The Good, Bad and Ugly: What’s Next for Bank CRE Portfolios

When New York Community Bancorp announced a $260 million fourth-quarter loss due mostly to a massive build up in loss reserves, it sent shudders down the collective spine of a banking industry that’s been waiting for a shakeout in the commercial real estate space. 

The $116 billion Hicksville, New York-based banking company, which has more than half of its loan book in CRE, reported net charge-offs of $185 million and boosted its loan loss provisions to $552 million. The company, whose bank brand is Flagstar Bank, also named a new executive chairman and cut its dividend 70% to beef-up capital levels. Share prices plummeted 60% in a week.

That’s triggered alarm bells on Wall Street that CRE credit problems could damage industry earnings and valuations and tamp down M&A activity – especially among beleaguered regional banks that are already contending with big challenges and tend to be big CRE lenders. 

“What happened at NYCB … indicates that we’re getting to the point where we’re going to see more losses materialize” in bank CRE portfolios, says Stephen Scouten, an analyst for Piper Sandler & Co. 

Some even worry that CRE woes could spark isolated deposit runs like those that fueled the rapid collapses of three large regional banks last year. 

“The fear is that the headlines around the credit issue are going to cause people to panic and leave the bank,” Scouten says. “It makes the group very hard for generalist investors to put money into, and that’s what we really need” to see valuations increase. 

Early Innings
Even so, no one inside the industry seems ready to hit the panic button just yet. Banks have seen this coming for a while now and have reserved well for potential credit losses. Yes, it will hurt earnings, but credit cycles are part of banking — even if we haven’t had one for more than a decade.

“This is early innings of a cycle and we’re going to continue to see things deteriorate,” says Christopher Marinac, director of research for Janney Montgomery Scott. “But the industry’s ability to weather the storm is way better than most people understand.”

Data on CRE loans indicates we’re nowhere near crisis stage yet. Figures compiled by Janney from required Federal Deposit Insurance Corp. disclosures show the average public bank’s tally of CRE loans 30-to-89 days past due or in non-accrual stood at 87 basis points at the end of 2023, compared to 69 basis points a year earlier.

Banks with more than $100 billion in assets had the highest totals, with 207 basis points of CRE loans in the problem category — up from 107 basis points at the end of 2022. But those banks have been aggressively building reserve cushions in anticipation of falling valuations, analysts say.

Conversely, institutions in the $1 billion to $3 billion size range saw problem CRE loans increase by just 7% during the same period to 113 basis points. 

“None of this is crazy levels,” said Nathan Stovall, director of U.S. financial institutions research for S&P Global Market Intelligence, at Bank Director’s Acquire or Be Acquired conference in January. “It’s an earnings hit, but not a safety-and-soundness hit.”

That doesn’t mean the hit won’t sting, or that the troubles won’t blossom into something more severe down the road. CBRE Group, the commercial real estate services firm, predicted last year that banks could lose $60 billion over the next few years on CRE loans gone bad.

Real Estate Is Idiosyncratic
There are no absolutes when it comes to the CRE market, and it can be difficult to generalize. For example, data centers, casinos and healthcare facilities have held their values well, according to S&P’s numbers, while retail, hotels and offices have struggled. New York Community Bancorp’s large multifamily portfolio in New York, where rent control can constrict earnings, may cause it problems; in other parts of the country, multifamily loans are doing fine.

“All real estate is idiosyncratic,” says Bruce Van Saun, chairman and CEO of $222 billion Citizens Financial Group, a superregional bank in Providence, Rhode Island. “Each property is unique. It’s location and tenants, length of leases, the quality of the building. What is it used for? Is it downtown or in the suburbs?”

For now, attention is on big banks with downtown office and retail loans. The pandemic sparked work-from-home practices that have left some office buildings and some cities half-empty. As leases come due, employers are reducing space, putting pressure on rents. 

Office valuations nationally are off 35% from their recent peaks, according to Green Street, a commercial real estate tracking firm.

“Large office in big cities is a slow-motion train wreck,” says Jeff Davis, the managing director of the financial institutions group at Mercer Capital. When those loans mature — the typical bank CRE loan renews every five years, and many were underwritten in 2021 or 2022 when rates were low — it could be a challenge to underwrite new ones, he adds.

Marinac expects to see more “keys thrown” in the year ahead as building owners give up on making loan payments. That typically creates problems for banks. CBRE predicts that banks could lose $26 billion over the next few years on office loans alone.

Regulatory Attention
With a storm looming on the horizon, banks’ CRE-to-risk-based capital ratios are getting more regulatory attention. Entering the fourth quarter of 2023, 546 banks had ratios above 300%, at which point examiners can ratchet up scrutiny. “You can operate above those levels, but you need to have your risk side in order to do so,” Stovall said. 

Some regional banks currently sit at more than double that level, according to Janney’s data.

As the potential for greater CRE pain increases, Marinac expects regulators to probe those and other banks with ratios above the guideline level to understand their plans for getting to the 300% threshold. “Banks will probably do a little less CRE, a little more C&I. They’ll retain earnings and cut out buybacks. Maybe they’ll raise some more capital or sell some assets,” he says. “It’s a math equation.” 

On Friday, the Federal Reserve’s Vice Chair of Supervision Michael Barr gave a speech noting that examiners have an eye on commercial real estate risk and are looking closely at whether banks are provisioning appropriately and “have sufficient capital to buffer against potential future CRE loan losses.” 

He noted that the Fed is looking at other kinds of risk as well and that examiners have “issued more supervisory findings and downgraded firms’ supervisory ratings at a higher rate in the past year. In addition, we have increased our issuance of enforcement actions.”

Getting Draconian
Banks are responding proactively, disclosing granular detail on their CRE loan books – often leveraging internal stress test data – and criticizing loans aggressively. They also are reserving against potential trouble. 

At Citizens, the $3.6 billion general office portfolio makes up about 5% of commercial loans. Van Saun says the company has already charged-off 4% of the portfolio and has set aside $370 million in loss reserves to cover another 10.2%. With the previous charge-offs, “that’s effectively 14% of those loans taken out of our capital,” he says. 

“That’s as draconian as you would ever see,” Van Saun adds. “Things would have to really get terrible to get to more than that.”

The process of clearing the deck of CRE loans that have scared off some investors won’t be painless, but it could set the table for a long-awaited rebound in valuations. “This perpetual CRE overhang has been a challenge for bank stocks,” Scouten says. “If we can ringfence the problem and crystalize the downside risks, the industry will be better off.”

This article has been updated to correct the percentage of office loans in Citizens Financial’s portfolio.