Office and retail space demand is declining
With the failure of two U.S. banks and the acquisition of one of the oldest lenders in Europe, investors are concerned about the viability of bank equities. The financial health of the sector is not as poor as some may believe, however, according to the available data.
In a note published earlier this month, Richard Fisher, senior analyst at AGF Investments Inc., made a note of the banks' exposure to commercial real estate (CRE), which is threatened by an increase in interest rates and vacancies yet shows little evidence of having a negative effect on the banks that are most exposed to the industry.
Recent information on CRE mortgage credit ratios from the Federal Deposit Insurance Corporation (FDIC) in the United States, for instance, shows that both net charge-off (NCO) and non-performing asset (NPA) rates are currently beneath cycle norms and well below levels observed during the Global Financial Crisis.
In the first quarter, the U.S. office vacancy rate passed a significant threshold when it increased to 12.9% -- surpassing the highest vacancy rate experienced during the 2008 financial crisis -- according to a report from the Wall Street Journal. Even though there was a low unemployment rate, the number was the greatest vacancy rate since CoStar Group Inc. started monitoring it in 2000.
Loan losses on commercial real estate have grown more significantly due to the current interest rate cycle. For many of the biggest institutions in the U.S. and Canada, there are grounds to think the consequences of such an event would be manageable. Today's capital levels are higher than in previous cycles, and most banks are required by law to use some kind of projected credit loss regime to soften the impact, Fisher noted.
When the economy recovered in the past, commercial real estate played a larger role in the expansion of the nation's economy. Cities and bank balance sheets might suffer from declining property values, which would limit lending to other sectors of the economy.
As some of the largest borrowers from and owners of commercial real estate, banks, pension funds, and asset managers may endure years of losses. North American public pension funds own about 9% of their assets in real estate, whereas commercial mortgages make up 38% of the average U.S. bank's loan holdings.
The largest banks in Canada routinely stress test their exposure to commercial real estate for more unfavourable capitalization rates and operational income. This exposure is properly rated and benefits from good collateral. Commercial real estate exposure for American banks is a little more complicated, but it is still controllable.
According to Deutsche Bank, office loans make up barely 1.9% on average and less than 5% of all loans at each of the biggest universal banks in the U.S. A rise in CRE loan losses may be tolerated by US banks even in the worst economic situations, according to a recent stress test by the US Federal Reserve.
For all commercial real estate loans still due in 2022, the Fed projected a cumulative two-year loss rate of 9.8%. Strategas Securities isolated office and retail loans expiring in 2023/24 using the data of the Mortgage Bankers Association's most recent U.S. commercial and multifamily survey and established two assumptions: that 45% of these loans are held by banks, and that all of these loans failed at the same time. Possible losses were calculated using these assumptions.
According to the analysis, total losses would be in the region of 29%, banks might have loan losses of between $60 billion and US$70 billion, and bank owned CRE loans would see a cumulative loss ratio of 65 basis points. Even though it is more painful than the Fed's stress test, the broader financial sector is thought to be able to handle it.
It seems doubtful that the bank's exposure to commercial real estate will be what triggers the next financial crisis, despite some investors' fears to the contrary, Fisher concluded.
