S&P Global Ratings believes commercial real estate (CRE) will likely continue to hamper asset quality credit metrics for U.S. banks over the next few years, particularly for those that are more heavily exposed to this asset class. However, in our view, the probability that problems in CRE will lead to a material weakening in the creditworthiness of rated banks has declined over the last year. This led us to revise our outlooks to stable from negative on six banks with material CRE exposures (see "Outlooks On Six U.S. Regional Banks Revised To Stable On Improved Ability To Handle CRE Challenges; Ratings Affirmed," Feb. 19, 2025).

Our more favorable outlook on CRE and these banks is based on a number of factors. Specifically, the U.S. economy has continued to grow and the Federal Reserve's three interest rate cuts in 2024 have helped stabilize CRE market prices. In addition, despite significant refinance activity, rated banks generally have reported only gradual deterioration in CRE asset quality in the last year while generating relatively good earnings and strengthening their balance sheets.

We expect additional losses on CRE loans in the next few years as banks work through remaining maturities. However, we have gained confidence that rated banks--even those with more concentrated exposure to CRE loans--will be able to absorb such losses without substantially affecting earnings. Most rated banks have also increased their capital, allowances for credit losses, and deposits, and have reported declines in their unrealized losses on securities, all supporting their financial strength.

Recent Rating Actions

On Feb. 19, we revised the outlook to stable from negative on six banks. The previous negative outlooks on the banks were largely due to their CRE exposure. In general, the banks' balance sheets improved since 2023, which should help them better withstand further CRE stress. The improvement in part comes from building capital ratios, including the impact of unrealized losses from securities portfolios.

Although these banks' CRE credit metrics have mostly deteriorated since 2023, they remain manageable, even with the stress experienced by CRE properties. In addition, profits have increased, along with deposit levels, all while banks lessened their reliance on brokered deposits and wholesale funding while lowering the rates they offered on these deposits.

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Most U.S. Bank Rating Outlooks Are Now Stable

The preponderance of stable outlooks (90% of our rated banks) reflects our belief that most banks we rate are positioned for the challenges in the year ahead. We expect Federal Deposit Insurance Corp. (FDIC)-insured banks in aggregate to post relatively good earnings with a decent 10.5%-11.5% return on equity (ROE). Specifically, we look for fairly small changes in revenue, expenses, and provisions compared with 2024. In a downside scenario, we would expect a greater increase in provisions to drive the industry ROE to the high-single digits.

Key Reasons We Believe U.S. Banks Can Handle CRE Risks

The U.S. economy should continue to avoid a recession

Our economists forecast the U.S. economy to expand 2.0% over the next two years, following 2.8% growth in 2024. Importantly, the U.S. ended last year with an unemployment rate of 4.0%, which we expect will tick up about 20 basis points (bps) over the next two years. We expect core inflation (CPI) to moderate from 3.4% at year-end 2024 to 2.4% over the next two years. Notably, the U.S. has avoided a recession despite the recent steep rise in interest rates that took the fed funds rate from near 0 in 2022 to 5.5% by mid-2023.

Still, there is a high degree of unpredictability in our economic forecast due to policy implementation by the U.S. administration and possible responses, particularly as it pertains to tariffs and the potential impact on the U.S. economy.

Office CRE valuations seem to have stabilized

According to the Commercial Property Price Index from Green Street, a CRE data company, a blend of all CRE property prices is down 18% from its 2022 peak. Positively, CRE prices rose in 2024, largely in the second half of the year, by about 5%. In regards to office, after posting sharp price declines of roughly 36% since their peak in 2022, office real estate prices have more or less stabilized in 2024, down only 1% over the last 12 months. Valuations for other CRE categories, such as multifamily, industrial, and retail, have largely increased over the last year but are still down from their peak. For example, according to Green Street, multifamily is up 14% over the last year but down 20% from its 2022 peak.

We believe what's helping valuations are a combination of the Fed rate cuts, a drop in interest rates from their peak, and ongoing economic growth combined with low unemployment. In the office market, investors with significant capital have also shown an appetite for properties at discounted valuations, and vacancy rates in some office buildings have declined as back-to-the-office mandates increased. Still, property performance remains idiosyncratic across CRE asset classes, with more modern office buildings faring better than older buildings.

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Many banks are paring back their office exposures

Most banks' exposure to CRE as a percentage of loans is relatively small. In addition, within CRE exposure, there is plenty of diversification. The amount of CRE exposure varies by bank asset size. For the largest banks (assets greater than $250 billion), non-owner-occupied CRE made up roughly 11% of their loans, and for smaller banks (less than $10 billion in assets, which we don't rate) the largest exposure is roughly 38%.

For banks we rate, the median exposure to CRE is roughly 19% of loans. Furthermore, the CRE exposure is diversified geographically by state and property type (i.e., multifamily, office, industrial retail, and lodging). Bank disclosures indicate that at the median, office exposure only comprises a low- to mid-single-digit percentage of total loans.

Altogether, such limited and diversified exposure, along with solid underwriting standards (with loan to value ratios at origination of about 60%) have helped keep bank CRE losses relatively low so far. Furthermore, many rated banks have reduced their office and overall CRE exposures as a percent of capital over the last year. Indeed, for all FDIC-insured banks, CRE loans to Tier 1 capital totaled 103% as of fourth-quarter 2024. This is down roughly 4 percentage points since 2023, partially also due to an increase in capital.

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CRE asset quality is holding up

Asset quality metrics have held steady despite roughly 25% of the $6.2 trillion of total CRE debt (which includes all CRE debt, not just loans related to banks) that was estimated to be refinanced from 2023-2028, according to S&P Global Market Intelligence data (see "Commercial real estate maturity wall $950B in 2024, peaks in 2027," Aug. 28, 2024).

CRE past due and nonaccrual loans totaled only about 1.7% of CRE loans at the end of 2024, up from roughly 1.2% the previous year. As a comparison, commercial mortgage-backed securities (CMBS) delinquency rates totaled 5.6% as of December 2024.

In aggregate, FDIC-insured banks reported that roughly 0.9% of their CRE loans had been modified as of year-end 2024, implying that most loans that have matured in the last year have been refinanced or paid off without modification.

Bank CRE charge-offs totaled roughly 1.9% cumulatively from 2023 through year-end 2024 (largely office-related), with the highest quarterly charge-off rate approaching only roughly 33 bps. This compares with the more severe 8.8% at the median assumed CRE charge-off in the Fed's latest nine-quarter stress test. At the median, rated banks reported total criticized loans that equated to 24% of their Tier 1 capital. We believe CRE loans likely make up a large portion of those criticized loans. Positively, the ratio rose only modestly compared with year-end 2023.

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Bank balance sheets have improved over the last year

After peaking at $19.7 trillion at year-end 2021, industry deposits declined through most of 2023, reaching a low of $18.3 trillion in third-quarter 2023. They have since risen and are now above $19 trillion, even as banks offer lower deposit rates to customers.

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Unrealized losses in banks' securities portfolios (available-for-sale and held-to-maturity) have also declined from their peak and totaled roughly $485 billion (roughly 6.5% of banks' securities portfolio) as of fourth-quarter 2024 versus $685 billion (12%) in third-quarter 2023. Many banks have repositioned a portion of their securities portfolio. This, along with securities maturing, boosted net interest income.

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Industry capital ratios have also risen. Roughly 80% of the U.S. banks we rate reported an increase in their common equity Tier 1 ratios in 2024. Notably, the median rated bank Tier 1 capital ratio rose to 13.0% at year-end 2024 from 12.3% a year earlier. Including available-for-sale and held-to-maturity unrealized losses, the ratio rose about 100 bps to 11.2% due to a decline in unrealized losses and capital retentions.

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Although bank CRE exposure increased about 4% since 2022, we believe the majority of the growth is related to multifamily and other well-performing CRE categories. Indeed, many banks, particularly those with heavy CRE exposure, have lowered their office exposure.

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The allowance to CRE loans for FDIC-insured banks in aggregate totaled 1.6% as of year-end 2024, little changed from 2023 but up significantly from 2022. While many regional and community banks continued to increase CRE allowances in 2024, some of the largest banks--which have less CRE exposure--held CRE allowances flatter in 2024.

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Solid profitability should help banks withstand a possible pickup in CRE credit losses

After likely posting an ROE of 11.5% in 2024, we project an industry ROE of 10.5%-11.5% in 2025. We expect a modest improvement in net interest income (NII) largely due largely to an increase in earning assets and higher fee income, offset by higher expenses and elevated provisions largely because of continued pressure from CRE.

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The most heavily exposed banks to CRE (with greater than 200% of capital) have been posting healthy preprovision net revenue (PPNR) and seem to be able to withstand a sudden unexpected increase in provisions to CRE. Specifically, for these banks, based on a PPNR run rate as of fourth-quarter 2024, a sudden need in one quarter to increase reserves by 100 bps would roughly halve PPNR. Although this is still significant, it is a modest improvement since last year. Moreover, as CRE prices have stabilized, the need to suddenly significantly increase reserves has moderated.

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Some Headwinds For Bank CRE Remain

Although investors have greeted the new administration with optimism in anticipation of its expected pro-business stance, uncertainty remains as to the administration's impact on the U.S. economy.

One risk is the possibility that policies enacted by the new administration would result in a pickup in inflation, possibly driven by higher tariffs, which in turn could result in either fewer rate cuts or even rate hikes. All else equal, higher rates would have a negative impact on CRE valuations. Notwithstanding the decent CRE bank asset quality, there is still a relatively high level of criticized loans outstanding. And these loans are more vulnerable to economic pressure.

Furthermore, according to S&P Global Market Intelligence, there is still another roughly $4.5 trillion of CRE loans (not just bank loans) due to be refinanced by 2028. Many of these loans will require the borrower to pay a higher interest rate, and there is no guarantee that such large amount of refinancing will continue to proceed smoothly, particularly if interest rates remain higher than previously expected.

Lastly, bank loan growth has been relatively modest over the last year, and banks are not projecting a significant pickup in loan growth in 2025. If loan growth does not materialize, pressure on revenue could in turn strain profitability, which banks rely on to offset a rise in credit issues such as CRE.

Related Research

• Macro Effects Of Proposed U.S. Tariffs Are Negative All-Around, Feb. 6, 2025
• U.S. Bank Outlook 2025 Published: Entering A New Phase Under A New Administration, Jan. 15, 2025
• CRE Debtholders Are Confronting Increasing Refinancing Risk And Charge-Offs In 2024; Outcomes Will Vary, June 3, 2024
• Some U.S. Regional Banks Could Face Higher Risk If Commercial Real Estate Asset Quality Worsens, March 26, 2024
• Outlooks On Five U.S. Regional Banks Revised To Negative From Stable On Commercial Real Estate Risks; Ratings Affirmed, March 26, 2024