How commercial real estate challenges are affecting banking

April 8, 2024 5:30 AM

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Commercial real estate continues to struggle to recover from pandemic-era changes, which have led to more vacancies in buildings — particularly office spaces — as well as higher interest rates. Banks across the country are fighting to prevent these issues from becoming bigger problems.

New York Community Bancorp's (NYCB) recent struggles highlight the rapidly declining value of rent-regulated apartment loans in New York City. Although banks have been making those loans for decades, the combination of the Housing Stability and Tenant Protection Act, which was passed in New York state in June 2019, along with rising interest rates and inflation has made it more difficult for landlords and property managers to turn a profit, said Wedbush Securities analyst David Chiaverini.

Since 2019, rent-regulated property valuations in New York City have been cut in half, said Seth Glasser, a multifamily real estate broker at Marcus & Millichap. The Housing Stability and Tenant Protection Act, which capped rent increases, limited the size of returns that landlords could earn for making renovations and eliminated eviction plans, among other provisions, was a turning point for rent-regulated properties.

Chiaverini said this legislation is squeezing net operating income at some rent-regulated properties, making it harder for borrowers when those loans mature in a higher-rate environment. Additionally, the costs of renovating and maintaining properties have increased, and rates have roughly doubled, but rent increases have been forbidden, according to Glasser.

NYCB's newly appointed CEO, Alessandro "Sandro" DiNello, said last month that the bank would be "laser-focused" on reducing its commercial real estate concentration as quickly as possible. For rent-regulated multifamily properties, though, Chiaverini said there's no quick fix.

Like NYCB, Valley National Bank is highly concentrated in commercial real estate: CRE-related loans make up around half of Valley's portfolio, which consists of a mix of apartments, retail buildings, offices, industrial buildings and health care facilities. Its portfolio is largely in New Jersey, New York City, elsewhere in New York state and in Florida, where Valley expanded years ago to diversify its footprint.

The office sector has struggled the most after it was hit particularly hard by the shift to remote work, with floors of office buildings continuing to remain empty, especially in New York City. Fortunately, Valley has largely stayed away from the big office towers in Manhattan that are facing steep declines in their value. Its office portfolio is instead largely made up of smaller buildings in suburban areas, and the bank's executives say the owners of those buildings remain in good shape.

If those property owners happen to face troubles, Valley's small-building focus makes it easier to turn a troubled office property into apartments or industrial centers, said Valley President Tom Iadanza. Government officials across the country have explored turning stressed office buildings into new housing, but they're finding that it's hard to make the math work.

"You can't take a Midtown high-rise and convert it to anything else today. Financially, it just doesn't work," Iadanza said, contrasting that with Valley's office loans where "you can do a lot more because it's not as big a space."

These trends have led Treasury Secretary Janet Yellen to address the current state of commercial real estate and its impact on banking. "There are some institutions that will face stresses from commercial real estate that we know was significantly impacted, particularly office buildings by the pandemic," Yellen said in recent testimony to the Senate Banking Committee. "Interest rates are higher, loans will need to be refinanced in an environment with higher interest charges, lower valuations and rising vacancy rates, so for some banks this will be a concern. But on balance, I think the system is well capitalized."

Read more below on how banks and the government are navigating the current challenges and apprehensions in commercial real estate.

NYCB struggles amid declining value of rent-regulated apartment loans

New York Community Bancorp's stock price has tumbled nearly 75% since the start of the year, as roughly one-fifth of all loans held by the Long Island-based bank are exposed to the New York rent-regulated multifamily market, according to Wedbush Securities.

New York Community built its business with landlords and property owners in the rent-regulated sector over the course of decades. But recent challenges, including an unexpected dividend cut and a poor fourth-quarter earnings report that included a large loss provision, have exacerbated scrutiny of the bank's vulnerability to weaknesses in the commercial real estate market.

"The good news is that this is very much unique to New York Community Bank in terms of the outsized exposure that they have to this asset class," Wedbush Securities analyst David Chiaverini recently told American Banker's Catherine Leffert. "The 2019 regulation laws that became more onerous, combined with interest rates having gone up as much as they have — that double whammy is what led to the most recent quarter's surprise in terms of how much [New York Community] needs to set aside."

Read more:

Troubles at NYCB highlight pain in rent-regulated real estate

Valley National Bank remains confident among CRE troubles

Valley National Bank's stock price, which fell sharply during last year's banking crisis, has tumbled 17% since turmoil hit the neighboring regional lender New York Community Bancorp. But executives at Valley, along with analysts who follow the bank, note that its loans are more diversified than New York Community's apartment-heavy portfolio and that it has a solid track record at keeping losses contained.

"Not all CRE portfolios are created equally," Travis Lan, Valley's deputy chief financial officer, said in an interview with American Banker's Polo Rocha.

The bank acknowledges its high concentration in commercial real estate, a constant source of investor angst as some offices sit empty and other types of buildings struggle with rising interest rates and costs. Valley is among the few regional banks — New York Community is another — where commercial real estate loans make up more than 300% of total capital, a threshold that triggers additional regulatory scrutiny.

Read more:

Valley National Bank, heavy on CRE, is confident despite investor worry

Bank 'stress' due to CRE losses is inevitable, according to Yellen

Treasury Secretary Janet Yellen testified before the Senate Banking Committee regarding higher vacancy and interest rates in commercial real estate and the impact on the banking sector, as New York Community Bancorp is facing turmoil including rapidly-installed new leadership, while trying to quell fears about its exposure to the commercial real estate sector and rapid selloff of shares.

"So it's obvious that there's going to be stress and losses that are associated with this," Yellen said in her testimony. "The banking supervisors are working with their banks to manage this risk and identify it. I believe this will not end up — I hope — being a systemic risk to the banking system."

The Financial Stability Oversight Council, which Yellen chairs, is working with bank supervisors to understand exposures, she said.

Read more:

Yellen expects bank 'stress' due to commercial real estate losses

Smaller and midsize lenders aren’t worried about CRE downturn

Small and midsize lenders with substantial exposure to CRE are not worried about how a downturn in commercial real estate could hurt the U.S. banking sector.

Banks whose commercial real estate portfolios have come under the microscope include Cullen/Frost Bankers, BankUnited, Bank OZK, WaFd Inc. and Brookline Bancorp. At all five of those banks, executives sought during recent earnings calls to reassure analysts about their commercial real estate books, even as high interest rates and remote work stamp the sector with question marks.

The largest of the bunch, the $49 billion-asset Cullen/Frost, reported a rise in charge-offs during the fourth quarter. But CEO Phil Green said Thursday that commercial real estate loans, which make up 36% of the bank's $18.8 billion book, weren't the source. "We saw an increase in problem loans this quarter," he said during the company's earnings call, "but it really wasn't from commercial real estate at all."

Read more:

Smaller regionals brush off commercial real estate worries

Bank merger delayed by deteriorating CRE credit

The $28 million, all-stock deal between Bank 34 and the Commerce Bank of Arizona (CBOA), was announced nearly a year ago and had to be completed within a year. However, both companies agreed at the end of 2023 to extend the completion deadline two months to June 28 after a deteriorating commercial real estate credit forced Bancorp 34 to restate third-quarter earnings.

Bancorp 34's difficulties come as banks around the country have dramatically scaled back commercial real estate originations in the wake of rising delinquencies. According to a report issued earlier this month by Trepp, third-quarter CRE originations by banks totaled $2.5 billion, down 46% on a linked-quarter basis and nearly 70% year over year. A recent academic paper, moreover, concluded nearly half of banks' office loans — one of the five CRE property types Trepp tracks — appear to be underwater, with loan balances in excess of an individual property's value.

Read more:

Troubled CRE loan delays merger plans for Arizona banks