A symbiotic relationship
Following the recent U.S. banking turmoil, U.S. commercial real estate
(CRE) has become a hot topic among market participants. CRE relies heavily
on small and midsize banks for financing, which just so happen to be the
most stressed financial institutions. Overall, the commercial property
industry in the U.S. owes $1.9 trillion to these banks, or twice what it
owes to large banks ($0.9 trillion), according to the Mortgage Brokers
Association. Small and midsize banks are heavily exposed to CRE, which
accounts for as much as 43 percent of their outstanding loans.
CRE is a key component of U.S. small and midsize banks’ lending portfolio
Bubble chart showing the composition of U.S. small and midsize banks’
lending portfolio. CRE represents a hefty 43 percent of the portfolio,
by far the largest component. It is followed by residential mortgages
(20 percent) and commercial and industrial loans (18 percent).
Additional components shown are Other consumer (12 percent) and Other
(7 percent).
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CRE (43%)
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Commercial and industrial loans (18%)
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Residential mortgages (20%)
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Other consumer (12%)
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Other (7%)
Source – RBC Wealth Management, FDIC, Refinitiv, Federal Reserve
A sore point
Structural and cyclical issues are darkening CRE’s prospects. Office real
estate is suffering from high vacancy rates due to the post-pandemic
aversion to commuting to a job and the practicalities of the
work-from-home trend. The shift to online shopping accentuated by waves of
lockdowns has also reduced foot traffic at many brick-and-mortar retail
locations. Cyclical issues such as the mass layoffs in tech
industry-dominated areas are compounding these challenges. The U.S. office
vacancy rate reached 12.5 percent in Q4 2022, just below the level seen in
the aftermath of the global financial crisis in 2008, according to data
provider CoStar.
By nature, CRE involves a high degree of debt and tends to struggle in a
rising interest rate environment. Lower vacancy rates translate into lower
rents. Landlords often have difficulty refinancing as the value of their
buildings slips below that of the loan granted to purchase the properties.
Some may have no other option than to offload their properties at steep
discounts or face bankruptcy.
This would be an additional, unwelcome challenge for those small banks
currently under stress, which are already losing deposits to their larger
competitors and higher-paying money market funds.
A manageable risk
Still, we see reasons to believe the risk of any additional problems at
small and midsize banks due to CRE defaults could be contained. For one,
small banks’ lending contributes less than three percent of U.S. GDP, and
U.S. commercial real estate mortgages constitute less than 20 percent of
all mortgages – it’s the residential market that’s the key. Furthermore, CRE
lending standards have tightened over the past decade. Commercial property
lenders now only offer loans on a maximum of 75 percent of property value,
providing a cushion should values decline. In addition, non-residential
real estate accounts for less than three percent of GDP.
Any CRE default would likely be isolated to a few U.S. regional banks and
smaller lenders, in our view, negatively impacting individual communities.
We think the direct damage to the U.S. economy would be limited, though
defaults would likely lead lenders to tighten lending standards further.
In an environment in which investors are already anxious, we believe any
further meaningful stress on some small and midsize banks could drag down
equities and bond yields, with potential spillover effects for global
financial markets.
How soft are European and Japanese banks’ soft spots?
Banks in Europe and Japan are also under scrutiny from market participants
as they both have proven fragile in the past. Both countries’ banking
channels are outsized, with profitability challenged by the negative
interest rate environment in which they’ve operated for years.
In Europe, similar to the U.S., the concerns centre around a potential
increase in the stock of bad loans and deposit flight which would likely
weaken banks substantially.
Yet European banks do not share the same issues as U.S. regional banks.
Regulation in Europe has made all banks there buy hedges to protect them
against the risk of higher interest rates decreasing the value of their
loans. Liquidity coverage ratios are also much higher in Europe. The
sector is less exposed than its American counterpart to CRE loans and has
strong capital buffers to absorb potential losses. Core equity has surged
close to 15 percent of risk-weighted assets, up from five percent in 2011.
European banks also are less prone to losing deposits to money market
funds as there are fewer cheap and easy-to-access alternatives to bank
accounts than in the U.S. Deposits are mainly retail and insured.
Corporate deposits are mostly broadly diversified, unlike Silicon Valley
Bank’s outsized exposure to tech startups, or that of Credit Suisse’s
family offices (private banking), which withdrew deposits in unison.
Overall, the increase in European regulatory oversight and the balance
sheet clean-up efforts which took place after the 2008 financial crisis
and the European sovereign debt crisis four years later have put the
sector on firmer footing.
But as we see it, tightening lending standards over the past few months
will likely crimp revenue growth somewhat. RBC Capital Markets points out
that the primary market remains effectively shut for banks, a worry at a
time when funding costs are expected by most observers to rise. Following
Credit Suisse’s demise, we think investors in Additional Tier 1 bonds will
likely demand a higher return.
As for Japanese banks, the concern is the effect a sharp increase in the
10-year Japanese government bond yield would have on capital adequacy
ratios, should inflation prove stubborn. Regional banks and Shinkin banks,
cooperative financial institutions serving small and medium-sized
enterprises and local residents, would then have uncomfortably low capital
adequacy ratios. Such a development would bear monitoring, in our view.
Mega institutions, however, would likely cope better, given their healthy
capital adequacy ratios of close to 11 percent, according to S&P
Global.
Quality is key
We see strong reasons to believe that the risks facing U.S. CRE and
European and Japanese banking systems can be contained. But the ongoing
tightening in lending standards in both the U.S. and Europe may be
accentuated should these pressure points flare up. We continue to
recommend investors focus on quality in portfolios, and we prefer
companies with business models that are not sensitive to the business
cycle.
Managing Director, Head of Investment Strategy
RBC Europe Limited
