Could Empty Office Space Spark 'Systemic Credit Event' At Regional Banks?

While investor sentiment is running high in the early weeks of 2024, risks remain that could topple the equity market rally that began in the fourth quarter of 2023. Among them: the threat of systemic risk should stresses in the commercial real estate sector hit regional banks.

Data from Apollo Academy suggests that smaller banks hold almost 70% of the outstanding loans from commercial real estate borrowers. Among these, banks with total assets between $1 billion to $10 billion are carrying CRE loans worth an average of nearly 35% of their total assets.

Compare that to the large banks with more than $250 billion worth of assets, and their exposure to CRE loans is little more than 5%.

Should investors be worried about regional banks’ exposure to CRE loans? Bank of America’s fund manager survey for February suggests there is already some concern.

BofA’s poll of global institutional investors shows that 16% of those surveyed thought a systemic credit event represents the biggest tail risk for markets in 2024.

Michael Hartnett, lead analyst on the BofA report, said: “U.S. commercial real estate takes the number one spot for the most likely source of a systemic credit event in 2024.”

Non-bank — or shadow bank — lending remains a concern, while China’s real estate meltdown is also seen as a possible source of a credit event.

Office Vacancy Rates Rise

Rising office vacancy rates are at the heart of the problem. As workers were increasingly asked to do their jobs from home during the COVID-19 pandemic, the trend has continued and nearly 19% of U.S. office space is empty.

While the office sector represents only a small part of the overall economy, regional banks are among the most exposed.

“Layer on top of this the Federal Reserve's historically rapid pace of interest rate rises, plus accelerating layoffs in professional and business services and the obsolescence of older office buildings, and it's not hard to see pain in the office sector getting worse,” said Joe Seydl, senior markets economist at JPMorgan Private Bank.

Credit Availability Shrinks

The availability of credit and sources of refunding is shrinking. The decline in bank lending as well as higher interest rates have driven demand for CRE loans to their lowest levels since the financial crisis in 2008.

So, as vacant office space rises and refunding becomes more costly, the rate of CRE loan delinquencies is rising. This presents a problem for regional banks.

Earlier this month, New York Community Bancorp NYCB shares fell by 60% after the bank reported a quarterly loss and cut its dividend. Downgrades quickly followed, with Morningstar cutting its rating due to NYCB’s “outsized” exposure to CRE.

While the bank has quickly responded, saying its balance sheet remains strong and liquidity ample, it also said it was considering selling some of its CRE loan portfolio, or would let the loans run off its balance sheet over time.

Germany’s Deutsche Pfandbriefbank (PBB), which has 15% of its loans tied up in the CRE sector, said last week the stresses in the CRE sector represent “the greatest real estate crisis since the financial crisis.”

Socks and exchange traded funds following both the regional banks and CFE sectors have fallen. The SPDR S&P Regional Banking ETF KRE is down 7% since the start of the year.

Some Good News, Maybe?

One caveat that JPMorgan Private Bank suggests is that, although the level of distress is comparable to percentages seen in the post-financial crisis period, it will likely take many years to play out.

Benzinga has already noted that alternative investment firms are now buying up distressed CRE assets, or offering property developers and owners loans as banks mitigate risk.

Over the course of 2024, interest rates should begin to come down, which should make servicing debt a little easier. And corporate bosses are increasingly recalling their staff back to the office, which may become a trend that causes vacancy rates to begin to fall.

Perhaps this combination of phenomena could give the CRE sector time to get back on its feet and ease concerns of credit risk in the regional bank sector.

Now Read: Could IBM’s Return To Office ‘Or Else’ Be Code For Poor Performance?

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