NEW YORK CITY—US bank lending into commercial real estate has now surpassed its pre-recession peak, a generally positive development. However, S&P Global Ratings warns that it’s not all good news.
“Exposure to CRE remains an important factor in our ratings on banks, and we believe the risk related to CRE has increased, which could have negative ratings implications over time,” says credit analyst Rian Pressman. An S&P article published this week notes that although the ratings agency’s assessment of each bank’s underwriting practices plays a critical role in its assessment of its CRE lending concentrations, lenders with higher concentrations may be at risk of downgrades “if the asset quality performance of the sector substantially worsens because of higher interest rates or deteriorating economic conditions.”
S&P identifies a number of pressure points for bank CRE portfolios that could be triggered by factors ranging from a spike in interest rates to exposure to markets or subsectors that pose risk. For example, markets directly exposed to the oil and gas industry raise a caution flag as far as S&P analysts are concerned.
Valuations in Houston’s office sector remain at risk “given the amount of space occupied by upstream and services companies within the oil and gas industry,” according to S&P. “We believe multifamily, retail, and industrial properties in energy regions may also be similarly affected over time, and we are carefully monitoring the exposures at our rated banks.”
Another emerging risk to bank asset quality is “CRE tied to overheated multifamily markets,” in S&P’s view. Citing the findings of the Office of the Comptroller of the Currency, S&P anticipates new construction to outpace demand, especially at the higher end of the market, with concomitant increases in vacancies and declines in rent growth. Although vacancy rates in general have been improving in sectors other than multifamily, S&P identifies certain CRE subsectors as troubled because of secular changes in the marketplace. “Retailers have come under pressure from evolving consumer preferences for purchasing goods online,” for example. “This has resulted in rising vacancy rates for brick-and-mortar retail locations nationwide. Shopping centers and strip malls have been particularly hard hit, particularly regional shopping centers (highly sensitive to a loss of an anchor tenant or ‘big box’ store) and lower-to-mid-range malls focused exclusively on retail (versus service providers).”
Similarly, S&P says, a secular change in the way people work has put a crimp on demand for suburban office buildings. Corporations have been relocating from the suburbs to city centers to attract Millennial-age employees. “Such moves also generally encompass a reduction in overall square footage, reflecting the proliferation of telecommuting arrangements,” according to S&P.
S&P sees bank exposure to retail and to suburban office parks as relatively limited. “However, increased delinquencies in this sector could result in possible contagion effects across other types of CRE,” according to S&P. “For example, banks are active lenders to REITs, and financial distress in retail or office subsectors of CRE could therefore indirectly hurt banks’ asset quality.
Last and certainly not least, S&P sees hotels as “particularly susceptible to cyclical economic weakness.” Judging by an analysis of default rates by property type for loans with debt service coverage below 1.0x, S&P says loans secured by hotels have a higher propensity to fall below 1.0x compared to other property types, “despite being originated at a higher going-in debt service coverage. Of the loans secured by hotels whose debt service coverage fell below 1.0x at some time during their loan term, 47% ultimately defaulted,” a much higher rate than for other property types.