While banks' solid underwriting of office loans is largely keeping credit issues in check for now, some lenders may need to ramp up their reserves to cover the possibility of loans flopping, according to a recent analysis by Moody's Ratings.
The loan-by-loan analysis of 41 anonymous banks' commercial real estate portfolios outlines the spectrum of pain that institutions are facing. Even though Moody's found that banks' underwriting was more conservative than the ratings firm had anticipated, the higher-for-longer interest rate environment is increasing the need for banks to shore up their capital, said Stephen Lynch, vice president and senior credit officer at Moody's.
"If that continues to stay elevated, it's going to put pressure on all asset classes, Lynch said. "It made us re-assess the risk levels of these banks with higher CRE concentrations. Even if underwriting for a particular institution was good, how do you compensate for that higher asset risk?"
Moody's found that, on average, the banks should be holding about twice the amount of reserves they currently have to cover potential office losses.
The ratings firm also determined that banks were generally more cautious about the future of office loans than they were about other types of commercial real estate. Expected defaults on office properties are at a decades-long high, according to a recent bulletin from the Federal Reserve Bank of Kansas City. The sector is
Highlighting those concerns, banks' average current expected credit loss, or CECL, reserves for their office portfolios were 2.2%, or roughly double those of their multifamily and other property loans, according to the Moody's report.
Moody's was able to evaluate 40 banks' office portfolios, and while it did not disclose the size range of those banks, it did say that their office portfolios totaled $31.9 billion.
Each bank seemed to evaluate their CECL reserves differently, but those with more office loans tended to allot more reserves, said Darrell Wheeler, head of commercial mortgage-backed securities research at Moody's.
Wheeler said what surprised him, though, were the outliers. Some 10 institutions have CECL reserves equal to or higher than what Moody's assessed, with one bank having alloted double the amount of recommended reserves. (Seven banks did not provide their loan-level CECL reserves to Moody's.)
The office loans reviewed for the report appeared relatively stable compared with all office loans across the country, Wheeler said. Among the banks in the Moody's report, the average office vacancy rate was 13.8%, while nationwide second-quarter trends show that vacancies in the office sector set a historical record at 20.1%.
The industry's exposure to the CRE sector is
"Concentrations are what usually get banks into trouble," Lynch said. "Even if we view the underwriting good, the risk appetite of management to allow that concentration to exist factors into our ratings."
Most banks currently need to have higher levels of capital and liquidity than they would in a lower-rate environment, he said, describing that conclusion as the "thesis" for recent actions the ratings firm took against certain banks.
Moody's announced last month that it put six banks on review for downgrade due to their concentrations in commercial real estate: First Merchants, F.N.B. Corp., Fulton Financial, Old National Bancorp, Peapack-Gladstone Financial and WaFd.
The Moody's report didn't highlight many cohesive trends across office loans, though, Wheeler said, since individual loans at different banks are so disparate.
The Kansas City Fed's bulletin also noted the variance in risk across commercial real estate, but it found a correlation between the size of office properties and their expected risk of default. In other words, larger spaces tend to be riskier, the Kansas City Fed researchers found.
Jordan Pandolfo, an economist at the Kansas City Fed who co-wrote the bulletin, said that while CRE concentration is a risk, it's important to evaluate the differences between sectors, property types, geographies, banks' underwriting and their loss provisioning.
"The big takeaway there is that commercial real estate risks are incredibly varied," Pandolfo said, referring to the Kansas City Fed's findings. "So it's quite difficult to identify which banks carry the most exposure risk to CRE based upon certain statistics like concentration ratios, or what percentage of their portfolio is commercial real estate."
