Despite the hard realities of mounting losses on real estate loans, we think a fair dose of hyperbole is going around. We dissect the problem before arguing the overall U.S. banking system is healthy and able to weather any volatility ahead.
February 8, 2024
By Atul Bhatia, CFA
The core business of banking is mundane. Deposits are turned into loans,
loans generate cash flows, depositors are repaid, and the whole cycle
starts up again. The picture is a little more complicated with stock and
bond investors included, but not by much.
Nothing about this is headline-worthy when done well, so we think it’s
disconcerting to see small U.S. banks in the news. This round of falling
regional bank stock prices comes amid concerns on banks’ exposure to
commercial real estate (CRE), particularly office and retail properties
that have been negatively impacted by changing work and shopping habits.
Line chart showing the performance of the KBW Regional Bank Index – an
index of regional banking stocks – and also the median of 92.93 for the
period of Jan. 13, 2023, through Feb. 7, 2024. Chart is showing an 11%
decline from Jan. 30, 2024, to Feb. 7, 2024; latest reading was 96.49.
Source – RBC Wealth Management, Bloomberg; data through 2/7/24
Unlike most of the doom-and-gloom predictions that pop up from time to
time, there is a kernel of truth to the narrative on CRE, in our view.
Losses are real, and the impact will be felt. At the same time, we think
press reports paint with too broad a brush when discussing the topic.
There are huge differences between the events of 2008, for instance, and
what we see as the reasonably likely outcomes for banks today.
At the level of publicly traded banks, we think it is very unlikely that
large banks will be stressed, and we are not concerned with the solvency
of the overall banking system. Instead, we think we are likely to see
stress in some smaller banks, as rising credit losses could force capital
raising that would, in turn, pressure security prices. Moreover, we would
not be shocked to see larger, well-heeled banks scooping up CRE-troubled
lenders at discounted prices.
In short, our view is not exactly “business as usual,” but is instead
“resolution as usual,” with any problems in small banks largely dealt with
by the normal capitalist process of resource reallocation.
CRE is a meaningful problem. Projects are closing and properties are being
sold well below recent appraised levels. Bank lenders, who are typically
the first in line for repayment, are almost certainly going to do better
than project developers and junior lenders, but “better” is different than
“good” and we’re expecting noticeable losses in the banking system.
According to the National Bureau of Economic Research (NBER), U.S. banks
overall hold approximately US$2.7 trillion in CRE loans, so this is not an
issue that has been manufactured to sell newspapers.
Not only is the size of CRE exposure an issue for banks, but it’s also
fundamentally different than the financing issues that hit regional
lenders last March. After Silicon Valley Bank’s (SVB) failure, the need
was to fund good assets as depositors left. That’s the textbook reason
central banks exist, and the Federal Reserve could – and eventually
did – provide the necessary loans to calm the waters. Last year, we pushed
back on the idea that there was a crisis largely because the solution was
obvious to us and easy to implement. Our view was that post-SVB, bank
failures were a policy choice, not an economic
This time around, though, we are not dealing with an easy-to-solve funding
mismatch, but a real problem: allocating the losses on loans that have
gone bad and where the bank will never recover the full amount of the
Those losses go first to the capital layer. A well-reserved and
capitalised bank in the U.S. will have equity to cover a loss of around 10
percent of its assets – some have more, some have a little less. Even in a
recession, that’s usually plenty to deal with credit losses, but
unexpected stress can quickly make the math look challenging: even if a
relatively trivial three percent of assets are tied to the most
problematic office loans, for instance, a simple calculation shows that
nearly 25 percent of a bank’s capital could be at risk in a scenario of
widespread defaults and low recoveries.
Any institution facing those kinds of losses would likely be forced to cut
dividends and take other measures to shore up its balance sheet and
appease regulators. Critically, though, we think a bank in that position
should still be solvent – we’re discussing deep wounds, not necessarily
Despite the real problems in the sector, there is also a fair dose of
hyperbole, in our view.
To begin with, CRE is an incredibly broad label, covering everything from
cold storage facilities to apartment buildings. The current set of
concerns is focused on three primary loan types: office space, retail, and
multifamily housing. But even within this set of assets there is huge
variation in the likely outcomes between individual properties. The US$2.7
trillion figure from NBER is a theoretical maximum exposure; the practical
risk in the banking system, we believe, is a small fraction of that
Importantly, the risks on the largest loans have been distributed through
securitisations and other transfer mechanisms. Outside of specialised
funds, very few investors that we are aware of have large allocations to
the most troubled CRE sectors. We believe this reduces – even if it does not
necessarily eliminate – the pressure to sell assets at deeply discounted
prices and minimises the odds of contagion, where losses in one sector
lead to forced selling in other markets.
For the banking system overall, we believe there is sufficient capital to
absorb a complete write-down of the entire US$2.7 trillion in estimated CRE
exposure, although that would leave it essentially drained of equity. The
issue, of course, is that the allocation of capital does not necessarily
match the allocation of likely losses. We believe this problem is
particularly acute at small lenders.
To begin with, smaller banks are the major players in the CRE space.
According to the NBER, banks with less than US$1.4 billion in assets account
for about US$419 billion of the banking system’s exposure; this corresponds
to about 25 percent of smaller bank assets by our calculations. In
absolute terms, the largest banks – those with over US$250 billion in
assets – have greater CRE exposure, but it amounts to less than five percent
of their overall investments, according to NBER data.
Small banks’ reliance on CRE is a double hit. Not only are they seeing
large write-downs on existing loans, but pressure from investors also
makes it difficult to aggressively originate new loans, reducing earnings
and making it more difficult to replenish the coffers. Larger banks, by
comparison, have diverse revenue streams and the impact of diminished CRE
lending is, on average, barely noticeable.
Bar chart showing exposure to commercial real estate, measured both as
a percentage of assets and against a hypothetical 10% capital
position, as a function of bank size. The data indicates that banks
with less than US$1.38 billion in assets have the highest exposure to
CRE while banks with US$250 billion in more assets have the smallest
exposure to the sector. Chart also shows there are approximately 4,000
banks with less than US$1.38 billion in assets, about 725 banks with
assets between US$1.38 billion and US$250 billion, and only 13 banks with
assets more than US$250 billion.
Source – RBC Wealth Management, National Bureau of Economic Research;
data through 12/31/22
Depositor and investor concerns about small bank exposure to a troubled
asset class also raise the risk of money being pulled from these
institutions, much like we saw after the fall of SVB. This time around,
however, it will not be as easy for the Fed to swoop in and provide
assistance, given the concerns around the ultimate repayment of the loans,
a factor that was absent in last year’s Treasury bond-focused turmoil.
Even banks that continue to find funding may need to pay more for it,
adding to financial stress. One bright spot we see for these banks is that
after last year’s depositor flight, there’s reason to believe that
remaining depositors are stickier and may stay with the bank despite
A final issue, particularly for the smallest community banks, is loan
concentration. Average loan sizes in the CRE world are much larger than in
retail banking, so even a few problem loans can have a meaningful impact
on the results and capital of a small bank. As an example, New York
Community Bank was in the news recently following a nearly ninefold
increase in loan loss provisions, driven partly by two CRE credits, as
well as increased reserve build for the loan portfolio in aggregate. And
that’s an institution with over US$100 billion in assets; for a smaller
community bank, a single bad loan is potentially a meaningful event.
Despite the realities and the risks, we think widespread bank failures
from CRE exposure remain unlikely. We see small banks coming under
pressure on two fronts: rising losses on CRE loans cutting into capital
levels, while more expensive funding and reduced lending opportunities
serve as a headwind to earnings. This may lead to some bank failures, but
we do not foresee anything that would unduly stress existing mechanisms to
resolve troubled banks.
We think the largest banks, by contrast, will likely do fine in any CRE
pullback, as their lower exposure and cheaper funding allow them to take
advantage as opportunities arise. We think the U.S. banking system is
healthy and will be able to weather the likely CRE volatility ahead.
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