CRE Issues Challenge Banks : Vacancy Rates and NPLs Hit Hard

CRE Issues Challenge Banks: Vacancy Rates and NPLs Hit Hard 

Commercial real estate (CRE) issues have gained significant attention this year, creating major challenges for the banking sector and raising concerns about the severity of the situation. Rising vacancy rates, short loan maturities, and loans issued during low-interest periods have all exacerbated the current problems. We have discussed this topic multiple times and now intend to analyze it through the lens of bank balance sheets to identify which banks are most affected.

Firstly, CRE loans represent a substantial 10% of the U.S. banking sector's total assets. They are the most common type of loan among banks, with 99% of banks holding positive CRE loans on their balance sheets. Consequently, this area requires close monitoring, particularly because CRE-related risks are distributed unevenly between large and small banks.

Community banks, which are small to medium-sized institutions, are of particular concern due to their significantly higher exposure to CRE loans compared to larger banks. The figure indicates that, on average, community banks allocate 45% of their loans to CRE, while the largest banks have a much lower concentration of around 12%. This disparity is expected, as community banks tend to take on more risks due to lower capital requirements. This highlights growing concerns about community banks and their CRE portfolios, a narrative frequently highlighted by the media.

However, high CRE concentration alone does not necessarily indicate problems. The real issue arises from the combination of high concentrations, insufficient reserves, and delinquency problems. Therefore, it's crucial to examine the Coverage Ratio, which compares CRE loans to reserves for losses (Allowance for Loan Losses) plus Equity Capital. This ratio effectively measures the 'leverage' in the CRE portfolio, with higher numbers indicating higher potential future risk.

Mid-sized banks have a Coverage Ratio of around 300%, while the largest banks have a much lower ratio of 50%. This difference supports the argument that community banks are at greater risk. However, examining Non-Performing Loans (NPLs) in CRE loans provides a different perspective.

Non-Performing Loans, defined as loans in non-accrual status or 90 days past due, are increasing across various bank portfolios, including large banks. The following figure shows the average CRE NPL percentage in CRE loans, categorized by bank size.

The biggest banks currently face significant NPL issues, particularly in the Non-farm Nonresidential Non-owner occupied component of CRE. This category is crucial because it includes loans where payments are primarily made from rental income, making it very sensitive to sector issues.

NPLs in the Non-owner component have reached alarmingly high levels among large banks, while they remain at normal levels for other sectors. As the largest component of commercial real estate loans, the significant spikes in NPLs among large banks will likely worsen credit conditions in the already troubled CRE market.

Conclusions CRE loan issues have been a topic of concern for some time, but the focus often remains on community banks. However, identifying the vulnerable banks is complex. While small and medium banks have higher exposure to CRE compared to large banks, they also have lower levels of non-performing loans.

The situation is expected to soon reveal its full impact. Banks experiencing increasing problems will raise their provisions, adversely affecting profitability and the credit market. Bank failures are almost inevitable, as warned by Federal Reserve Chairman Jerome Powell.