Smaller Banks Face Bigger Risk of CRE Loan Losses

Although Fitch Ratings says it doesn’t anticipate a repeat of 2008 in terms of banks’ losses on commercial real estate loans, “current metrics will likely deteriorate once stimulus measures wind down and forbearance programs expire. When this occurs, we expect smaller CRE-concentrated banks in the U.S. to be more susceptible to elevated losses.”  

Conversely, says Fitch, the largest U.S. banks have very modest exposures to this asset class, at about 5% of assets. Within the Fitch-rated U.S. bank universe, only four banks are on Rating Outlook Negative driven by CRE-related exposures, among other factors. 

There’s a donut-hole effect in terms of the markup of the banks with higher exposure to CRE loans—and therefore risks. In common with the largest banks, the smallest ones have pared back their CRE exposure since the Great Financial Crisis. In fact, Fitch says, those with assets of less than $100 million have decreased CRE exposure the most relative to the size of their overall balance sheets.  

Over the same time period, banks with assets between $10 billion and $250 billion were the only segment to increase exposure. This exposure averaged 16% as of March 31, 2021, compared with 12% of assets in 2008. 

Fitch notes that bank asset quality remains solid—for now. Nonetheless, the full extent of realized losses from the pandemic has not yet been realized due to a combination of factors, including the delayed recognition of problem loans.  

At year-end 2020, banks held about $286 billion in Section 4013 modified loans, or roughly 2.6% of total loans outstanding. Section 4013 of the CARES Act gave banks temporary relief from accounting and disclosure requirements for troubled debt restructurings (TDRs). “These loans, which otherwise would have been categorized as TDRs, could be vulnerable to deterioration when this forbearance measure expires at the end of the year.” 

Other financial participants, including non-bank financial institutions (NBFIs), account for nearly 13% of the CRE lending market. Fitch-rated NBFIs with more meaningful exposure to the CRE sector include four mortgage REITs, all on Stable Rating Outlook Stable. Also rated are pensions, traditional investment managers and alternative investment managers with indirect exposure to CRE. 
 
“Nonetheless, expectations for a significantly worse credit environment are mitigated by an improving macroeconomic backdrop, notwithstanding uncertainty around variants and the potential for renewed lockdowns,” Fitch says. 

In addition to expectations of relatively low levels of noncurrent CRE loans based on projected unemployment levels, banks have meaningfully reduced CRE lending concentrations, particularly in higher loss content acquisition, and land development and construction lending. For example, construction lending totaled 21% of capital as of this past March , down materially from over 70% of capital in late 2007.  

However, there are longer-term uncertainties related to certain CRE asset classes, notably office, retail and lodging, which may lead to deterioration in these sectors over time,’ Fitch reports. “For office, this reflects structural changes as a result of the pandemic, with more businesses adopting work-from-home policies. We expect that this will affect larger cities more than lower-cost smaller markets.”