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Exposure to U.S. office loans grows unsettling

Feb 15, 2024 | Public | 0 comments

Regional and mid-sized banks in the United States are considered most vulnerable to losses on commercial real estate (CRE) loans, particularly those tied to that country’s shaky office sector. However, newly released commentary from the credit rating agency, Morningstar DBRS, traces a wider radius of fallout with financial institutions worldwide demonstrating an upward trend in impaired loans on U.S. commercial properties.

“In our view, many banks will need to make some downward revisions to property valuations and, as a result, incur higher provisions and loan losses,” says Nicola De Caro, senior vice president, global financial institutions, at Morningstar DBRS.

Analysts are watchful as roughly USD $1.2 trillion in CRE debt is set to mature over the next two years, including about USD $300 billion on office and retail properties secured through banks and commercial mortgage-backed security (CMBS). That’s occurring in the context of interest rate uncertainty, tightening lending standards and sliding property valuations.

“Refinancing certain transactions, particularly in the office space, will likely require additional equity and/or restructuring. We also expect an increasing number of borrowers unable or unwilling to pay,” the commentary states.

Among large U.S. banks, Wells Fargo is highlighted for a soaring percentage of charge-offs pertaining to CRE loans over the past year. CRE loans, primarily for office assets, accounted for 30 per cent of the bank’s charge-offs in the fourth quarter of 2023 compared to 2 per cent in Q4 2022. Concurrently, the regional New York Community Bank registered USD $552 in provisions for credit losses (PCLs) in Q4 2023, up from USD $62 million in Q3.

“The increase was primarily driven by higher net charge-offs and reserve build-ups to address weakness in the office sector and potential repricing risk in the multi-family portfolio, which has seen an increase in criticized loans,” Morningstar DBRS reports. “In our view, medium-sized banks and regional banks are more vulnerable to further market deterioration, given that they typically have a higher proportion of CRE within their loan portfolios.”

MSCI’s annual results for 2023 show a negative 8.4 per cent total return across the U.S. property index, attributed in large part to slipping office performance. “There were significant writedowns on the office sector in our U.S. portfolios,” MSCI executive director, Ken O’Brien, told a recent CRE industry gathering in Toronto.

Also speaking at that event, Mark Rose, chief executive officer of Avison Young, noted that some Class B and C office properties in the U.S. are now in negative cash flow situations arising from a combination of high vacancies and “skyrocketing” credit and operations costs. Meanwhile, the U.S. Federal Reserve is advising against foreclosure.

“These banks do not want negative cash flowing buildings back,” Rose said. “The banks are holding onto them because, if they take it all in one year, we could have another systemic banking crisis. The Fed has told them: Just engage in work-outs.”

For Canadian banks, gross impaired loans (GILs) tied to U.S. CRE now account for 22 per cent of total business and government GILs, up from 7.6 per cent at the end of 2022. U.S. CRE loans are also a growing portion of identified credit risk, now representing 41.7 per cent of PCLs versus 21.1 per cent in Q4 2022.

Morningstar DBRS lists Royal Bank of Canada, Toronto Dominion Bank, Bank of Montreal and Canadian Imperial Bank of Commerce as large Canadian lenders experiencing this “credit quality deterioration”, and notes that office properties make up a larger share of their CRE loan books within the U.S. than in other regions. However, the risk is considered minimal.

“The total global office sector exposure at the large Canadian banks is generally well diversified and relatively small, comprising approximately 10 per cent of total CRE loans and ranging from a very manageable 0.8 per cent to 1.9 per cent of total loans and acceptances,” the commentary confirms.

Elsewhere, Germany’s Pfandbriefbank (pbb) is positioned more precariously. As a specialized real estate lender, about 15 per cent of its CRE loans are in the U.S. and office properties make up 80 per cent of that quotient. “pbb is also largely exposed to its home market in Germany, where CRE is also under pressure,” Morningstar DBRS observes.

As well, Tokyo-based Aozora Bank recently stress tested its CRE loan book in the U.S., in which 47 borrowers hold USD $1.89 billion in non-recourse office loans, representing 6.6 per cent of total loans. The exercise assumed that some properties would decline in value by 60 per cent over the next two years, which, in turn, translated into an average loan-to-value (LTV) of 177 per cent. Loans with LTV in excess of 100 per cent were downgraded to non-performing status, increasing the ratio of non-performing loans in Aozora Bank’s U.S. office exposure to 38 per cent — a jump up from 13.8 per cent in Q3 2023.

The post Exposure to U.S. office loans grows unsettling appeared first on REMINET.


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