Broad-based commercial real estate risk measures do not capture the full picture of risks to individual banks, according to an April 18 report from the Federal Reserve Bank of Kansas City.
The probability of a CRE default is nearly 25 percent higher for office spaces with more than 500,000 square feet, which are disproportionately in large metropolitan areas. The property type is also a factor: Defaults on retail, hotels and hospitality CRE properties increased during the pandemic. Expected defaults on office properties are at decade highs as rising interest rates and an increase in remote work have limited office property valuations and sparked concerns about their future profitability.
“Banks’ exposure to CRE risk depends on more than just one loan concentration,” said Kansas City Fed Economist Jordan Pandolfo and Senior Economist Blake Marsh. “Other key factors include the stringency of the bank’s underwriting, its willingness and ability to monitor existing borrowers, and the capital and loan loss provisions it holds against potential losses.”
Higher interest rates and a fall in office attendance have caused concerns about bank exposure to CRE. Banks provide an estimated $3 trillion in financing to the sector. Cumulative excess returns on bank stocks was negatively tied to the share of assets banks held as CRE loans as of February. Excess losses were most pronounced for banks with a large exposure to CRE.
“CRE lending can make up a significant share of a bank’s total loan portfolio, particularly at small and regional banks,” they added. “Thus, any downturn in the performance of loans backed by CRE properties could pose challenges to the long-term viability of exposed banks.”