{"id":12920,"date":"2024-02-09T09:52:12","date_gmt":"2024-02-09T14:52:12","guid":{"rendered":"https:\/\/www.rbcwealthmanagement.com\/en-eu\/?p=12920"},"modified":"2024-02-09T09:52:13","modified_gmt":"2024-02-09T14:52:13","slug":"are-banks-facing-a-real-estate-reckoning","status":"publish","type":"post","link":"https:\/\/www.rbcwealthmanagement.com\/en-eu\/insights\/are-banks-facing-a-real-estate-reckoning","title":{"rendered":"Are banks facing a real estate reckoning?"},"content":{"rendered":"\n

By Atul Bhatia, CFA<\/strong><\/p>\n\n\n\n

\n The core business of banking is mundane. Deposits are turned into loans,\n loans generate cash flows, depositors are repaid, and the whole cycle\n starts up again. The picture is a little more complicated with stock and\n bond investors included, but not by much.\n <\/p>\n

\n Nothing about this is headline-worthy when done well, so we think it\u2019s\n disconcerting to see small U.S. banks in the news. This round of falling\n regional bank stock prices comes amid concerns on banks\u2019 exposure to\n commercial real estate (CRE), particularly office and retail properties\n that have been negatively impacted by changing work and shopping habits.\n <\/p>\n

Bank stocks pull back; remain above recent lows<\/h3>\n

Despite an 11 percent drop in seven days, index is above near-term median<\/h4>\n
\n
\n \"Performance\n \n Line chart showing the performance of the KBW Regional Bank Index \u2013 an\n index of regional banking stocks \u2013 and also the median of 92.93 for the\n period of Jan. 13, 2023, through Feb. 7, 2024. Chart is showing an 11%\n decline from Jan. 30, 2024, to Feb. 7, 2024; latest reading was 96.49.\n <\/p>\n
    \n
  • \n
    <\/div>\n KBW Regional Bank Index\n <\/li>\n
  • \n
    <\/div>\n Median\n <\/li>\n <\/ul>\n

    \n Source – RBC Wealth Management, Bloomberg; data through 2\/7\/24\n <\/p>\n <\/div>\n <\/div>\n

    Problems, yes; catastrophe, no<\/h2>\n

    \n Unlike most of the doom-and-gloom predictions that pop up from time to\n time, there is a kernel of truth to the narrative on CRE, in our view.\n Losses are real, and the impact will be felt. At the same time, we think\n press reports paint with too broad a brush when discussing the topic.\n There are huge differences between the events of 2008, for instance, and\n what we see as the reasonably likely outcomes for banks today.\n <\/p>\n

    \n At the level of publicly traded banks, we think it is very unlikely that\n large banks will be stressed, and we are not concerned with the solvency\n of the overall banking system. Instead, we think we are likely to see\n stress in some smaller banks, as rising credit losses could force capital\n raising that would, in turn, pressure security prices. Moreover, we would\n not be shocked to see larger, well-heeled banks scooping up CRE-troubled\n lenders at discounted prices.\n <\/p>\n

    \n In short, our view is not exactly \u201cbusiness as usual,\u201d but is instead\n \u201cresolution as usual,\u201d with any problems in small banks largely dealt with\n by the normal capitalist process of resource reallocation.\n <\/p>\n

    First, the hard realities<\/h2>\n

    \n CRE is a meaningful problem. Projects are closing and properties are being\n sold well below recent appraised levels. Bank lenders, who are typically\n the first in line for repayment, are almost certainly going to do better\n than project developers and junior lenders, but \u201cbetter\u201d is different than\n \u201cgood\u201d and we\u2019re expecting noticeable losses in the banking system.\n According to the National Bureau of Economic Research (NBER), U.S. banks\n overall hold approximately US$2.7 trillion in CRE loans, so this is not an\n issue that has been manufactured to sell newspapers.\n <\/p>\n

    \n Not only is the size of CRE exposure an issue for banks, but it\u2019s also\n fundamentally different than the financing issues that hit regional\n lenders last March. After Silicon Valley Bank\u2019s (SVB) failure, the need\n was to fund good assets as depositors left. That\u2019s the textbook reason\n central banks exist, and the Federal Reserve could \u2013 and eventually\n did \u2013 provide the necessary loans to calm the waters. Last year, we pushed\n back on the idea that there was a crisis largely because the solution was\n obvious to us and easy to implement. Our view was that post-SVB, bank\n failures were a policy choice, not an economic\n requirement<\/a\n >.\n <\/p>\n

    \n This time around, though, we are not dealing with an easy-to-solve funding\n mismatch, but a real problem: allocating the losses on loans that have\n gone bad and where the bank will never recover the full amount of the\n original loan.\n <\/p>\n

    \n Those losses go first to the capital layer. A well-reserved and\n capitalised bank in the U.S. will have equity to cover a loss of around 10\n percent of its assets \u2013 some have more, some have a little less. Even in a\n recession, that\u2019s usually plenty to deal with credit losses, but\n unexpected stress can quickly make the math look challenging: even if a\n relatively trivial three percent of assets are tied to the most\n problematic office loans, for instance, a simple calculation shows that\n nearly 25 percent of a bank\u2019s capital could be at risk in a scenario of\n widespread defaults and low recoveries.\n <\/p>\n

    \n Any institution facing those kinds of losses would likely be forced to cut\n dividends and take other measures to shore up its balance sheet and\n appease regulators. Critically, though, we think a bank in that position\n should still be solvent \u2013 we\u2019re discussing deep wounds, not necessarily\n fatal ones.\n <\/p>\n

    The sun will come up tomorrow<\/h2>\n

    \n Despite the real problems in the sector, there is also a fair dose of\n hyperbole, in our view.\n <\/p>\n

    \n To begin with, CRE is an incredibly broad label, covering everything from\n cold storage facilities to apartment buildings. The current set of\n concerns is focused on three primary loan types: office space, retail, and\n multifamily housing. But even within this set of assets there is huge\n variation in the likely outcomes between individual properties. The US$2.7\n trillion figure from NBER is a theoretical maximum exposure; the practical\n risk in the banking system, we believe, is a small fraction of that\n amount.\n <\/p>\n

    \n Importantly, the risks on the largest loans have been distributed through\n securitisations and other transfer mechanisms. Outside of specialised\n funds, very few investors that we are aware of have large allocations to\n the most troubled CRE sectors. We believe this reduces \u2013 even if it does not\n necessarily eliminate \u2013 the pressure to sell assets at deeply discounted\n prices and minimises the odds of contagion, where losses in one sector\n lead to forced selling in other markets.\n <\/p>\n

    Go big or stay home?<\/h2>\n

    \n For the banking system overall, we believe there is sufficient capital to\n absorb a complete write-down of the entire US$2.7 trillion in estimated CRE\n exposure, although that would leave it essentially drained of equity. The\n issue, of course, is that the allocation of capital does not necessarily\n match the allocation of likely losses. We believe this problem is\n particularly acute at small lenders.\n <\/p>\n

    \n To begin with, smaller banks are the major players in the CRE space.\n According to the NBER, banks with less than US$1.4 billion in assets account\n for about US$419 billion of the banking system\u2019s exposure; this corresponds\n to about 25 percent of smaller bank assets by our calculations. In\n absolute terms, the largest banks \u2013 those with over US$250 billion in\n assets \u2013 have greater CRE exposure, but it amounts to less than five percent\n of their overall investments, according to NBER data.\n <\/p>\n

    \n Small banks\u2019 reliance on CRE is a double hit. Not only are they seeing\n large write-downs on existing loans, but pressure from investors also\n makes it difficult to aggressively originate new loans, reducing earnings\n and making it more difficult to replenish the coffers. Larger banks, by\n comparison, have diverse revenue streams and the impact of diminished CRE\n lending is, on average, barely noticeable.\n <\/p>\n

    \n Large number of banks have CRE risk, but large banks have less of it\n <\/h3>\n
    \n
    \n \"Exposure\n \n Bar chart showing exposure to commercial real estate, measured both as\n a percentage of assets and against a hypothetical 10% capital\n position, as a function of bank size. The data indicates that banks\n with less than US$1.38 billion in assets have the highest exposure to\n CRE while banks with US$250 billion in more assets have the smallest\n exposure to the sector. Chart also shows there are approximately 4,000\n banks with less than US$1.38 billion in assets, about 725 banks with\n assets between US$1.38 billion and US$250 billion, and only 13 banks with\n assets more than US$250 billion.\n <\/p>\n
      \n
    • \n
      <\/div>\n Percentage of banking system assets (RHS)\n <\/li>\n
    • \n
      <\/div>\n Average CRE exposure as % of assets (RHS)\n <\/li>\n
    • \n
      <\/div>\n Average CRE exposure at 10% effective capital (RHS)\n <\/li>\n
    • \n
      <\/div><\/div>\n Number of banks (LHS)\n <\/li>\n <\/ul>\n

      \n Source – RBC Wealth Management, National Bureau of Economic Research;\n data through 12\/31\/22\n <\/p>\n <\/div>\n <\/div>\n \n

      \n Depositor and investor concerns about small bank exposure to a troubled\n asset class also raise the risk of money being pulled from these\n institutions, much like we saw after the fall of SVB. This time around,\n however, it will not be as easy for the Fed to swoop in and provide\n assistance, given the concerns around the ultimate repayment of the loans,\n a factor that was absent in last year\u2019s Treasury bond-focused turmoil.\n Even banks that continue to find funding may need to pay more for it,\n adding to financial stress. One bright spot we see for these banks is that\n after last year\u2019s depositor flight, there\u2019s reason to believe that\n remaining depositors are stickier and may stay with the bank despite\n negative headlines.\n <\/p>\n

      \n A final issue, particularly for the smallest community banks, is loan\n concentration. Average loan sizes in the CRE world are much larger than in\n retail banking, so even a few problem loans can have a meaningful impact\n on the results and capital of a small bank. As an example, New York\n Community Bank was in the news recently following a nearly ninefold\n increase in loan loss provisions, driven partly by two CRE credits, as\n well as increased reserve build for the loan portfolio in aggregate. And\n that\u2019s an institution with over US$100 billion in assets; for a smaller\n community bank, a single bad loan is potentially a meaningful event.\n <\/p>\n

      Many paths ahead<\/h2>\n

      \n Despite the realities and the risks, we think widespread bank failures\n from CRE exposure remain unlikely. We see small banks coming under\n pressure on two fronts: rising losses on CRE loans cutting into capital\n levels, while more expensive funding and reduced lending opportunities\n serve as a headwind to earnings. This may lead to some bank failures, but\n we do not foresee anything that would unduly stress existing mechanisms to\n resolve troubled banks.\n <\/p>\n

      \n We think the largest banks, by contrast, will likely do fine in any CRE\n pullback, as their lower exposure and cheaper funding allow them to take\n advantage as opportunities arise. We think the U.S. banking system is\n healthy and will be able to weather the likely CRE volatility ahead.\n <\/p>\n","protected":false},"excerpt":{"rendered":"

      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.<\/p>\n","protected":false},"author":15,"featured_media":12921,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"rbcwm_post_date":"2024-02-08T09:43:08","editor_notices":[],"rbc_url_alias":"","rbcwm_featured_desktop_image_position":"","rbcwm_featured_mobile_image_position":"","_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[80],"tags":[517,519,518],"rbcwm_content_owner":[506],"rbcwm_need":[],"rbcwm_segment":[96,97],"rbcwm_solution":[],"rbcwm_topic":[81],"rbcwm_channel":[],"rbcwm_format":[],"class_list":["post-12920","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-analysis","tag-bank-stocks","tag-losses-in-the-banking-system","tag-u-s-bank-stocks","rbcwm_content_owner-pag","rbcwm_segment-business-owners-and-entrepreneurs","rbcwm_segment-individuals-and-families","rbcwm_topic-global-insights"],"acf":{"rbcwm_subtitle":"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.","rbcwm_post_author":"","rbcwm_custom_breadcrumb_text":"","rbcwm_custom_breadcrumb_link_url":"","rbcwm_disclaimers":{"add_disclosures":["Yes"],"perspective_disclaimer":"","expandable":[],"omit_from_pages":[],"disclaimer_footnote":""},"rbcwm_insight_cta_id":[8231],"rbcwm_pagination":{"next_link":"","next_link_text":"Next article","previous_link":"","previous_link_text":"Previous article"},"rbcwm_video_duration":"","article_time":"","rbcwm_enable_toc":false,"rbcwm_toc_selector":"h2"},"yoast_head":"\nAre banks facing a real estate reckoning?<\/title>\n<meta name=\"description\" content=\"Despite the hard realities of mounting losses on real estate loans, we think a fair dose of hyperbole is going around. 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