Is it time to start worrying about asset quality in the commercial real estate sector?

Nonperforming loans in the non-owner occupied segment of CRE ticked up in the first quarter, according to BankRegData.com. It was the first worsening in the category since 2010.

Some bankers and industry observers shrugged off the increase in problem loans, saying a slight uptick is to be expected given the robust demand for CRE loans of all types these days. It should be noted, too, that while total nonperforming loans on non-owner-occupied properties increased 4.3% from the fourth quarter, to $4.8 billion, they are still down 29% from a year earlier and 53% from two years earlier.

Still, the situation could be cause for alarm, especially when also taking into account other economic indicators that can affect credit quality. Markets such as Houston and Washington, for example, are experiencing high office-vacancy rates and staring at a glut of apartment buildings and other properties — yet new construction continues.

"We have been worried and we continue to monitor it," said Victor Pierson, the chief executive of the $1 billion-asset Moody National Bank in Galveston, Texas. The worsening of nonperforming CRE loans "suggests that there is a softening, whether from oversupply or soft demand."

In suburban Maryland and Virginia, some entire office buildings sit completely vacant, said Ron Paul, chairman and chief executive of the $6.1 billion-asset Eagle Bancorp in Bethesda, Md.

"Some of these buildings are inefficient to lease and the tenants are moving out," Paul said.

The slight weakening of asset quality on non-owner-occupied loans comes at a time when regulators are expressing growing concern about banks' CRE exposure.

More than 1,400 banks with less than $10 billion in assets have CRE to total risk-based capital ratios that exceed 300%, according to Chris Marinac, an analyst at FIG Partners. The 300% threshold is only a guideline, but any bank over the line can expect to get a call from its examiners, Marinac said.

"More scrutiny is the expected result of higher CRE concentrations above 300%," Marinac said. Bankers will need to defend themselves and explain how their internal processes provide the necessary cushion if those loans go bad, he said.

To be certain, asset quality for CRE loans is as pristine as it's been in years. Rates of nonperforming loans in the multifamily, construction and both owner-occupied and non-owner-occupied categories have all declined steadily over the last five and a half years.

Wells Fargo, one of the few banks to break out CRE lending by subcategory, has reported declines in nonaccrual rates for each of the past two quarters on loans across its entire CRE portfolio, according to data compiled by Trepp LLC. That portfolio consists of office buildings, apartments, warehouses, retail properties and shopping centers.

Some specific markets, such as high-end residential real estate in New York, could be "a little bit overheated right now," Tim Sloan, Wells Fargo's president and chief operating officer, said during a June 3 presentation to investors. But, overall there are no commercial markets "where we've got the big flashing red light," Sloan said.

But the slight blip that happened during the first quarter could be the canary in the coalmine for CRE loans, said Bill Moreland, a partner at BankRegData.com in Dallas. Part of the reason is that many banks have accelerated their CRE loan growth, he said. At March 31, banks had $1.54 trillion of CRE loans on their books, up 9.2% from a year earlier, according to Federal Deposit Insurance Corp. data. In the non-owner-occupied category, total loans increased 10.6%, to $751.6 billion, according to BankRegData.com.

Responding to fast growth in the category, regulators in December issued a joint statement expressing concerns about underwriting standards and risk-management procedures.

"Financial institutions should maintain underwriting discipline and exercise prudent risk-management practices to identify, measure, monitor, and manage the risks arising from CRE lending," federal banking regulators said in the statement.

Additional hints of trouble have popped up in local markets. Some luxury apartment buildings in the Houston area have recently begun offering months of free rent, in order to lure customers, Pierson said. That's never a good sign, he said.

"They're having to give away too many incentives," Pierson said.

The potential for interest rate hikes later this year could also cause problems on loans on properties that are under construction, said Candace Wiest, the CEO of the $51 million-asset West Valley National Bank in Goodyear, Ariz. The Phoenix market already has too many new multifamily projects underway, she said.

"I am stunned by the number of new apartments in the metro area," Wiest said. "If a real estate project is in trouble now, a 50-basis-point increase isn't going to make it prettier."

But Marinac said there's no reason to panic. Banks can continue to make new CRE loans, even in areas where the market seems overheated or there is an abundance of vacant office buildings, as long as they adjust pricing and terms accordingly.

"They simply have to be cautious and I would advocate getting a higher loan rate to compensate for the higher risk," Marinac said.

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