Regional banks with commercial real estate exposure still face risks

Near the beginning of February, we received some worrying news from the banking world. Credit rating agency Moody's downgraded New York Community Bancorp's rating to junk. Meanwhile, NYCB reported significant losses due to commercial real estate loan failures.

Commercial real estate is an area that is struggling given how the pandemic has changed our work and lifestyle habits. But are there more challenges ahead for banks with exposure to commercial real estate, or are the risks too much?

Kevin Fagan is Head of Commercial Real Estate Economic Analysis at Moody's Analytics, but please note that the firm operates independently of Moody's Credit Ratings. He wrote a new article about this and talked about it with “Marketplace Morning Report” host Sabriben He Akul. Below is an edited transcript of their conversation.

Sabri Ben Akour: Can you explain the relationship between commercial real estate and banks, especially local banks, and why so many people are concerned?

Kevin Fagan: There's actually one slightly frivolous reason why people are worried. Because last year, some bad data came out that suggested banks' exposure to commercial real estate was higher than it actually was. There was a statistic of 80%. [commercial real estate] The loan was from a local bank. That's clearly not true. But now some of these local banks actually have high exposure. And many loans will mature in 2024. Some of them will result in losses.

ben ashour: Well, that seems to be happening at NYCB as well. Is NYCB a sign of things to come?

Fagan: That's true in a way, but I think this story is more nuanced than many of the headlines suggest. Commercial real estate, if you think about it, is really the physical manifestation of the entire economy. As you know, offices reflect the employment that uses them. It's really a mirror of the entire economy. Therefore, it tends to rise and fall. But my point is that this cycle is actually relatively benign from peak to trough in vacancy rates, even for offices. And in fact, while rents have not kept up with inflation, they are actually rising.

But to answer your question directly, this is a sign of things to come, as other banks are also having challenges. But unless something else is going on, they won't face any problems. There's something wrong with their business model. And there was actually a lot more going on at NYCB.

ben ashour: We understand that many people are still working from home. We know that leases are long-term and are still being renewed and renegotiated. Wouldn't you be surprised about this photo especially for the office?

Fagan: The office remains a very important part of the workplace. Obviously, it will evolve into a different situation in the future, but it will still exist as a necessity.

In fact, what's happening in the office is not unprecedented. The 1990s saw a period of massive consolidation in how companies used office space, going from about 250 square feet of office space per employee to about 125 square feet per employee. However, office values ​​and rents continued to rise. The reason is that we have shifted from manufacturing to services and professional services. As a result, the employment rate for office users increased at a faster pace than the general employment rate, and offices were filled despite a net decrease in demand.

So while some more banks will suffer, other asset classes that are doing well will help them. If you're doing well as a business, you'll do pretty well. And even an office has a recovery rate, and you can extend that maturity a little bit more, especially if you think the recovery potential of an office is high.