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The Canadian banks are likely to face rising credit stress in their commercial real estate portfolios, but these exposures should ultimately prove manageable, says DBRS Morningstar.

In a new report, the rating agency said the office sector in both Canada and the U.S. faces “significant challenges” — amid high vacancy rates, high interest rates and weaker valuations — and represents a key concern for the Canadian financial sector.

“In DBRS Morningstar’s view, headwinds facing the office sector, which include oversupply, obsolescence and work-from-home dynamics, are secular, and the sector will take longer to recover than during normal cyclical lows, particularly in weaker markets,” it said.

At least in the near term, office occupancy rates are unlikely to return to pre-pandemic levels, DBRS said, and it maintains a negative outlook on the sector in both Canada and the U.S.

Given these conditions, it’s expected that credit metrics for office loan portfolios will ultimately deteriorate too.

“The Big Six’s impaired loans on [commercial real estate] have started to tick up, and a substantial portion of the increase is likely being driven by the U.S. office portfolio,” the report said.

“Significantly higher interest rates and easing but persistent inflation continue to weigh on the industry,” the report also noted. It added that lending growth in the commercial real estate sector “declined sharply” in the banks’ fiscal third quarter (to July 31), as the early signs of credit stress appeared in these portfolios.

“Outstanding office loans declined quarter over quarter as the banks have tightened lending, and appetite for new loans is highly limited, while total [commercial real estate] loan growth slowed considerably, averaging just 0.1% for the quarter, driven by a cautious approach to the industry and a slowing market,” it said.

DBRS also noted that any credit losses that do materialize should prove “manageable” as these exposures remain relatively modest within the banks’ overall loan books.

It reported that total office exposure at the Big Six was approximately $51 billion in the third quarter, “representing just 1.2% of total loans and acceptances on average.”

“Canadian banks have prudently limited new lending in the office space and are closely monitoring and increasing provisions for credit losses on existing [commercial real estate] loans,” said Josh Veenkamp, assistant vice-president at DBRS, in the report. “Conservative underwriting should help mitigate potential credit risks, with generally low loan-to-value levels at origination providing a buffer against collateral value risk.”