Bank Execs cite CRE Lending Worries as Back-to-Office Momentum Wanes
January 25, 2023 | Jake Mooney | Market Intelligence S&P Capital IQ
Bank executives are taking steps to account for elevated risks in commercial real estate lending, especially on loans backed by office properties, as workers’ return to offices following the worst months of the COVID-19 pandemic remains difficult to predict.
Office loans are among the most worrisome credit risks at the moment, but there are also reasons for concern about construction projects and other real estate sectors, including retail and multifamily, executives said on fourth-quarter 2022 earnings conference calls. Most characterized their own companies’ portfolios as solid, with default rates across the industry still low.
Full-year office-sector data showed ongoing challenges. National vacancy rates for class A office properties rose 60 basis points year over year to 17.7% as of the end of 2022, putting them 590 basis points above pre-COVID-19 levels, Morgan Stanley analysts said in a Jan. 11 note.
Due to fewer completions, national class B vacancies were lower, at 16.0%, even as demand lagged, the analysts said. In Sun Belt markets, they added, class A vacancy rates are currently 290 basis points higher than vacancy rates in class B properties because of swelling class A supply.
At Citizens Financial Group Inc. CFO John Woods said in a Jan. 17 call that the company is seeing signs indicating it should be putting away reserves to deal with “adverse back-to-office trends.”
“There isn’t a business that I have heard of that isn’t thinking about reducing their space,” Banc of California Inc. President and CEO Jared Wolff said on a Jan. 19 earnings call. “And so that begs a lot of questions when leases come up, how’s that going to perform?”
Rising risks
As of the 2022 third quarter, the delinquency rate for CRE loans at U.S. banks was falling, and the number of U.S. banks taking on levels of CRE exposure in excess of regulatory guidance was trending upward. Many of the top office lenders were increasing their allocations to the sector. In a fourth-quarter earnings call on Jan. 19, however, executives at Synovus Financial Corp. — a leading office lender — said the bank’s CRE pipeline has declined 60% to 70%.
In other fourth-quarter 2022 earnings calls, Truist Financial Corp. Chief Risk Officer Clarke Starnes said the company is assessing the risks of lending against CRE, including office, in case the economy slows. M&T Bank Corp. executives said about 20% of the company’s office portfolio was classified as criticized as of the end of 2022 and cited the sector’s potential for rising charge-offs in 2023.
Banc of California’s Wolff said the bank would stay away from office and hotel lending at the moment, along with most construction lending, but he added that materials costs are lower than in recent years and said the best developers know how to time projects during downturns so that they are ready to lease when the economy improves.
FB Financial Corp. President and CEO Christopher Holmes said on a Jan. 17 earnings call that construction lending has the potential for unhappy surprises, but added that the bank takes comfort in its longstanding construction relationships. Still, the office sector, in which about 23% of the bank’s CRE exposure is concentrated, “could get soft.”
“I think it has gotten soft in places,” Holmes added.
Distinctions between properties
Within the office property sector, lenders say there are important distinctions that could affect loan performance. Market participants typically distinguish between class A and “trophy” properties and lower-rent class B and C buildings. They also differentiate between properties in urban central business districts and those in the suburbs.
Before the pandemic, downtown urban properties were often regarded as more reliable investments because of their central locations and the scarcity of central business district development sites, which makes building competing properties nearby more difficult. The pandemic shook up that dynamic in many markets, though, allowing more office workers to stay closer to home and discouraging many from commuting into central business districts as often.
Citizens Financial executives said they expect suburban properties to fare better than urban ones, and they cited their own portfolio’s heavy suburban weighting. Metropolitan Bank Holding Corp. executives similarly noted their office portfolio’s suburban orientation and conservative underwriting. At KeyCorp, meanwhile, Chairman and CEO Christopher Gorman said in a Jan. 19 earnings call that the company’s $250 million class B and C central business district office portfolio represents “real risk going forward” as tenants cut costs.
In the Washington, D.C., area, economic activity is stronger in the suburbs than in the central business district, a dynamic that is affecting both retail and office properties, with the office vacancy rate in the city at about 20%, Eagle Bancorp Inc. executives said on a Jan. 19 earnings call.
“The good news is, there’s a fairly big separation in vacancy between trophy in A properties and then B and C properties,” Executive Vice President Janice Williams said. “The B properties have a much higher vacancy rate today than either trophy or A.”
The market for existing CRE loans remains unsettled, KeyCorp’s Gorman said.
“Just like in the M&A environment, I think people are in price discovery,” he said. “Obviously, if you take my example of B- and C-class office, there’s a lot of people that have impaired equity, but I think people are going to have to, frankly, endure some more pain before there’s a meeting of the minds on kind of how to restructure, how to bring in fresh equity, etc.”
