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Q2 2024 Credit Research Outlook The Rolling Risk of Commercial Real Estate

Ever since central banks started their aggressive rate hiking cycle in 2022, there have been broad concerns that a systemic credit problem could surface in CRE. However, we believe that CRE could contribute to a cyclical “credit squeeze” rather than a “credit crunch” during this cycle.

Credit Research

“I’m not leaving … I’m not leaving …”

—Leonardo Di Caprio as Jordan Belfort in Wolf of Wall Street

Commercial real estate (CRE) continues to be in the spotlight for credit investors and bank credit research analysts. Like Jordan Belfort in the blockbuster movie, CRE is not going anywhere and will continue to cause damage in capital markets for the foreseeable future. During this past quarter, lenders and investors in the US, Japan, Germany, and Canada reported sizable credit losses or write-downs related to US CRE.

CRE-related stress put New York Community Bancorp (NYCB) in the headlines, and we expect to continue to see idiosyncratic episodes like this for some US regional banks. While we recognize that CRE is a “slow-moving storm” that we will be dealing with for years, we also believe that systemic risks related to the sector remain limited.

Doctor Diagnoses Superb Health

The US Federal Reserve’s (Fed’s) 2023 bank stress tests showed that banks have enough capital to weather a 40% decline in CRE prices and an unemployment rate of 10%. The results are reassuring; however, this extensive risk-assessment exercise only included the country’s largest banks. The Federal Reserve Board’s H.8 data show that banks not included in its annual stress tests hold ~67% of all US CRE loans.

Further, CRE loans make up ~30% of these banks’ total assets — versus only ~6% for the banks that were part of the Fed’s stress tests. Figure 1 demonstrates how disproportionate the growth of CRE (as a percentage of total assets) has been over the last 40 years for US banks of various sizes. The concentration in the largest banks has remained consistent, and limited, whereas it has increased in a pronounced manner for banks with under $10 billion in assets.

We believe that the most severe risks in CRE are concentrated in the office sector as the pandemic-induced structural shift has increased remote and hybrid work. From this view, the outlook appears less challenging, as the share of CRE loans with regional banks that are office-related is less than 5% of total assets and generally under 2% for larger banks. Still, there is risk that regional banks do not currently have large enough loan-loss provisions if conditions in office loans deteriorate more than anticipated, if issues spread to other segments of CRE, or if credit performance deteriorates outside of CRE. These conditions may impair the regional banks’ ability to lend to households and businesses, leading to lower credit creation, which might weigh on economic growth over time. This is a greater risk than a systemic shock to the banking system, in our view.

What We Think

As our regular readers know, we prefer to do business with large, systemically important banks and financial institutions. CRE exposure for these types of institutions is more limited relative to regional banks. They are also subject to the stringent annual Fed stress tests. Further, we are able to use the extensive disclosures that these banks provide to run our own stress tests on banks’ CRE portfolios.

Outside our US bank investment counterparties, the vast majority of issuers on our credit approval list have very limited direct exposure to the US CRE market. Among the banks that participated in the European Banking Authority’s (EBA) 2023 transparency exercise, some specialized German lenders and German Landesbanks have high exposure to US CRE compared to their capital levels (Moody’s investor services; Sector Comment: Banks-Europe; 2/14/24).

However, those institutions are not on our credit approval list for State Street Global Advisors Cash Funds. We use the EBA transparency report disclosures to ascertain the overall size of CRE exposures (US and European loans) for banks in our coverage universe. We then apply our own stress tests to these bank portfolios to supplement the EBA test. Similarly, we conclude that the CRE-related risks for European banks remain largely an earnings event, rather than one that would materially threaten capital levels.

Systemic or Not?

Ever since developed market central banks embarked on their historically aggressive rate-hike cycles in 2022, there have been broad concerns that a systemic credit problem could surface in CRE, or in some other leveraged segment of the economy. Even when there was consistent, elevated risk of recessions around the globe, it was our view that the key balance sheet metrics underlying developed market economies suggested a limited risk of a systemic credit disruption.

However, we also believe that CRE could contribute to a cyclical “credit squeeze” during this cycle. We distinguish a “credit squeeze” from a “credit crunch” as an environment where strong credits can still obtain financing, albeit at a higher rate, while weak credits may be priced out of the market. In a “credit crunch,” liquidity dries up for all borrowers. With consumer and corporate balance sheets remaining in adequate condition through this cycle, a “credit squeeze” continues to be more likely than a “credit crunch,” as a downside scenario, in our view, even if idiosyncratic events related to CRE and US regional banks may persist.

The prospect of higher-for-longer interest rates will increase the probability of a “credit squeeze” and cause further stress in CRE, as well as well as for high-yield-type corporates and leveraged loan borrowers. As such, our credit research team is vigilant in limiting exposure to investment counterparties whose credit profiles could be negatively impacted by the degradation of the more leveraged parts of global economies.

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