Empty office

The troubled U.S. commercial real estate sector is a key vulnerability for banks, and a lingering source of potential financial market instability, suggests Morningstar DBRS.

In a new report, the rating agency noted that banks in a number of markets reported higher losses on loans to the commercial real estate sector — particularly the U.S. office sector, which is still feeling the lingering effects of the pandemic, amid an already-tougher interest rate environment.

“The combination of a significant increase in interest rates since mid-2022, weaker economic growth, and structural changes such as remote working have led to a sharp drop in demand for commercial real estate globally as well as a decline in value of the underlying collateral. As borrowers experience reduced financial flexibility, asset quality is starting to deteriorate,” the report said.

Indeed, it noted that in the fourth quarter some of the large U.S. banks, along with mid-sized, community banks, reported higher credit losses, driven by their commercial real estate exposures.

For instance, New York Community Bank reported that credit loss provisions jumped from US$62 million to US$552 million in the fourth quarter.

“In our view, medium-sized banks and regional banks are more vulnerable to further market deterioration, given that they typically have a higher proportion of commercial real estate within their loan portfolios,” the report said.

And that vulnerability isn’t limited to U.S. banks. Similarly, in Canada, weakness in the office sector has become “a main driver of credit quality deterioration” for the big banks, the report said.

For the big Canadian banks, gross impaired loans on U.S. commercial real estate represented 22% of total business and government impaired loans in the fourth quarter. That’s up from 17% in the third quarter, and 7.6% in the fourth quarter of 2022.

These stresses are likely to intensify, as the commercial real estate sector “remains under pressure globally amid higher refinancing risks and dropping valuations,” the report said.

Refinancing risks have increased due to higher interest rates, along with “the upcoming wave of debt maturities, tighter liquidity conditions and dropping property valuations,” the report noted — adding that in the U.S. alone, US$1.2 trillion of debt is set to mature in the next two years.

Given record-high vacancy rates in the office sector — which are unlikely to recede as hybrid work arrangements remain popular — commercial real estate valuations are likely to fall too, the report said.

“Against this backdrop, refinancing certain transactions, particularly in the office space, will likely require additional equity and/or restructuring. We also expect an increasing number of borrowers unable or unwilling to pay,” it said.

As a result, banks with exposure to the sector will likely face deteriorating credit quality too.

“In our view, many banks will need to make some downward revisions to property valuations and, as a result, incur higher provisions and loan losses,” the report said.

Beyond that, the deteriorating climate also poses a potential systemic risk, it warned.

“Given the renewed market pressure after the banking turmoil of last spring, we will continue to monitor closely any potential implications on depositor confidence and liquidity at banks,” it added.