Report: Fears of Bank Loan Portfolios Overstated, but 70% Office Loans To Default

With $440 billion of loans backed by commercial real estate properties set to mature this year, there have been plenty of fears around the health of the nation’s banking system — but the threat is overstated due to improved lending and transaction metrics at commercial banks. 

That’s the conclusion from a new report by Moody’s Ratings that analyzed credit metrics of 41 U.S. commercial banks and found that most loans have been conservatively underwritten and there is enough tangible common equity in banks’ reserves to withstand either refinancing challenges or loan defaults. 

Kevin Fagan, head of research at Moody’s Analytics, emphasized that the amount of outstanding CRE debt for banks remains the same as it was in September 2023, with the nation’s largest banks increasing their CRE lending activity slightly, the regional banks declining their exposure, and community banks actually growing CRE debt totals by 9 percent, mainly through office deals. 

“By and large, the exposure is pretty steady, regardless of the tumult we’ve seen over the last year,” said Fagan, who added that average commercial bank loan-to-value (LTV) ratios on CRE deals have climbed back up to pre-pandemic levels.

“They had gone down to below 60 percent, but now they’re in the 66 percent to 67 percent range, so there’s some loosening going on as we’re getting clarity on the riskiness of the market and which assets are stable and which ones are the highest potential for loss,” he explained. 

Moody’s noted that the U.S. is now nearly eight full quarters into “a down cycle” — where transaction volumes and lending volumes are negative year-over-year across each quarter. 

However, the ratings agency also noted that the market hit an inflection point in the first quarter of 2024 in terms of capital markets activity, with life insurance companies, the commercial mortgage-backed securities markets, and debt funds all showing positive lending and transaction volumes year-over-year. 

“It looks like we are going to be in positive [transaction] territory for Q2 2024,” said Fagan. “The May data isn’t quite done yet, but early indications are we’re heading out of this where we pick up [transaction volumes]. … We were 6 percent below the prior year volume, but it looks like we’re going into positive territory.”  

Fagan noted that large multifamily deals, along with industrial and non-mall retail deals, are driving positive transaction volumes that are close to the 2019 threshold for regional banks. He emphasized that the commercial bank lending sector is seeing more demand for CRE debt from borrowers, even as underwriting standards are tightening. 

But there are some areas of concern for the banking system. 

At the beginning of the year, $930 billion in CRE loans were expected to mature across all lender types, with $440 billion of those maturities scheduled to come from banks. 

In terms of distress, nonperforming assets haven’t yet impacted the commercial banking sector too seriously, and those issues have thus far centered around the nation’s largest banks and their loans backed by non-multifamily assets — office, for example.

Banks with greater than $250 billion in assets have seen their share of delinquencies rise over 3 percent in 2024, while smaller banks’ delinquencies remain below 1 percent. That said, roughly 70 percent of bank office loans are not paying off at maturity, according to Moody’s. 

With one quarter of banks’ CRE loans set to mature before the year is out, the problems around the office sector are expected to come to the surface — but still not prove fatal.  

“With maturities coming up, we are likely to see those bank delinquency rates go up beyond the pretty benign level they are at right now,” said Fagan. “If one-third of those [loans coming due] are office, half of those are going to default for real, then you’re looking at 4 percent of bank loans [being in the red], so it’s a relatively small percentage even with a draconian estimate of what’s going to happen with office.” 

This optimistic conclusion comes with several chunks of data to buttress the hopeful outlook.

Average LTVs in loans originated by U.S. banks “are fairly conservative,” in the 50 percent to 60 percent range, and that average debt yields are in the high single digits, indicating that most CRE properties can still pay off mortgage rates as they are refinancing around a 7 percent interest rate, per Moody’s.  

Even so, most of their CRE loans will mature by the end of 2025, and these maturities are equal to 63 percent of tangible common equity (TCE)  for the median bank — a metric of financial strength that indicates how much pain a bank can withstand. 

The 41 banks Moody’s surveyed have an average of nearly 13 percent of TCE exposed to CRE loans with a debt service coverage ratio (DSCR) below 1.0x — the general threshold indicating that the asset’s revenue cannot service its debt metrics. That’s a noticeable amount, per Moody’s analysis. 

In other words, many U.S. banks won’t have the capital on hand to service their loans as they either default or mature into a higher interest rate environment as sponsors seek refinancing. 

As interest rates rise, assets with already low DSCRs are likely to further erode as the lack of inability to service the debt on the loan restricts refinancing options within an existing capital structure. 

“It’s an interest rate story. Leaving inflation higher for longer is problematic for CRE asset classes,” said Stephen Lynch, vice president and senior credit officer at Moody’s. “We did find that, on the whole, the underwriting came in pretty well, but we did see property types that are risky exposures that lead to large losses for individual loans.” 

Brian Pascus can be reached at bpascus@commericalobserver.com