Investors may be looking at commercial real estate risk all wrong and missing these opportunities
The threat from a looming wave of maturing commercial real estate loans has been well telegraphed to investors, but it’s possible the metrics they are using to protect themselves from risk are flawed. Many investors have been avoiding bank stocks with high concentrations of commercial real estate (CRE) exposure. However, that metric may miss banks that have riskier loans on their books despite having lower concentrations of CRE. For that reason, investors may want to take a more granular look at the types of loans a bank holds. In doing so, they may find some larger banks are on shakier ground than their CRE concentration suggests. Wall of maturity About 30% of outstanding CRE debt is due to mature between 2024 and 2026, according to data provider Trepp. When this debt matures and the property owners look to refinance, borrowers will face much higher debt payments due to rising interest rates, and economics could become untenable, especially given that the value of many office properties has declined. Owners may decide it’s easier to just to hand back the keys and walk away. The heightened concern about default risk is clearly weighing on bank stocks, which are already fighting the headwinds of higher interest rates. Indeed, the gap between both the KBW Bank Index (up about 4% year to date) and the SPDR S & P Regional Banking ETF (KRE) (down 12% year to date) versus the S & P 500 Index (up nearly 14%) is even wider now than it was during the regional bank crisis in the spring of 2023, UBS analyst Erika Najarian wrote in a research note Thursday. For the moment, the troubled loans are contained. According to CoStar , about 1.23% of all outstanding CRE loans are considered at risk, but the trend may be heading in the wrong direction. At the end of the first quarter, the Federal Deposit Insurance Corp. said the amount of real estate loans past due or in nonaccrual status was $35 billion, up 9% from the fourth quarter of 2023 and 59% higher than the same period a year ago, marking the highest level in 11 years. Investors have been punishing regional bank stocks, especially when the bank’s commercial real estate exposure tops more than 300% of its total equity . That is a benchmark the Federal Reserve has deemed excessive. Stephens analyst Matt Breese said that many of the Northeast and Mid-Atlantic banks he covers that have CRE concentrations above 300% are trading below total book value. But CRE concentrations shouldn’t be the only consideration for investors. Past due loans Stephens analysts have noted that the FDIC’s first-quarter banking profiles revealed that banks with more than $250 billion in assets are the ones seeing an acceleration of past due loans, despite having some of the lowest CRE concentrations. The rate of troubled loans in this group was 4.48% in the first quarter. The analysts said that was far above the 1.47% rate at regional banks and 0.69% at community banks. The trend likely reflects that some of the bigger banks have exposure to large, high-profile office properties in major metropolitan areas. These properties have been particularly hard hit by downtown areas that were battered by the pandemic and companies that are looking to downsize their real estate needs in an age of hybrid work. The Kansas City Fed also called this out in a report , saying that the risk of default from office properties rose with the size of the property. It estimated that if a property was larger than 500,000 square feet, it had a 22% risk of default, while a building that was smaller than 150,000 square feet might have a default risk of less than 5%. In other words, community banks might be less risky than the CRE exposure figure would suggest. According to Breese, there isn’t one single metric that can be easily isolated, but investors could consider the average loan size at a bank as well what asset classes are exposed to interest rates and some of the other negative forces at play. “I think you start to isolate a much smaller piece of that pie,” he said, in an interview. Within Breese’s coverage area, his top stock picks are NBT Bancorp ., Webster Financial and Valley National Bancorp . While the latter two have some exposure to New York City real estate, both banks benefit from strong management teams, he said. (New York real estate markets are navigating both falling office values as well as the dynamics of rent-regulated multifamily properties.) Still, even these stocks are likely to have a tough go as long as interest rates stay high and fears about CRE persist. Connecticut-based Webster has fallen more than 22% year to date, while New Jersey’s Valley National has tumbled 40%. NBT, down about 16% year to date, has fared slightly better. NBTB YTD mountain NBT Bancorp shares year to date. Breese sees NBT as both a defensive and offensive play as it has strong funding and a low CRE concentration of 203%. It also has a compelling opportunity ahead as an upstate New York bank located in an area that is seeing a lot of investment in semiconductor manufacturing from companies such as Micron Technology . UBS’ Najarian said the bank scanned stocks that were both sensitive to interest rates and had the most CRE exposure and Providence, R.I.-based Citizens Financial Group had the “most compelling stand-alone ‘story.'” She cited factors such as private banking traction and a reduced drag from swaps as two catalysts. For larger banks, the sentiment could be improving, according to Piper Sandler analyst R. Scott Siefers. In early June, he explained that the larger banks have fewer outstanding “wildcards” and improving fundamentals such as the chance for a turnaround in net interest income and a bounce in investment banking business even with higher interest rates. Siefers also likes Citizens Financial as well as Cleveland’s KeyCorp. He has an overweight rating on both stocks. Citizens is up less than 3% year to date, while KeyCorp. shares are down nearly 7% over the same period. “Financial-only investor interest has increased, though generalists still seem mostly disengaged,” Siefers wrote.
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