Real-Estate Doom Loop Threatens America’s Banks
Regional banks’ exposure to commercial real estate is more substantial than it appears
Bank OZK had two branches in rural Arkansas when chief executive officer George Gleason bought it in 1979. The Little Rock lender today has billions of dollars in commercial real-estate loans, including for properties in Miami and Manhattan, where it is helping fund the construction of a 1,000-foot-tall office and luxury residential tower on Fifth Avenue.
Regional banks across the country followed a similar playbook, gorging on commercial real-estate loans and related investments in big cities over the past decade.
With the commercial real-estate market now in meltdown, those trillions of dollars in loans and investments are a looming threat for the banking industry—and potentially the broader economy. Banks’ exposure is even bigger than commonly reported. The banks are in danger of setting off a doom-loop scenario where losses on the loans trigger banks to cut lending, which leads to further drops in property prices and yet more losses.
Bank OZK hasn’t pulled back from lending, but it has started to see some signs of market trouble. In January, a developer defaulted on a roughly $60 million loan from Bank OZK after construction costs escalated, the bank said. The loan was considered relatively safe because it was far below the building site’s value of $139 million in 2021. In December, a new appraisal put the property’s value at $100 million.
The bank is effectively stuck with the property. “Buying land in the current unstable environment is not something that a lot of people will do,” Gleason, the CEO, said during an April earnings call. Bank OZK declined to comment.
Cumulative change in commercial real-estate exposure since March 2015, by bank size
Today’s troubled market, fueled by rising interest rates and high vacancies, follows years of boom times. Banks roughly doubled their lending to landlords from 2015 to 2022, to $2.2 trillion. Small and medium-size banks originated many of those loans, and all that lending helped push up property prices.
Bank OZK’s success over the years allowed Gleason to build himself a 27,000-square-foot French chateau-style mansion in Little Rock, which he filled with a vast collection of European art. “I’ve never said that what we do is risk-less,” Gleason told the Journal in 2019. Still, he added, he considers OZK “probably the most conservative” commercial real-estate lender.
Over the past decade, banks also increased their exposure to commercial real estate in ways that aren’t usually counted in their tallies. They lent to financial companies that make loans to some of those same landlords, and they bought bonds backed by the same types of properties.
That indirect lending—along with foreclosed properties, trading portfolios and other assets linked to commercial properties—brings banks’ total exposure to commercial real estate to $3.6 trillion, according to a Wall Street Journal analysis. That’s equivalent to about 20% of their deposits.
The volume of commercial property sales in July was down 74% from a year earlier, and sales of downtown office buildings hit the lowest level in at least two decades, according to data provider MSCI Real Assets. When deals begin again, they will be at far lower prices, which will shock banks, said Michael Comparato, head of commercial real estate at Benefit Street Partners, a debt-focused asset manager. “It’s going to be really nasty,” he said.
Lending is the lifeblood of all real estate, and regional and community banks have long dominated commercial real-estate lending. Their importance grew after the 2008 financial crisis, when the country’s biggest banks reduced their exposure to the sector under scrutiny from regulators. Low interest rates made higher-yielding real-estate loans lucrative to hold.
That strategy now appears risky after the Federal Reserve raised interest rates. Banks are under pressure to pay depositors more to keep customers from fleeing to higher-yielding investment alternatives. Without cheap deposits, banks have less money to lend and to absorb losses from loans that go bad. Depositors withdrew funds from many small and regional lenders earlier this year after the collapse of three midsize banks stoked fears of a systemwide crisis.
The doom-loop scenario is starting to play out in big cities where office vacancies have soared. Real-estate investors that are unable to refinance their debt, or can only do it at high rates, are defaulting. The lenders, no longer getting the debt payments, often have to write down the value of those mortgages. Sometimes the bank ends up owning the property.
“The plumbing is clogged right now,” said Scott Rechler, chief executive of real-estate investor RXR. “And that is going to create a backup that will eventually overflow on the commercial real-estate markets and on the banking system.”
When Rechler asks banks to refinance his office loans now, few respond. In some cases, he said, it’s not even worth trying. Rechler had a $240 million mortgage coming due on a 33-story office building in lower Manhattan. Vacancies were high, renovating or converting the building would be expensive and the cost of a new mortgage was way up. He ran the numbers and decided to default on the loan. RXR said that it’s been working with the lender to market the building for sale to repay the loan at a discount, and that they have discussed possible loan modifications if the building isn’t sold.
Banks’ exposure to commercial real estate, quarterly, 2015-23
Note: Loans to small businesses are secured by commercial properties like car washes or churches where less than 50% of the repayment source comes from rental incomes. Construction loans are used to acquire land and develop properties including single- and multifamily projects. Office and apartment loans are those where at least 50% of the repayment source comes from a third party such as a tenant. Loans to commercial real estate investors are made to parties whose revenues or assets are primarily derived from real-estate holdings and ventures. Other assets linked to commercial properties include trading portfolios, properties acquired in foreclosure and bank offices. Commercial mortgage-backed securities valuations are based on the amortized cost of held-to-maturity and available-for-sale portfolios.
Source: Wall Street Journal analysis of FDIC data
Besides banks, lenders such as private debt funds, mortgage REITs and bond investors can also provide funding—but many of them are financed by banks and can’t get loans. “We are seeing a serious credit crunch developing,” said Ran Eliasaf, managing partner of Northwind Group, a private real-estate lender.
Earlier this year, Buffalo, N.Y., regional lender M&T Bank reported nearly 20% of loans to office landlords were at higher risk of default. The bank has reduced commercial estate lending by 5%. At the end of June, the bank wrote off $127 million worth of loans for three offices and a healthcare facility in New York City and Washington, D.C., according to the company. It also has unrealized losses on $2.5 billion worth of securities that are tied to loans for offices, apartments and other commercial properties, according to the Journal’s analysis. M&T declined to comment.
Darren King, who oversees retail and business banking at M&T, said at a June investor conference that the bank’s commercial-real estate losses would be a slow grind. “It won’t be Armageddon all in one quarter,” he said.
For its analysis, the Journal tallied hundreds of billions of dollars worth of indirect lending, which often isn’t clearly disclosed, by analyzing banks’ reports filed with the Federal Deposit Insurance Corp. and tapping former bank examiners for their knowledge of bank lending practices.
Between 2015 and 2022, banks more than doubled their indirect real-estate exposure. That included loans to nonbank mortgage companies and to real-estate investment trusts that own and operate buildings and lend to landlords. It also included investments in bonds known as commercial mortgage-backed securities, or CMBS. Banks boosted lending to small businesses that used property as collateral as well.
Holdings of CMBS and loans to mortgage REITs and other nonbank lenders accounted for about 18% of the nearly $3.6 trillion in commercial real-estate exposure in 2022, or nearly $623 billion, according to the Journal’s analysis.
The first quarter of 2023 marked the first decline in banks’ commercial real-estate holdings since 2013, according to the Journal’s analysis. At that point, banks’ overall securities holdings had lost nearly $400 billion in value, largely due to higher interest rates. Banks don’t have to mark down the value of loans in most cases, so the real losses are likely greater.
Banks with less than $250 billion in assets held about three-quarters of all commercial real-estate loans as of the second quarter of 2023, the Journal’s analysis shows. They accounted for nearly $758 billion of commercial real-estate lending since 2015, or about 74% of the total increase during that period.
That increase in lending helped boost commercial real-estate prices by 43% from 2015 to 2022, according to real-estate firm Green Street.
Banks and real-estate developers could be relieved from a downward spiral by lower interest rates or by investors stepping up to buy distressed properties. Wall Street firms are raising funds to scoop up properties, but many properties will likely be sold at well below their recent prices, potentially triggering losses for owners and lenders. Roughly $900 billion worth of real-estate loans and securities, most with rates far lower than today’s, need to be paid off or refinanced by the end of 2024.
Nearly $900 billion in commercial property loans are maturing this year and next, forcing many landlords to seek out more expensive financing from private investors and banks still willing to lend.
Maturing commercial property loans by lender type
Note: Other lenders include commercial mortgage backed securities, insurance companies and private and government lenders.
Source: MSCI Real Assets
Real-estate developer Riaz Taplin’s financier of 20 years, First Republic Bank, failed in May. That put him on a scavenger hunt for cash.
The San Francisco Bay-area developer was turned down by a subsidiary of regional lender PacWest Bancorp. The bank was a big real-estate lender but many of its depositors fled in the spring, worried about potential losses. “They’re like: Riaz, we’re just trying to get through the storm,” he said. “Call back when it’s not a torrential downpour.”
PacWest was bought by Banc of California in July for about $1 billion. By then the bank had already sold a real-estate lending unit and a $2.6 billion property portfolio. PacWest and Banc of California declined to comment.
Taplin said he is still able to get loans from other banks, but they are smaller, more cumbersome and take longer to close. And banks will only lend to him if he deposits money there, he said. He now has deposits with four banks and has to constantly move money among them.
Regulators have been warning banks about commercial real-estate lending for years. In 2015, the country’s banking regulators joined together to warn that high concentrations of commercial mortgages and poor risk management put banks “at greater risk of loss or failure.”
Many banks responded by making individual loans less risky, but collectively increased lending and loosened their underwriting standards in other ways.
Centennial Bank, based in Conway, Ark., became a big funder of developers building luxury skyscrapers in New York and Miami. Construction loans are among the riskiest types of real-estate lending.
John Allison, chairman of the bank’s holding company, Home BancShares, told the Journal in late 2019 that representatives from the Federal Reserve urged him to slow down the bank’s lending. “They’re telling us the construction lending space is going to blow up…and the world is coming to an end,” Allison recalled. “And I said, ‘You know what? I don’t see it.’” Centennial continued increasing its construction loans, although they grew more slowly than deposits during the pandemic.
Home BancShares said it didn’t lose money on construction loans and that a surge in deposits stashed away in supersafe investments reduced the bank’s risk. “If the big, bad wolf shows up it will hurt a lot of banks, but it won’t hurt Home BancShares,” Allison said in a recent interview.
In June, after the failure of three regional banks, Federal Reserve Chairman Jerome Powell called for “regulatory strengthening” for regional and local banks because of risky levels of commercial real-estate exposure.
Regulators’ playbook for banks now is similar to its strategy after the 2008 financial crisis: allow banks to work with struggling borrowers and allow them to keep mortgages on their books at face value in many cases.
That approach will be ineffective because interest rates have risen so much, said Tyler Wiggers, a lecturer at Miami University in Ohio and former adviser to the Federal Reserve Board on commercial real estate. “All of a sudden banks have borrowers who are saying, holy crap, I was paying at 3.5% and now I’m paying 7.5%,” he said. “If borrowers aren’t able to service their debt then banks have to recognize this as a bad loan.”
Banks are selling commercial mortgage-backed securities. While mortgage-backed securities helped cause the 2008-09 financial crisis, more recently issued securities are considered safer than their precrisis counterparts because lending standards are now more conservative. Banks own about half of the bonds outstanding, according to Bank of America Global Research, the result of a pandemic-era buying binge.
Banks added $131 billion to their CMBS holdings in 2020 and 2021. Real-estate companies happily met that demand by doubling their annual issuance to $110 billion in 2021, according to commercial real-estate data company Trepp. CMBS issuance fell to $16.4 billion in the first half of this year.
When banks were snapping up CMBS, property owners were able to load up on debt tied to their buildings. In early 2021, an affiliate of Brookfield Asset Management borrowed $465 million in CMBS and other debt against the Gas Company Tower, a 52-story office building in downtown Los Angeles.
At the time, appraisers valued the property at $632 million, according to Trepp, up from a valuation of $517 million when Brookfield bought the building in 2013. When the loans came due this February, the owner defaulted. An appraiser earlier this year cut the building’s estimated value to $270 million.
Written by Shane Shifflett