Roll the dice. Buy a property. Collect rent. Pass Go.
The rules of Monopoly are much like the rules of
After three large regional banks collapsed last spring, the industry has been moving around and around the board.
There have been temper tantrums, as investors suddenly call it quits on bank stocks they owned for years, and CEOs defend the
There have been bankruptcies, as the owners of empty office buildings and struggling apartment buildings hand over the keys to banks. If enough of them do so, banks that made far too many real estate loans may crumble and sit out the rest of the game.
And there will be the real-life equivalent of Monopoly's jail cell, as regulators and
Pierre Buhler, a managing director at the consulting firm SSA, said he's recently changed his outlook on the odds of a banking apocalypse as he continues helping financial institutions resolve their troubled building portfolios. While the hit to CRE may handicap lenders, it won't "destroy everything," Buhler said.
"The size of the problem is huge, but it will not materialize all at once," Buhler said. "I always predicted a tsunami. In some ways, I was doom and gloom. Today I'm in a slightly different set of shoes."
Bankers seem encouraged that the narrative is turning in their favor. There's been a broader recognition that not every player has the same strategy. Those lenders that are in bigger trouble are the ones that took bigger risks.
But the game is still in its early stages, and some commentators believe we're facing a slow-moving train wreck. (For its part, Parker Bros. says Reading Railroad is still worth $200 on the Monopoly board.)
When asked how much distress the CRE sector is facing, experts are often equivocal. It depends, they say, on geography, the borrower, the sector, the building's square footage and the size of the loan. Plus, there's the roller coaster of interest rate hikes since 2022, the pandemic shift in work-from-home practices and, in some previously hot markets, an overbuilding of apartments.
In the hotly contested debate about the scale of doom, those nuances are everything.
"The No. 1 thing to understand is that commercial real estate is a really big, heterogeneous market," said Jamie Woodwell, who heads CRE research at the Mortgage Bankers Association. "Each and every property and loan is really unique. What you see often is folks painting commercial real estate — and commercial real estate's impact on banks — with very broad brushstrokes. Now of all times is not the time to do that."
Still, hundreds of small banks are
In other words, there's no reason to think that many banks are ready to pass Go and collect $200.
Bigger loans, bigger losses
It's no secret that massive office buildings in major city centers are suffering the most, as bustling suites of busy employees have been hollowed out.
Return-to-office mandates after the pandemic have stanched the bleeding, but remote-friendly industries, such as the technology sector, simply need less space than before. While the office is far from dead — and some fresh-to-the-workforce employees crave camaraderie — work patterns are undergoing a generational shift that has yet to fully shake out.
It's the bigger banks that are generally taking the hits as the value of urban office buildings goes underwater.
The larger a bank is, the more likely it is to make loans on bigger office towers, according to experts. And a recent study by the Federal Reserve Bank of Kansas City found that the bigger an office building is, the higher the chance that the borrower will default.
That's perhaps why the CEOs of megabanks and larger regional banks have been warning about their office books for more than a year, though they've noted that any losses would be gradual.
"It's a long movie," Mike Santomassimo, Wells Fargo's chief financial officer,
Wells Fargo, Bank of America, PNC Financial Services Group, Truist Financial and other large banks long ago set aside money to protect themselves against losses in their CRE portfolios. So unless the losses are ultimately more severe than the banks are expecting, they have accounted for the coming trouble in their financial positions.
Thus far, everything is "going as we've expected," PNC CEO Bill Demchak told analysts in July, as office loans that the Pittsburgh-based bank long ago flagged as troubled were starting to develop problems.
"Look, it's not a great outcome, but there's nothing in there that I think is going to surprise us," Demchak said.
If there are more losses than the big banks currently predict, that would eat away at their ability to handle a recession, assuming one does eventually hit.
But the big banks have plenty of other ways to make money, including their large credit card businesses and their Wall Street dealmaking arms. That diversification offers protection in a scenario where nasty surprises in commercial real estate force them to stash away more money.
Towering concerns
Loans on the biggest office towers — where stress has been particularly severe — largely sit outside the banking system. Many of these credits are in investment vehicles known as commercial mortgage-backed securities, which offer exposure to U.S. real estate for investors around the globe.
CMBS loans are typically far larger and somewhat riskier than those held by banks. Banks usually require borrowers to have more skin in the game to avoid overburdening them with debt.
"On average, banks have, in this cycle at least, what is probably less risky exposure than the nonbanks," said Brian Graham, a partner at the consulting firm Klaros Group.
If a building is worth $10 million, a bank will typically only lend its owner about $6 million, giving the lender a hefty 40% cushion in case the property's value falls sharply.
The margin for error in CMBS deals tends to be smaller, with borrowers holding as little as 25% equity, according to an S&P Global Ratings report. And the buildings that are part of CMBS transactions are often far larger, with property values sometimes rising as high as $1 billion, the S&P report said.
A smaller cushion means a loan can go underwater far more quickly, saddling the borrower with debt payments on properties whose values have plunged.
Valley National Bancorp, a regional bank in New Jersey, isn't far from one of the epicenters of the office stress: Manhattan. But Valley executives are quick to point out that the bank's office portfolio doesn't touch New York City's skyline.
Valley only has six office loans that are over $50 million, one of which is on its own headquarters in Morristown, a top executive said in July. The bank does have a vast amount of exposure to the office CRE market, but it's based on a big pool of relatively tiny loans, with an average loan size of $3 million.
Concerns about the CRE sector are understandable, Valley CEO Ira Robbins said in an interview, but "when you dial back, the exposure" is in the CMBS market and with Wall Street firms.
"All this consternation about what's going on in the regional and midsize bank space — the real pressure and stress has been on an actual very different subset than what the regional banks hold," Robbins said.
The percentage of CMBS loans that are delinquent is hovering around 5%, compared with about 1.5% for bank loans, according to an S&P Global Ratings report in June, though banks also invest small amounts in the CMBS market. The figures include all types of CRE properties, including retail, hotels and apartment buildings.
The metrics on office space in particular are more discouraging. Some 11% of office CMBS loans that the ratings firm KBRA tracks are either delinquent or managed by a "special servicer," whose job is to work out solutions that minimize losses to investors.
Suburbs aren't subpar
It's a different story in suburbia, where
Office buildings with smaller suites and garden-style properties outside of the central business districts are seeing less of a valuation crunch and fewer cash-flow problems.
Midsize banks listed just 1.5% of their CRE nonowner-occupied loans as delinquent or nonperforming in the first quarter, compared with 4.5% at the largest banks, according to the Federal Deposit Insurance Corp.
Densely urban Class B and C properties — graded on a descending letter scale that corresponds with the quality of the building — are generally performing the worst among CRE assets, said John Toohig, head of whole loan trading at Raymond James. But in the suburbs, Class B and C buildings are "not doing as poorly," and Class A buildings are holding up "very well," he said.
Medical office buildings have been a bright spot in banks' CRE portfolios, as the health care sector has largely avoided the cash-flow crunches and work-from-home shifts that have affected other industries.
Bank CEOs are also differentiating between two types of office space: buildings where revenue comes from renting space to tenants, and owner-occupied CRE, where a business holds the deed to its workspace and has borrowed money to finance it.
"Every loan you make has risk," Klaros' Graham said. "It's not like owner-occupied commercial real estate isn't in any way risky. … It behaves differently in different economic scenarios."
While an institutional investor that owns a large office building may give up the keys when it's economically rational to do so, an owner-occupant may work harder to hold onto a property that the borrower uses to operate a business.
Such debt functions more like a run-of-the-mill business loan, bankers say. Instead of judging owner-occupied loans using traditional CRE metrics, the deals are far more about the cash flow and growth of the borrower's business, the argument goes.
So if a dentist takes out an office loan to fund her dental practice, the bank doesn't need to focus on vacancies as much as cavities.
One problem with that reasoning is that in recent months, banks' business loan portfolios
While banks "have bifurcated their office book into owner-occupied" and regular office CRE, it's not at all clear that "there will be a substantial performance difference between these two buckets," Seaport Research Partners analyst Laurie Havener Hunsicker wrote in a recent note to clients.
One-offs or the start of a trend?
Though news coverage of the commercial real estate turmoil has recently
Investors are noticing and penalizing any banks that reveal negative surprises, even if their overall credit metrics remain healthy. Indiana-based Merchants Bancorp's stock price fell 15% on July 30 after it reported that some of its multifamily and senior housing borrowers were having a harder time keeping up with higher interest rates.
Nathan Race, an analyst at Piper Sandler, argued in a note to clients that the sharp drop was "unwarranted." Merchants has a solid track record of conservative underwriting and is working proactively with borrowers to find solutions that limit any losses, he noted.
Bank of Marin Bancorp in California saw its stock price fall some 12% on July 29 after stashing away $5.2 million for a potential loan loss. The loan is tied to a San Francisco office building whose post-pandemic value plunged from $33.5 million to $9.2 million, though Bank of Marin CEO Tim Myers told analysts that the building's owners have pledged enough cash to cover their payments until the contract ends in 2026.
Other banks that reported upticks in CRE troubles also haven't signaled any alarm. They say any issues are building-specific — a suddenly vacant office building here, an older apartment building there.
Write-offs on bad loans do remain low, but they are rising. As so-called one-off situations mount, analysts predict that small banks will have to follow the lead of their larger peers and start setting aside more money to protect against loan defaults.
At OceanFirst Bank in New Jersey, Chairman and CEO Christopher Maher says the bank has studied its downtown exposures with a "fine-tooth comb" and has consistently stress tested its CRE portfolio against rougher scenarios.
"The positive news is those stress tests have been so positive" that the math hasn't justified setting aside that money, Maher told analysts, adding that OceanFirst executives look at the portfolio "really carefully every quarter and make thoughtful decisions about it."
Other small and midsize banks put more buildings on their watch lists last quarter — a sign that the owners are struggling to keep up with their loan payments or are at risk of a big tenant leaving. Some buildings are slowly being taken off those watch lists, but only because banks have given up hope and have written off the loans.
First Western Financial in Denver is in the process of building reserves and selling a few properties as it works to resolve its exposure to nonperforming assets.
"There's a whole sausage-making process here that's well underway," President and CEO Scott Wylie told analysts in July.
The good news is that the vast majority of banks are still making money, even if their margins have gotten pinched over the past two years. Those profits should help ease the blow from
"Banks are still solidly profitable," said Terry McEvoy, an analyst at Stephens. "When you're profitable, you can create capital to absorb future losses."
But there's still the question of how big the set-asides will have to be.
If losses wipe away one-fourth or half of banks' earnings, the pressure on CRE-heavy banks "seems manageable," analysts at S&P Global Ratings wrote this year. But a larger buildup of reserves "raises the specter of potential market confidence sensitivity," they wrote.
Multifamily blues
There's also work for banks to do outside of the office sector. Rifts in the multifamily housing market have begun to inch their way down lenders' balance sheets, though experts say those issues will be more isolated and cyclical compared with the turbulence in workspaces.
Fixed-rate deals that were inked in a zero-rate environment are beginning to become unprofitable for banks. High inflation is putting pressure on the costs for landlords of constructing, insuring and maintaining their properties.
And stricter regulations in one part of the country, New York state, have ended the heyday of the financing of rent-regulated apartments.
So far this year, both New York Community Bancorp and First Foundation in Dallas have
New York Community
First Foundation isn't seeing many borrowers who can't make their payments, but it is facing an old-fashioned duration mismatch. The bank rapidly accelerated the growth of its multifamily book in the era of zero rates. But its profits have recently been faltering as the cost of the deposits the bank uses to fund its loans has shot up. Now, First Foundation is making
There's another factor that's been putting pressure on banks' multifamily portfolios across the South and Southeast, where the supply of apartments swelled in anticipation of rent increases that didn't come to fruition. In cities like Austin, Atlanta and Nashville, post-Covid demand for rental housing hasn't kept up with construction. For building owners, unexpectedly low demand has meant less income, coupled with the squeeze from rising payments to lenders.
Some observers pointed to factors that suggest multifamily real estate will enjoy more favorable outcomes than the office sector.
"The thing about multifamily versus office is, everyone is born short a roof," said Jeff Davis, who leads advisory firm Mercer Capital's financial institutions group.
"Every person is going to have to have some sort of roof over their head. … Not everyone is going to have to go into an office," he said.
But Aaron Jodka, a research director at the CRE brokerage firm Colliers, said that because the multifamily business is cyclical, muted income, high expenses and the swift kick of interest rates could make those loans spiral quickly.
Kicking the can
So far, the biggest trigger for problems in CRE lending has been the much-feared maturity wall. As loans hit the end of their terms, borrowers are finding the math no longer works for the credits they booked when interest rates were low.
In some cases, the problem is fixing itself. Several bankers said in recent earnings calls that certain potentially at-risk borrowers ended up paying in full at the end of the loan period. Some may have sold their buildings and paid off banks with whatever was left. Others may have gotten a new loan elsewhere on worse terms and used the proceeds to pay off the bank, moving the risk off the banks' balance sheets.
But the majority of loans that are left on the books may still present problems if bankers can't figure out a solution.
CRE loans are coming to maturity in a different interest rate environment than when they were made — and at a time when underlying property values are unclear. As their loans reset to today's higher interest rates, cash-strapped borrowers will struggle, making it less likely that the banks will get repaid.
"Sometimes you get this vicious cycle that can cause interest rate risk to become credit risk," Klaros' Graham said.
Banks are doing what they can to offer flexibility.
"At the end of the day, the banks don't want to become property owners," said Julie Solar, a senior director who tracks U.S. banks at Fitch Ratings. "So there's a mutual incentive on the part of the bank and the borrower to try to come to some agreement."
Those solutions may include extending the tenor of the loan, working with sponsors to bring more equity to the table or another mutually beneficial plan that allows the property owner to avoid selling at a loss.
Regulators have blessed the practice,
Skeptics of such tactics have several derisive terms to describe such processes — Extend and Pretend, Delay and Pray, Survive Until '25. Bankers counter that they can only make modifications for borrowers who are in relatively good shape, since extending a doomed loan would raise the ire of their regulators.
The size of the problem is huge, but it will not materialize all at once. I always predicted a tsunami. In some ways, I was doom and gloom. Today I'm in a slightly different set of shoes.
Semantics aside, loan modifications are giving distressed CRE borrowers a temporary breather. And they do push out whatever crunch an individual borrower feels for at least another year.
About $400 billion of CRE loans were originally slated to mature in 2023, but more than $300 billion were pushed to 2024 or beyond, according to a report from Morgan Stanley analysts.
And it's not always the case that the pain is merely delayed. Sometimes extending the maturity of a loan can help lender and borrower alike to hunker down until property values stabilize, and the market acclimatizes to the effects of interest rate changes.
"I wouldn't say kicking the can never works," said Brett Rabatin, Hovde Group's regional bank research leader. "Sometimes it does. Time does tend to fix commercial real estate in many cases."
Hunting for distress
Some loans are troubled enough that banks just want to get them off their balance sheets. And for those banks ready to sell foreclosed properties, there's plenty of dry powder on the sidelines ready to be deployed.
Toohig, as a loan trader, said he's hearing about lots of interest from private credit funds, which are "licking their lips" at problem properties.
"The number of phone calls we are getting from private credit saying, 'Hey, show me all your distressed portfolios,'" Toohig said. "There's a bunch of money out there hunting for that distress and so far, it just hasn't come. So there'll be plenty of buyers for this. Right now, there are just not as many sellers."
That dynamic marks a major difference from the financial crisis 15 years ago, when private credit wasn't as ubiquitous and lenders were deleveraging after suffering major losses.
At the end of the day, the banks don't want to become property owners. So there's a mutual incentive on the part of the bank and the borrower to try to come to some agreement.
As banks are settling in to the reality that they will have to write down those properties, Bull Realty in Atlanta is brokering more and more post-foreclosure sales, according to the firm's CEO, Michael Bull. The increase in sales is also helping settle fuzziness in a building's worth by allowing for comparisons to the sales price of the property next door.
As appraisals continue to pile up, more banks will be forced to make decisions about how to handle their beleaguered properties.
"I think we're starting to see appraisers do more realistic appraisals on the bank's current portfolio," Bull said. "And that's going to cause more than banks to say, 'All right, well, if we've got to write this down, let's go ahead and do something with it.'"
Bull added that underwriting is also getting steadier as the interest rate outlook mellows out following the rapid rise of yesteryear.
So far, though, there aren't many clear markers about the extent of the bleed in CRE. That is to say: As banks have done what they can to avoid foreclosing and risk selling properties at a loss, there is still a lot of price discovery to be done.
Concentrating on 300%
As the dust continues to settle, regulators and investors have been scrutinizing banks with heavy exposure to commercial real estate. And one long-known, rarely enforced rule of thumb has made a comeback.
Years-old guidance from regulators flags fast-growing banks where CRE loans make up more than 300% of risk-based capital as a potential trouble spot. Hundreds of banks are beyond that mark, some significantly so.
At the same time, investors are punishing or staying away from banks with large CRE concentrations, even if their portfolios remain healthy.
Banks above the 300% cutoff are now generally on a diet, even if their large exposures were seemingly not a problem for either their regulators or investors before March 2023. These banks are cutting back on any new CRE lending, and they are reclassifying some owner-occupied loans away from the CRE bucket.
Behind the scenes, bank regulators appear to be escalating their warnings. Banks have largely been mum, but there's widespread recognition that their regulators are at the very least taking a closer look than they were before.
"The regulators have been very clear that it is an ongoing concern, and we take those cues seriously," Steve Gardner, chairman and CEO of Pacific Premier Bancorp in Southern California, told analysts in July. His institution reported a CRE concentration of 324%.
Valley National Bancorp in New Jersey is on a CRE diet of its own. It laid out plans in April to reduce its CRE concentration below 400%, down from 460% at the time.
The decision came despite Valley executives' confidence in the bank's CRE portfolio — to the point that they told analysts the amount they set aside each quarter to cover potential losses had "peaked."
Valley's Robbins said the bank has a decades-long track record of keeping any problems in check — even after the 2008 crisis. Still, he said, Valley realized that an outsize CRE business can "create a lot of consternation" and hurt its shareholders through a much lower stock price.
There are some downsides to cutting back in commercial real estate lending. Valley and other CRE-heavy banks are trying to figure out how to pivot without denting their profits as they diversify into other areas with heavy competition.
As CRE-heavy banks pull back, CRE-lite lenders are diving into the sector despite having "no idea" how to underwrite loans without taking too much risk or how to effectively work with borrowers once they run into problems, Robbins said.
He also griped about what he sees as the downsides of homogenization in the banking industry.
"Everyone's being pushed to look the exact same," Robbins said. "Is that really what the U.S. banking system was built off of? What are the unintended consequences of pushing everyone to look the exact same?"
Hope springs eternal
Despite all the angst, there are some signs that the worst is over.
The Federal Reserve appears poised to cut interest rates soon, relieving some of the pain that's dragged down the CRE sector. The central bank may not cut rates by all that much for fear about reigniting inflation. But even bringing rates down from over 5% to 4% in a few months would help, said Colliers' Jodka.
"It won't save them all. But if interest rates go to 2.5%, it saves a ton of deals," Jodka said.
Even keeping rates flat for the last year has helped spark life back into the CRE market. Properties are once again starting to change hands — though some are selling at big discounts — since lenders can extend credit without fear that rising interest rates will ruin the math.
"There's definitely a level of stabilization that's happening and some positive momentum that's been building over the past few months," said Wei Xie, a research leader for the Eastern U.S. at the commercial real estate firm JLL.
Downsizing is still happening, as leases expire and remote-friendly companies decide they want smaller spaces. But there's one encouraging sign: Companies are again signing more office leases.
Leasing activity rose 15% in the second quarter and was at its highest point since the start of the pandemic, JLL found recently. Big-ticket leases drove much of the activity, such as Bloomberg LP's lease renewal for its 900,000 square-foot office in Manhattan.
There's also the likelihood that the supply of office space will shrink in the face of falling demand. With the future of the office in doubt and interest rates still sky-high, there is little appetite to build new office buildings. It won't happen right away, but less supply in the next couple of years should naturally raise the price of existing workspaces, analysts said.
Woodwell of the Mortgage Bankers Association, said uncertainty is keeping people away from CRE, even though it could be an auspicious time to consider jumping in.
"This is often the type of period where you look back on it and say, 'Wow, those were the best equity investments or loans that we've made,'" Woodwell said.
