Regional Banks Continue Feeling Pressure From Office CRE Loans

For some time, many government bank regulators, analysts, and others have assumed that the weak link in commercial real estate lending by financial institutions has been smaller than community ones. But a new analysis by Reuters suggests that regional banks are feeling the strain of lending, especially on office projects. And a previous deep dive by Morningstar said that the 4,100 or so community financial institutions that represent 90% of commercial banking are in better shape now than before the pandemic.

Start with the Reuters analysis that examined earnings reports from “nearly a dozen mid-sized and regional” U.S. commercial banks. The organization compared third-quarter reports in 2024 to those from 2023 and looked at the percentages of non-performing loans (NPLs) in their commercial real estate loan portfolios. These were loans in which the borrowers missed scheduled payments.

The first question to ask is how representative fewer than a dozen banks might be. Regional and mid-sized banks range in size between $10 billion and $100 billion in assets, which is roughly 104 banks according to the Federal Reserve’s June 30, 2024 list of financial institutions with at least $300 million in consolidated assets. A dozen examples, assuming they were taken randomly, would be far smaller than the number needed to get a 95% confidence interval with a 5% margin of error. So, the Reuters analysis is anecdotal and not statistical. This can’t necessarily be extrapolated to explain the entire population of mid-sized and regional banks.

That said, close to a dozen this size that are growing problems with CRE loans are not a good sign. Reuters didn’t provide average or median comparisons but did specifically call out some banks.

For example, Flagstar Financial, the new name of New York Community Bancorp, took a $388 million charge-off on its $2.6 billion office loan portfolio. KeyCorp saw 5.1% in its small office portfolio as NPLs. The year before, the number was 2.3%. In the third quarter of 2023, NPLs were 0.16% of its office loans, while in 2024 it rose to 0.18%. As Reuters noted, KeyCorp hasn’t been originating new office loans.

“I anticipate continued challenges in CRE in the years ahead. Office demand has been reduced by remote work adoption. Retail space faces a similar headwind from e-commerce adoption. Warehouses were over-absorbed in the pandemic period and have begun a period of normalization,” Jason Benowitz, senior portfolio manager at investment firm Segall Bryant & Hamill, told Reuters.

Community banks with less than $10 billion in assets by the Fed’s definition — are in contrast doing better. In the second quarter of 2024, overall that group made a 0.95% return on assets and a 9.60% return on equity, with 93% of them profitable in the second quarter of 2024, according to Morningstar. Net income was up over the first quarter “despite higher loan loss provisioning with community banks generating positive operating leverage,” the firm said. Net income interest and net non-income interest grew faster than non-interest expenses.

The amount of commercial and multifamily real estate loans was the sum of multifamily residential (7.52%), nonfarm nonresidential (30.54%), and construction and development (8.21%), or about 46.3% of the total loan mix. According to Morningstar, the CRE loans “have held up better than we have expected given higher interest rates, inflationary pressures, and lower valuations.” It’s unexpectedly good news given all the speculation about CRE loans that banks hold.