A service of

Finding troubled commercial real estate requires ‘bank-by-bank’ scrutiny, sector participants say

  • Regional and community banks without metro office space seek to quell fears
  • Bank M&A is at standstill but more sales of CRE books, other assets expected

Sticky work-from-home trends mean hard times for banks overexposed to office space and supporting retail in large metro areas, and identifying which institutions are holding problem commercial real estate (CRE) loans poses a challenge for investors and the broader industry, sector participants and advisors said.

Of USD 2.17trn in nonfarm, nonresidential commercial real estate – including office and downtown retail – held by US banks larger than USD 50bn in assets at the end of 2022, more than 71% was held by banks with assets of less than USD 100bn, according to the Financial Stability Report released this month by the US Federal Reserve.

Fears that lenders could be left holding the bag as the market corrects are adding to headwinds that have battered stock prices of regional and community banks, and brought sector M&A to a near-standstill.

Investors will be forced to drill down into each institution to determine where the problems lie, three banking sector participants said. 

“You just have to go bank by bank and figure out which ones have exposure and which ones don’t,” said David Foss, CEO of Jack Henry & Associates [NASDAQ:JKHY], which specializes in providing technology to banks with assets from USD 500m to USD 50bn.

There are analogies in the oil and gas declines of a few years ago, when investors scrambled to figure out which institutions had outsized credit bases focused on oil fields and fracking, Foss recalled. “Those banks, all of a sudden, were persona non grata,” he said.

Office real estate in major metropolitan markets – where declines in value already exceed 40%, in some cases – is not a major concern for the vast majority of community and regional banks, market participants said.

At the National Bankers Association, which represents minority-owned institutions, member banks are more likely to lend for buildings like churches and other owner-occupied structures from which businesses are operated daily, President and CEO Nicole A. Elam, told a panel at the Milken Global Conference this month.  

There could be more exposure to office loans among some member banks in South Florida, as well as some Asian community banks, she said.

Commercial real estate is a significant part of the business model at Legends Bank in Clarksville, Tennessee, a 25-year-old community bank with about USD 840m in deposits.

That portfolio is heavy on loans to local developers for construction of multi-family-homes and owner-occupied businesses, with no major office assets or exotic financing, said Thomas Bates Jr., president and CEO of Legends Bank. 

“We’re not seeing what we’re hearing on the news,” he said. “I think everybody needs to take a collective breath, and don’t look for a problem where there’s not necessarily a problem.”

Indeed, investors are scrutinizing the commercial real estate environment.

A number of commercial real estate sub-sectors continue to do well, as do some office properties away from major metros, according to several market participants and investors.

“We are devoting a lot of resources to looking at this asset class and understanding that not all commercial real estate is bad and not all office is even bad,” said Michael Buchanan, deputy chief investment officer at Western Asset Management Company.

Many commercial borrowers took advantage of the zero-interest-rate environment to refinance their loans during the pandemic, several advisors said. 

A common structure calls for a 10-year-loan with a fixed rate for the first five years, followed by an adjustable rate for the balance of the term, they said. As those loans reach the end of their fixed-rate term in the coming two to three years, worries are that distressed office landlords beset by work-from-home woes will be unable to refinance affordably at today’s elevated rates.

“There’s going to be a lot of changes to capital structures that need to happen as long as rates stay this high,” said Jacob Kotzubei, co-president at Platinum Equity.  

Reports of deteriorating office loans are growing and in the week before Easter, owners of four significant office buildings in New York City turned keys over to banks, citing failed business models, Paul Dietrich, chief investment strategist for B. Riley Wealth, told a panel at the firm’s conference last week.

“You just need a few big buildings, and that bank is in trouble,” he said. 

If rates come down quickly enough, the worst fears surrounding CRE loans might not come to pass, according to several advisors. In the worst cases, some banks could find themselves with limited options for restoring liquidity, the advisors said.

“They are going to get caught holding the bag, and they’re going to need to find a buyer,” said James Montgomery, co-founder and managing partner at March Capital

Notwithstanding recent forced M&A to rescue distressed banks, insiders are expecting very little dealmaking in the sector due to potential acquirers’ own battered stock prices and misalignment between buyers and sellers about bank values.

Recent challenges in the banking sector have only strengthened support for the notion that bigger-is-better, which is likely to drive M&A over the long term, they said.

The next few months, however, “will be quite slow as people try to figure out their own books,” said one advisor, who asked to remain anonymous.

Another obstacle to dealmaking is the looming threat of additional regulation as a result of the recent bank failures, which could keep potential acquirers on the sidelines as they await clarity on how onerous new rules will be, said Kamal Mustafa, chairman of banking advisory firm Invictus Group.

“Once that dust settles, there will be many owners who throw up their hands and want to get out,” he said.

Broader concerns about the sector – much of it fueled by short sellers on social media – are challenging stock prices and deposit levels, forcing some banks to scramble for liquidity, several banking sector participants said. 

PacWest Bancorp [NASDAQ:PACW], which lost three-quarters of its value since the regional banking crisis began in early March and last week agreed to sell off its commercial real estate loan book for what is being described as a “discount” at USD 2.7bn, is an instructive example.

PacWest was actually “performing really well,” until the shorts and social media targeted the company with a wave of negative claims, sending the stock plunging in a “self-fulfilling prophecy,” Jack Henry’s Foss said. 

Each sharp drop invokes memories of Silicon Valley Bank, First Republic, Signature Bank and Silvergate Bank.

Given the confluence of challenges, it is likely that other banks will seek to sell off commercial real estate as well as other assets, two bank sector participants said. 

“Will there be another one after PacWest? Probably…I’ve already heard a couple of names floated out there,” Jack Henry's Foss said, adding: "We'll just have to hope that things calm down."