Banks Start to Take Their Lumps to Address CRE Exposure

Several banks have raised capital to tackle their commercial real estate concentrations, despite the hit to shareholders – and many more are expected to follow their lead.

New York Community Bancorp in Hicksville, New York, FirstSun Capital Bancorp in Denver and First Foundation Inc. in Dallas, have all turned to investors as part of broader plans to purge commercial real estate-related loans.

More banks are having difficult discussions with investment bankers and potential investors about absorbing any hits tied to selling concerning assets, investment bankers say.

“We’re hearing, seeing and partaking in conversations with banks that are feeling pressure about CRE concentrations,” says Matt Shields, a managing director and head of FIG capital markets at Performance Trust Capital Partners.

“Raising defensive capital unlocks the ability for them to be proactive, solve the problems in their balance sheets and get earnings to a better place over the long run,” Shields adds.

Pressure Points
A rapid increase in interest rates has raised concerns about credit quality in CRE books as banks also deal with the low yields from loans made at historically low rates. A post-pandemic decline in the need for office space has created added challenges.

A more-intense focus on CRE is the latest in a series of challenges associated with high interest rates, following last year’s liquidity panic and banks’ ongoing efforts to manage their underwater securities holdings.

“In hindsight, extending durations in bond portfolios and making multiyear fixed-rate loans at low rates was a bad decision,” says Jeff Davis, managing director of Mercer Capital’s financial institutions group.

“The balance sheets at many banks are impaired because the earning power is impaired,” Davis adds. “A lot of management teams have been waiting for rates to come down so they can sell assets at a smaller loss.”

As a result, more banks are looking to mitigate their exposure.

New York Community got the ball rolling earlier this year, raising roughly $1 billion by selling securities to a group led by former Treasury Secretary Steven Mnuchin. The infusion came weeks after the company reported a surprise fourth-quarter loss tied to CRE-related problems.

The $112.9 billion company, which has exposure to rent-regulated apartment loans in New York City, expects elevated loan-loss provisions over the rest of this year. “While this year will be a transitional year for the company, we have a clear path to profitability over the following two years,” said Joseph Otting in a May press release. The former Comptroller of the Currency became CEO of the bank at that time of the capital infusion.

Meanwhile, the $7.8 billion FirstSun Capital Bancorp increased the capital-raising target in late April for its pending purchase of HomeStreet in Seattle by 34%, to up to $235 million. The $9.5 billion HomeStreet is expected to unload about $300 million of commercial real estate loans as part of the deal.

More recently, $13.6 billion First Foundation announced in early July it had sold $228 million of securities to a group led by Fortress Investment Group, which should reduce its ratio of CRE loans to total risk-based capital from 519% to 436% and allow it to sell lower-yielding multifamily loans.

“We want to take some of our multifamily loans and shift them into available for sale, take a mark-to-market,” CEO Scott Kavanaugh said during a conference call to discuss the capital infusion. “We want to be very thoughtful about the process. …  We believe we’ve got a pretty clear path set out that we’re working on.”

The capital infusion also ushered in fresh leadership at First Foundation, where veteran bank executive Simone Lagomarsino was named bank’s president.

A FirstSun spokeswoman declined additional comment and efforts to reach New York Community and First Foundation were unsuccessful.

Sources of Pressure
Banks of all sizes are facing regulatory pressure to get CRE exposures down, says Scott Hildenbrand, chief balance sheet strategist and head of depository fixed income at Piper Sandler & Co. “Banks are clearly looking at all the levers they have so they can address capital and improve future earnings,” he says.

Shields said directors and investors want to see CRE concentrations go down, and “the heavy hand of regulators is starting with the bigger banks, but it will trickle down to those as small as $100 million of assets.”

Of course, it is about more than sheer asset size. Regulators scrutinize banks with CRE concentrations of more than 300% of total risk-based capital, if outstanding CRE loans grew by 50% or more during the past 36 months.

Challenging Strategy
Now is not the optimal time for banks to raise defensive capital. Raising capital to address loan concentrations can have quite a cost – for the bank and for existing shareholders.

“At the end of the say, you get capital when you can, though it is a lot more expensive today than it was a year ago,” Davis observes. “It doesn’t look great for existing shareholders, given massive dilution.”

Davis says that, including the warrants involved, dilution for New York Community’s prior investors exceeded 50%, while hedge fund manager Tom Brown estimated that First Foundation’s shareholders were also diluted by 50%.

“Based on the information I have, the First Foundation capital raise looks like one of the most punitive actions against existing shareholders I have ever seen,” Brown wrote in a recent newsletter.

While most efforts have focused on common and preferred stock, industry experts said that some banks are considering issuing subordinated debt. Several banks have tried other strategies to boost capital without harming investors, selling insurance agencies and Visa Class B shares, or by selling – then leasing – branches and office buildings. But those options are limited.

Bigger banks shouldn’t have too much difficulty given relatively high stock prices and diverse balance sheets, while smaller privately held banks are also in a good position because they can raise capital at better valuations by turning to their communities and local shareholders, Shields says.

Publicly traded banks with less than $2.5 billion of assets will likely face the biggest capital-raising challenges because their shares, by and large, are “languishing below book value,” Shields adds.

Another complication is that banks with high CRE exposure “tend to trade on the lower side,” impacting the valuations of their stock offerings, Hildenbrand said.

Investment bankers, however, are advising banks to take a hard look at restructuring their CRE books. Much like repositioning the securities portfolio, banks that are willing to take their lumps now should produce better earnings over the long run.

Unlike underwater securities, CRE presents the added concern about credit deterioration, creating a situation where even a well-capitalized bank could have issues if it overlooks potential problems.

“What happens if we have another bad credit cycle?” Davis says. “Even the banks that look like they have a lot of capital will have to deal with that.”

Shields looks at the reverberating impacts. “Credit is the scariest thing because it can have the most-vicious impact on your earnings and capital levels,” he says.