Commercial real estate (CRE) sectors, such as office, multifamily, retail, hotel, and industrial, have widely experienced falling prices, driven largely by the sharp rise in interest rates in 2023 and certain dynamics specific to each asset class. Office prices had seen the steepest declines, according to Green Street, a CRE data and analytics company. Interest rates have likely reached a pinnacle, and expected rate cuts in the second half of the year could ease some of the CRE pricing pressure. That said, the path of rate cuts is still uncertain, and even if they materialize, we don't expect them to affect CRE prices to a large degree.

The impact of declining CRE prices on some regional banks' creditworthiness has come into further focus. Credit quality metrics, such as delinquencies and charge-offs--although rising--are still relatively benign for most banks. But criticized CRE loans have picked up and are high at some banks, particularly as more CRE loans reach maturity. Challenges at New York Community Bancorp (unrated), which triggered a plunge in its stock price and an eventual capital raise, also have increased the focus on regional bank CRE exposures. (We define CRE as loans backed by investor-owned, multifamily, and construction and development properties). S&P Global Ratings recently reviewed its rated banks, focusing largely on the banks with highest proportion of loans to the CRE sector, and as a result revised outlooks on five regional U.S. banks to negative from stable (see "Outlooks On Five U.S. Regional Banks Revised To Negative From Stable On Commercial Real Estate Risks; Ratings Affirmed").

Despite the stress in CRE markets, there are a number of offsetting factors that should help rated banks' loan portfolios withstand significant CRE losses. CRE behaves differently across distinct geographies and property types. The granularity of banks' CRE portfolios, particularly for regional banks, often is an offsetting positive factor. Indeed, each property type in a bank's CRE portfolio will likely behave differently from a cash flow standpoint depending on its location, tenant makeup, and condition of the property. Besides this, banks have a built-in cushion to absorb CRE write-downs as loan-to-value ratios at origination typically range from 50%-65%. Lastly, office properties--the most stressed asset class within CRE--usually only represents a small portion (low- to mid-single digits) of rated banks' total loan portfolios.

Despite these buffers, the path ahead for CRE asset quality is uncertain. For the last few years, with more vigilance since the sharp rise in interest rates, we have been stress testing the banks using various loss rates to see the impact on their capital levels. From our analysis, most banks seemed well-positioned to handle that stress, absent a recession, which is not our base case.

Building on that analysis, we examined how potential CRE stress could affect earnings in the event of greater CRE deterioration than our base case, which calls for a gradual increase in charge-offs over many quarters. Viewed from this lens, the banks with the highest exposure to CRE could face a strain on profits if they had to quickly build significantly higher allowances to withstand unexpected CRE deterioration in their portfolios. That could meaningfully hit those banks' quarterly earnings, and sensitivities to market confidence could lead to both customer and depositor attrition.

When we reviewed our rated banks, we looked closely at banks that either had CRE loans of at least 30% of total loans or 200% of Tier 1 capital; office loans of at least 30% of Tier 1 capital; or CRE loans close to any of those thresholds and a sizeable amount of delinquent, nonaccrual, criticized, or modified loans. We also applied various stress tests to each bank's CRE loans to measure the potential impact of a pickup in CRE losses to not only capital levels, but also earnings.

How We Evaluated A Bank's Creditworthiness In The Face Of A Possible Rise In CRE Losses

Given that CRE delinquencies and charge-offs have remained relatively low, we relied on other factors to try to determine how resilient the banks we rate could be to an unexpected build up in losses in their CRE loan portfolio. Some of the most relevant factors we looked at were:

• The size and mix of CRE exposures;
• The allowance for credit losses for CRE loans as a percentage of past due, nonaccrual, and modified loans, and as a percentage of CRE loans;
• The dependence on uninsured deposits relative to on-balance-sheet and contingent liquidity to gauge funding and liquidity resiliency should market confidence sensitivity issues arise;
• The potential impact of hypothetical charge-off levels of various severity to preprovision net revenue (PPNR) and capital; and
• The potential impact on PPNR should a bank need to significantly build its allowance through higher provisions either in one quarter or one year.

A 50 basis point (bps) increase in provisions in one quarter seems manageable for this cohort, but a sudden 100-bps increase raises the specter of potential market confidence sensitivity, in our opinion, particularly for the highest exposed CRE banks (see chart 1).

Chart 1

Results Of U.S. Bank CRE Review

For the five banks where we revised outlooks to negative from stable, the outlook revisions mainly reflect the risk that deterioration in these banks' CRE portfolios could significantly hurt their asset quality and performance. In May and August 2023, we had also revised our outlook on two banks--Columbia Banking System Inc. and S&T Bancorp--for reasons partially related to CRE. In August, we had also lowered the rating on Valley National Bancorp, which now carries a negative outlook. The ratings on nine U.S. banks, or 18% of the rated bank portfolio, now have negative outlooks, mainly reflecting CRE risk.

That said, our ratings and outlooks on certain other banks with heavier-than-peer CRE exposure remain unchanged. We believe these banks have mitigating individual circumstances that make downgrades less likely. These factors include, among other things, their ratings relative to peers; an ability to absorb significant loan losses through strong earnings; and relatively low exposures to office loans.

Most U.S. Bank Rating Outlooks Are Stable

The preponderance of stable outlooks reflects our belief that most banks we rate are positioned for the challenges in the year ahead. Although we believe industry profitability will fall somewhat in 2024 due largely to a decline in net interest income and elevated provisions, we still expect Federal Deposit Insurance Corp. (FDIC)-insured banks in aggregate to post a decent 10% return on equity (ROE). Specifically, we look for net interest income to decline roughly 3%-4% this year and for industry provisions to rise to $102 billion from $86 billion in 2023, with banks building allowances largely for CRE and credit cards. Most rated banks have manageable CRE exposures with office loans typically making up a low-single-digit portion of their loans. In a downside scenario, we would expect a greater increase in provisions to drive the industry ROE between the mid- and high-single digits.

From a funding perspective, bank deposits rose in the fourth quarter (up more than 1%), although the mix continues to shift to higher-yielding deposits, thus pressuring net interest margins. Banks have also increased their wholesale borrowings to bolster on-balance-sheet liquidity and have increased the amount of assets they pledge so as to be better prepared for possible liquidity needs. Capital ratios have also been rising as many banks look to build capital either as a defensive measure and for more stringent capital requirements.

Appendix

CRE pricing trends

According to Green Street, a data analytics firm, CRE prices have declined since 2021, with office prices down the steepest.

Chart 2

Bank exposure to CRE

At the median of banks we rate, CRE comprises 19% of total loans. Office at the median only comprises 3% of loans. For the most exposed banks to CRE, office typically ranged in the mid-single digits of loans and reached a high of 8% of loans for the most heavily exposed to CRE rated banks.

Credit trends

CRE loans at least 30 days past due or nonaccrual for the banking industry increased to 1.2% of CRE loans in the fourth quarter, from 0.6% a year earlier and 0.5% in 2019. Of the banks we rate, which includes many banks without material CRE exposures, at the median, that ratio was a lower 0.5%, or 0.9% including modified CRE loans. The median allowance for CRE loans for banks we rate totaled 1.5%, and for most banks, this amount covered all past due and restructured loans. However, the coverage ratios are declining as past due loans rise.

Chart 3

CRE debt maturing

According to the Federal Reserve, there was roughly $4 trillion of CRE debt outstanding as of third-quarter 2023, excluding loans from government-sponsored entities that lend to multifamily and health care (e.g., Fannie Mae and Freddie Mac) and our estimate of owner-occupied properties in the U.S. Banks own roughly half of this debt. According to the Mortgage Bankers Assn., roughly 28% of this debt comes due in 2024. For most rated banks with meaningful CRE exposure, we believe roughly 10%-30% of CRE debt comes due this year, but some banks have a significantly higher percentage.

In general, when a loan approaches maturity, the bank lender will assess the value of the property. If the borrower cannot, or chooses not to, obtain financing from another lender, the bank may seek additional equity from the owner of the property if its value has fallen to help protect the bank in case there is default. If the loan was originally fixed rate, refinancing could pressure the ability of the borrower to service the loan if the refinancing is at a significantly higher rate.

As relationship lenders, banks may not view foreclosing on CRE property as their best course of action if extending the terms of a CRE loan or restructuring the debt would offer better long-term prospects. Also, with funding costs rising, we believe banks will do their best to maintain or add earning assets to preserve net interest income and profitability. As long as a CRE loan makes economic sense, a bank with balance sheet capacity is likely willing to extend a loan.

Although modest so far, we believe a rising number of CRE loans could be modified in some way, most notably through term extensions. We also believe that CRE upcoming maturities are leading to a buildup in criticized loans as banks further assess their portfolios' creditworthiness.

Related Research

• Outlooks On Five U.S. Regional Banks Revised To Negative From Stable On Commercial Real Estate Risks; Ratings Affirmed, March 26, 2024
• Uphill Battle Continues: Highlights From The U.S. Commercial Real Estate Webinar, Feb. 21, 2024
• Credit FAQ: What Declining Commercial Real Estate Values Could Mean For U.S. Banks, June 5, 2023