Banks and the Commercial Real Estate Challenge
The question for monetary policymakers and bank supervisors is this: Will CRE losses ricochet through the U.S. economy? Historically, real estate losses have amplified economic downturns, for example in New England in the 1990s. Declines in asset prices can be amplified beyond real estate when financial institutions such as banks cut back their loan supply in response to losses on bad loans and when foreclosures lead to fire sales of properties. Thus, regulators use capital requirements and supervision to ensure the safety and soundness of banks in the face of losses. This should ensure that banks have enough capital to withstand losses from CRE loans and continue to lend. Moreover, banks themselves have already responded to challenges by reducing the supply of CRE lending. The Fed looked at this in July and found that a significant net share of banks reported tightening lending standards for all types of CRE loans.
An important confluence of risks emerges as profit margins at smaller banks are pressured by depositors demanding higher rates just as these same banks are particularly exposed to CRE.
Still, in some particularly levered buildings, it is likely that debt holders, including banks, will also experience losses. Since the average loan-to-value ratio is typically below 60 percent, however, even if office real estate values fall by more than 30 percent, equity owners will likely bear most of these losses. (See "Out of the Office, Into a Financial Crisis?" Econ Focus, Second Quarter 2023.)
One way to measure the overall risk in the banking system is through top-down stress testing models, such as the CLASS model. These models stress banks on paper by assuming bad economic scenarios and seeing how much capital banks would have to support lending. Updates of these models that account for losses on long-duration assets from higher interest rates show an increasing number of banks with strained capital under stress.
But all real estate is local, so it's important to consider potential losses and their amplification at the bank level rather than in aggregate. For example, we saw with Silicon Valley Bank that some banks can be outliers in terms of their exposure to risk assets and the vulnerability of their deposits. In this regard, bank size matters: Nonfarm nonresidential CRE mortgages tend to be a small share of total assets held by banks overall but a larger share of total assets of smaller banks. Thus, an important confluence of risks emerges as profit margins at smaller banks are pressured by depositors demanding higher rates just as these same banks are particularly exposed to CRE.
In summary, while the post-COVID-19 economic environment has been throwing some tough punches at CRE, the knockout doesn't seem to be here. As the U.S. economy comes into better balance, risks from CRE are mitigated by strong economic growth. For now, CRE represents one more challenge for bank-dependent borrowers and CRE-lending banks. Yet there are clearly storm clouds on the horizon and supervisors will be carefully monitoring risks in bank portfolios. Careful credit risk analysis has always been key to sound banks and their ability to supply credit.
Anna Kovner is executive vice president and director of research at the Federal Reserve Bank of Richmond.
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