Stress Testing the Foundations: Analyzing the Vulnerability of Us Banks To Falling Commercial Real Estate Values

The commercial real estate sector’s continued challenges could potentially impact US banks. Franklin Templeton Fixed Income’s Shawn Lyons discusses the ongoing commercial real estate crisis and how US banks are safeguarding themselves against these issues.

Key takeaways:

  • Falling valuations of commercial real estate (CRE), especially in downtown office areas, will have a limited impact on both large globally systemically important banks (G-SIBs) and regional banking organizations, due to manageable exposure to the sector.
  • Enhanced risk-based reserve requirements and stricter accounting methodologies, enacted following the global financial crisis (GFC), require banks to identify potential losses and absorb them over time, reducing the potential for large, one-time write-offs.
  • In the event of a default on loans, banks retain the ability to work with borrowers to reach a settlement that is beneficial for all parties.

Office CRE, how bad is it really?

Lower-than-expected Return to Office (RTO) dynamics and declining CRE valuations have captured headlines over the past several months with tales of barren city centers. There are reports of wastelands full of empty offices and storefronts that have been beset by increasing crime rates, creating a “doom loop” where property prices continue to fall unchecked. Although we believe this is going a bit too far, we do have some concerns about vacancy rates. Office vacancy rates reached 17.1% nationwide in July with heavily impacted areas—such as San Francisco, Austin and Houston—topping 20%.1 This is in addition to a large amount of office space that is available for sub-lease.2

We have begun to see an uptick in office property delinquency rates. Trepp, a commercial mortgage-backed securities analytics firm, reported that office delinquencies increased to 2.38% in the first quarter 2023 (Q1), up from 1.58% at the end of last year. Trepp also reported serious delinquencies, 90 days or more, also moved higher, reaching 1.03% at the end of Q1. Projections are for delinquencies to continue higher as vacancy rates are increasing. It should be noted that delinquency rates for retail (6.75%) and lodging (4.45%) still far exceed office delinquencies, although those levels are trending lower.

However, banks also hold a blend of exposures across other sectors including health care, lodgings, industrial warehousing, multi-family residential and retail. Exposure to downtown office and retail (the most problematic sectors) is more heavily focused on smaller community banks (Other) versus Category I G-SIBs (e.g. Bank of America, Bank of New York Mellon, Citigroup, and JPMorgan Chase & Co.) and Category II–IV regional banks (e.g. Regions Financial Corp., U.S. Bancorp, PNC Bank, Bank of the West).3

Office Exposure as a Percentage of Total Assets