Fed Report Highlights Risk of Bank Exposure to Commercial Real Estate

Commercial real estate (CRE) poses a risk to U.S. banks, particularly smaller, regional lenders that are most exposed to the sector, according to the Federal Reserve in its latest Financial Stability Report.

Of the 60% of CRE loans held by banks, more than two thirds of those are held by lenders with less than $100 billion in assets as defined by the Fed. Collectively, they have nonfarm, nonresidential CRE loan portfolios totaling $1.55 trillion, of which $500 billion is invested in office and downtown commercial real estate.

Losses on CRE loans will depend on the borrower’s degree of leverage, as property owners with high equity cushions are less likely to default, according to the report. Also, banks that issue loans with higher loan-to-value (LTV) ratios are more likely to experience financial difficulty as these loans are harder to refinance or modify. When real estate prices fall, as they have in recent months, LTV ratios rise.

Among regional banks, exposure to commercial real estate as a percentage of total loans ranged from 15.8% at KeyCorp (KEY) to 40.2% at Pasadena, Ca.-based East West Bancorp (EWBC). The share of loans invested in commercial property has generally held steady among most mid-sized lenders, with PacWest Bancorp (PACW) seeing a notable decline in exposure. At PacWest, CRE loans as a share of total loans fell to 20% in the first quarter, down from 33% in the same quarter last year.

Commercial real estate encompasses offices, hospitals, retail space, industrial space, and multifamily units. While many economists have warned about commercial real estate, most of the worst distress has been confined to office properties, which make up 24.2% of the $10 trillion CRE market.

"Among the categories of CRE, only offices—particularly those in big cities—are struggling right now due to the rise of remote work, along with certain retail properties like restaurants that depend on office workers," said Joseph Wang, CIO at MonetaryMacro.com.

Loans on office properties are disproportionately issued by the smallest lenders, which have greater exposure to the sector than big banks and mid-sized regional lenders.

"The smallest banks—those which few people have heard of—tend to be the most exposed to commercial real estate and are most at risk," Wang said. "I don’t believe this crisis is systemic, as big banks and even most regional lenders have little exposure," Wang added.