Are banks facing a real estate reckoning?

Analysis
Insights

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.

Share

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.

Bank stocks pull back; remain above recent lows

Despite an 11 percent drop in seven days, index is above near-term median

Performance of the KBW Regional Bank Index

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.

  • KBW Regional Bank Index
  • Median

Source – RBC Wealth Management, Bloomberg; data through 2/7/24

Problems, yes; catastrophe, no

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.

First, the hard realities

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 requirement.

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 original loan.

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 fatal ones.

The sun will come up tomorrow

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 amount.

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.

Go big or stay home?

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.

Large number of banks have CRE risk, but large banks have less of it

Exposure to commercial real estate as a function of bank size

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.

  • Percentage of banking system assets (RHS)
  • Average CRE exposure as % of assets (RHS)
  • Average CRE exposure at 10% effective capital (RHS)
  • Number of banks (LHS)

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 negative headlines.

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.

Many paths ahead

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.


This publication has been issued by Royal Bank of Canada on behalf of certain RBC ® companies that form part of the international network of RBC Wealth Management. You should carefully read any risk warnings or regulatory disclosures in this publication or in any other literature accompanying this publication or transmitted to you by Royal Bank of Canada, its affiliates or subsidiaries.

The information contained in this report has been compiled by Royal Bank of Canada and/or its affiliates from sources believed to be reliable, but no representation or warranty, express or implied is made to its accuracy, completeness or correctness. All opinions and estimates contained in this report are judgments as of the date of this report, are subject to change without notice and are provided in good faith but without legal responsibility. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Every province in Canada, state in the U.S. and most countries throughout the world have their own laws regulating the types of securities and other investment products which may be offered to their residents, as well as the process for doing so. As a result, any securities discussed in this report may not be eligible for sale in some jurisdictions. This report is not, and under no circumstances should be construed as, a solicitation to act as a securities broker or dealer in any jurisdiction by any person or company that is not legally permitted to carry on the business of a securities broker or dealer in that jurisdiction. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice.

This material is prepared for general circulation to clients, including clients who are affiliates of Royal Bank of Canada, and does not have regard to the particular circumstances or needs of any specific person who may read it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. To the full extent permitted by law neither Royal Bank of Canada nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or the information contained herein. No matter contained in this document may be reproduced or copied by any means without the prior consent of Royal Bank of Canada.

Clients of United Kingdom companies may be entitled to compensation from the UK Financial Services Compensation Scheme if any of these entities cannot meet its obligations. This depends on the type of business and the circumstances of the claim. Most types of investment business are covered for up to a total of £85,000. The Channel Island subsidiaries are not covered by the UK Financial Services Compensation Scheme; the offices of Royal Bank of Canada (Channel Islands) Limited in Guernsey and Jersey are covered by the respective compensation schemes in these jurisdictions for deposit taking business only.


Let’s connect


We want to talk about your financial future.

Related articles

A crisis for a few banks is not a banking crisis

Analysis 7 minute read
- A crisis for a few banks is not a banking crisis

Shaking up corporate Japan

Analysis 6 minute read
- Shaking up corporate Japan

Positioning for inflation shocks

Analysis 7 minute read
- Positioning for inflation shocks