exposure is concentrated in smaller banks with less than $10 billion in assets. We wouldn't be surprised to see a bank failure here. However, even in a bearish scenario (particularly office property CRE losses exceeding those of the 2008 financial crisis), we do not expect the banks we cover to face significant capital risks.
We found that generalists don’t delve into these details.
When CRE risk comes into the spotlight, such as immediately after news of the New York City debt distress breaks, the entire sector tends to sell off. We believe that periods of heightened risk sentiment related to CRE present opportunities for cheaper valuations.
We believe some of the risk premium the banks are experiencing will fade as the market better understands the underlying risks of CRE. Therefore, current holders need not panic, but M&T Bank MTB and Zions watchers should be prepared. These banks may be experiencing a period of higher CRE risk discounts, which could present an opportunity.
The table below shows that even in a bear market, these banks' projected CET1 ratios (which measure a bank's capital relative to its assets) would still be above regulatory minimums.