Charge-offs and Bigger Reserves: Inside the CRE Crisis at the Regional Banks

Trillions of dollars in commercial real estate loans will mature in the next couple of years. During recent earnings calls, the regional banks sought to re-assure markets on how they are fending off a crisis. ’Extend and pretend‘ is not a strategy.

As yearend 2023 earnings season continues, a major concern for analysts following regional banks is commercial real estate exposure, especially on office properties.

A standout among the regionals reporting was Fifth Third Bancorp, which had some of the most upbeat news on the office front.

Fifth Third’s chairman, CEO and president Timothy Spence, noted the bank’s record full-year revenue and 5% deposit growth for 2023 (vs. an industry-wide decline) before addressing CRE.

“Although it would be foolish to expect it to repeat forever, in commercial real estate we experienced zero net charge-offs in 2023 and only two basis points in delinquent loans as of early January,” said Spence. He also reported that criticized office CRE loans came to a relatively low 6%. [Emphasis added.]

Analysts asked how the bank did all that.

Spence said disciplined screening of CRE customers was part of the story, but there was more to it.

“We’re underwriting commercial real estate, specifically office, at something below 60% loan-to-value,” said Spence. He said that borrowers were supporting their projects as well — “They’re writing checks to reduce the debt as necessary.”

Facing the Commercial Real Estate ‘Wall’

Spence also pointed out that the bank’s office CRE maturities were split evenly over the next four to five years.

“We don’t have that so-called ‘wall of maturities’ that we’ve heard from some other banks and that you’ve heard of in the marketplace.”

— Timothy Spence, Fifth Third Bancorp

The “wall” refers to a mammoth amount of CRE debt maturing in 2024 and beyond. Trepp, which tracks real estate trends, says that $2.2 trillion in CRE debt will mature between now and the end of 2027. Much of that debt will require refinancing. The catch, according to Trepp, is that the last time high levels of CRE debt were maturing, interest rates were much lower. The current “wall” will face today’s higher rates.

Office CRE debt faces challenges that will take some years to work through. In December, the Office of the Comptroller of the Currency issued its Semiannual Risk Perspective for Fall 2023.

“Risk in the office market remains high and is expanding beyond urban business districts,” the report said. “Although risk remains highest in urban core markets, vacancy rates are rising for suburban submarkets.”

The report pointed out that office CRE is undergoing multiple structural shifts simultaneously. New leases have been reflecting companies’ desire to trim back space — regional banks themselves are doing that, according to executive comments — as remote work practices continue to settle out.

“There is some resiliency in five-star and newer buildings, but these leases often include concessions, and, because of low demand, could negatively affect less well-situated properties,” according to the report.

The assessment also pointed out that the office market generates ripple effects, in that fewer employees in an urban business district means that smaller firms serving those people head into trouble and cause rising vacancy rates on their own CRE.

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CRE: Early Action and Reserves are Weapons of Choice

In general, other regional bank leaders didn’t have as good news to share as Spence. However, their general position was: “We’re on it and we’re working with borrowers to contain things.”

Where they can, they have minimized the portion of their CRE loans, and loans in general, that the office sector represented. In other cases, the emphasis was on early action and building reserves ahead of charge-offs. Leaders stressed the importance of communication with office CRE borrowers.

At Truist, Clarke Starnes, vice chair and chief risk officer, said that two factors are complicating the outlook. One is that there have been comparatively few sales of office real estate, making it hard to arrive at firm values. Another factor is that many leases are coming up for renewal, and it remains to be seen how drastically lessees will resize their needs for office space.

At Citizens Financial Group, Bruce Van Saun, chairman and CEO, said that reserves for the bank’s $3.6 billion office CRE portfolio had been hiked to $370 million. That 10.2% ratio, considered strong, is based on the bank’s outlook for the market, which Van Saun said “is much worse than we’ve seen in historical downturns.”

“We’re watching the maturity wall and we’re on top of all these credits, very carefully, and we’re working them out.”

— Bruce Van Saun, Citizens Financial Group

Van Saun said the bank was already restructuring some deals, while also reviewing where charge offs might be necessary.

At M&T, “one advantage we have in office is that we have a really good distribution of maturities,” said Daryl Bible, senior executive vice president and CFO. “Over two thirds of our maturities start in 2026 and beyond. So I think that’s a positive.” All of the banks continue to anticipate multiple Federal Reserve rate cuts over the course of 2024, though they didn’t always agree on the number of cuts that would be made.

Bible noted that M&T has been shrinking its CRE portfolio by about $3 billion a year for the last couple of years and that the portfolio would be shrunk by a like amount in the period ahead.

“We’re doing this on a measured pace so we can do it and still meet the needs of our good long-term clients,” said Bible. Where possible the bank is shifting CRE financing to off-balance-sheet alternatives.

At PNC Financial Services Group, office CRE represents 2.5% of the total loan portfolio, exceeded only by multifamily loans (4.8% of the total portfolio) among CRE categories.

“The CRE office portfolio is where we continue to see the most stress, and the fourth quarter’s net loan charge offs were $56 billion. We continue to expect future losses on this portfolio. However, we believe we’ve adequately reserved for those potential losses.”

— Bill Demchak, PNC Financial

The regional bank Q&A sessions demonstrated that some perspective helps when looking at the regionals’ aggregate numbers.

Read more: 7 Keys to De-risking Commercial Real Estate Lending

Keeping Perspective on Office CRE

At Huntington Bank, for example, analysts cited an increase in commercial real estate net charge offs, all from the office portfolio. Brendan Lawlor, deputy chief credit officer, said that the $20 million in charge offs in the fourth quarter was driven by only three transactions. In response, he said, the bank has increased its reserves for office CRE. (CRE represents 10.2% of the bank’s total loan portfolio, led by multifamily loans at 3.9% of total loans, industrial loans at 1.7%, and office CRE loans at 1.5%.)

At KeyCorp, exposure to office CRE is minimal, with two-thirds of the bank’s CRE portfolio consisting of multifamily loans. Steven Alexopoulos, senior equity analyst at JPMorgan Securities, told Chris Gorman, chairman and CEO, that a perception was growing in the market that banks had fallen into an “extend and pretend” pattern, hoping to wait things out.

“I know you don’t have a large office portfolio, but I’m sure some of them came up for renewal,” said Alexopoulos. “What’s happening? Are you able to renew because the LTV, like you said, was 60%?”

Gorman said a historical viewpoint was helpful here.

“We had outsized losses in real estate during the financial crisis, and we said we’d never do that again, and we literally ripped the business down to the studs and rebuilt it, and rebuilt it around an underwrite-to-distribute model,” said Gorman.

He added that the bank has been very selective in who it works with in real estate over the post-crisis period.

“What’s happening on the ground is because of the people that we’re financing, when we go through the math and because of the rise in interest rates, because they qualify as a criticized loan, we go to them and we ask them for an interest reserve,” said Gorman, “and they give it to us.” An interest reserve account, funded by the borrower, gives the lender some protection on interest payments.

Gorman says this and other steps the bank began implementing a decade ago are paying off in the current environment.

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