Space to lease in New York City's Penn 2 building in May 2024. Vornado Realty Trust last year paused part of a massive redevelopment plan to renovate Penn Station after high interest rates and a shift to working from home sparked a crisis in the commercial real estate market.
Stephanie Keith/Bloomberg
Strong bank underwriting of office loans has largely contained credit problems for now, but some lenders may need to boost reserves for possible loan defaults, according to a recent analysis by Moody's Investors Service.
A loan-by-loan analysis of 41 unnamed banks' commercial real estate portfolios paints a picture of the various struggles facing financial institutions. Moody's concluded that banks had underwritten loans more conservatively than the ratings agency expected, but high interest rates for a long time are increasing the need for banks to shore up capital, said Stephen Lynch, a vice president and senior credit officer at Moody's.
“If these levels remain elevated, it puts pressure on all asset classes,” Lynch said. “This has forced us to reassess the risk levels of banks with high CRE concentrations. Even if a particular institution is well underwritten, how do you compensate for that higher asset risk?”
Moody's concluded that, on average, banks would need to hold roughly double the reserves they currently hold to cover potential office losses.
The ratings agency also determined that banks are generally more cautious about the future of office loans than other types of commercial real estate. A recent report from the Federal Reserve Bank of St. Louis found that projected defaults on office properties are at their highest in decades. The sector has become a top concern for analysts and investors as work-from-home trends and high interest rates put pressure on the values of these properties.
Underscoring these concerns, Moody's report found that banks' average current expected credit loss (CECL) reserves for their office portfolios are 2.2%, roughly double the rate for multifamily and other real estate loans.
Moody's was able to assess the office portfolios of 40 banks, and while it did not disclose the size range of those banks, it said the total office portfolio value was $31.9 billion.
Darrell Wheeler, head of commercial mortgage-backed securities research at Moody's, said banks likely assess CECL reserves differently, but that banks with more office loans tend to allocate larger reserves.
But Wheeler said he was surprised by some of the numbers: About 10 institutions had CECL reserves equal to or greater than Moody's assessment, and one bank had allocated double the recommended amount. (Seven banks did not provide loan-level CECL reserves to Moody's.)
Wheeler said the office loans examined in the report appear to be relatively stable compared to overall office loans nationwide. The average office vacancy rate for banks in Moody's report was 13.8%, but national second-quarter trends showed the office sector's vacancy rate hitting a record high of 20.1%.
The industry's exposure to the CRE sector has put banks in a bind even when specific loans look strong: Federal Reserve data shows a correlation between higher CRE loan concentrations and lower returns on bank stocks.
“Concentrations often get banks into trouble,” Lynch said. “Even if we judge the underwriting to be good, the management's risk tolerance in allowing that concentration influences the rating.”
He said most banks now need to have higher levels of capital and liquidity than they would have in a low-interest rate environment, a conclusion he said was the “rationale” for the actions ratings agencies have recently taken against certain banks.
Moody's said last month it was considering downgrading six banks — First Merchants, FNB Corp., Fulton Financial, Old National Bancorp, Peapack-Gladstone Financial and WaFd — because of their concentration in commercial real estate.
But Moody's report de-emphasized consistent trends across office loans because individual loans from each bank were so variable, Wheeler said.
While the St. Louis Fed report noted variability in risk across commercial real estate, it found a correlation between the size of an office property and its expected default risk. In other words, the more space there is, the higher the risk tends to be, the St. Louis Fed researchers found.
Jordan Pandolfo, an economist at the St. Louis Fed who co-authored the bulletin, said that while CRE concentrations are a risk, it's important to evaluate differences across sectors, property types, regions and bank underwriting and loss reserves.
“The key takeaway here is that commercial real estate risk is extremely diverse,” Pandolfo said, referring to the St. Louis Fed's findings, “so it's very difficult to pinpoint which banks have the most CRE exposure risk based on specific statistics like concentration ratios or what percentage of their portfolio is commercial real estate.”