Commercial Real Estate and Financial Stability: Evidence from the US Banking Sector

Salih Fendoglu

doi:10.5089/9781513578286.065.A001

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Commercial Real Estate and Financial Stability: Evidence from the US Banking Sector

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Mr. Salih Fendoglu

Mr. Salih Fendoglu
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Publication Date:: 26 May 2021

eISBN:: 9781513582894

ISBN:: 9781513582894

Language:: English

Keywords:: commercial real estate, banking, loans, nonperforming loans; charge-off rate; price scenario; loan ratio; CRE lending; price decline

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This note analyzes the implications of changes in commercial real estate (CRE) prices for the stability of the US banking sector. Using detailed bank-level and CRE price data for US metropolitan statistical areas, the analysis shows that, following a decline in CRE prices, banks with greater exposures to CRE loans perform worse than their counterparts, experiencing higher non-performing CRE loans, lower revenues, and lower capital. These effects are particularly pronounced if the drop in CRE prices turns out to be persistent because of possible structural shifts in CRE demand—for example, because of an increased trend toward e-commerce and teleworking—even after the coronavirus disease (COVID-19) pandemic is over. The impact of a decline in CRE prices is especially true for small and community banks, which tend to have the highest CRE loan exposures. While the US banking sector has remained resilient during the pandemic crisis due to strong capital buffers and massive policy support, these findings suggest that continued vigilance is warranted with regard to potential downside risks to CRE prices amidst ongoing structural shifts in the sector.

Abstract

Introduction^†

The commercial real estate (CRE) sector in the United States has been hit hard during the COVID-19 pandemic. Following lockdown measures introduced to contain the spread of the virus and the associated decline in social mobility, the demand for contact-intensive CRE spaces such as traditional brick-and-mortar retail, restaurants, hotels, and offices plunged significantly in 2020. Consequently, CRE transaction volumes and prices, particularly, in the hotel, retail, and office segments, declined sharply (Figure 1). Compared to other regions, the decline in CRE transactions and prices has been more pronounced in the United States.

While the adverse shock to the CRE sector could be considered as temporary, at least partly reversing as the pandemic is brought under control and the economy recovers, the preexisting structural trends towards increased digitalization, e-commerce, and working-from-home—which have further accelerated during the pandemic crisis—create considerable uncertainly around the outlook for the sector and suggest that further price declines may be possible, at least in some CRE segments. Given the heavy reliance of the sector on bank financing in the United States,¹ a significant downward pressure on CRE valuations as a result of a persistent drop in demand could be a potential source of stress for banks, especially for those with large CRE exposures, and pose financial stability risks (IMF, 2021).²

Against this backdrop, this note uses detailed US bank-level data and location-specific CRE prices over the period 2001–2020 to investigate the following questions:

How does a decline in CRE prices affect banks’ profitability and solvency?
How large bank capital losses could be if CRE prices were to remain depressed permanently?

To address these questions, the analysis proceeds in three steps. First, the effect of CRE loan exposure on bank performance is empirically identified. Next, these estimates are used to conduct a capital loss scenario, which assesses the credit and revenue losses that banks may incur under different CRE price forecasts, and potential bank capital losses based on a forward-looking provisioning rule.³

The findings show that, following a decline in CRE prices, banks with ex-ante higher CRE loan exposures perform considerably worse. They experience a significantly higher CRE non-performing loans ratio, higher CRE loan charge-off rates, lower revenues, and lower capital. Bank capital losses are estimated to be modest on average under a variety of CRE price scenarios, but significantly larger for small and geographically concentrated community banks, especially if the CRE price drop were to be persistent. As such, policymakers should remain vigilant amidst ongoing structural shifts in the CRE sector, and may benefit from maintaining the frequency of stress tests for small/community banks to assess financial stability risks in a timely way. ⁴

Bank Financing of the Commercial Real Estate Sector

Commercial banks are important players in the CRE debt market in the US, and CRE lending is a significant component of their overall business lending. ⁵ On average, CRE loans accounted for nearly half of the total business loans made by banks over the last decade (Figure 2, panel 1). Beyond the sheer volume, which surpassed $2.3 trillion prior to the pandemic, a disproportionately large share of these loans has been extended by small- and medium-sized banks (defined as banks with total assets less than $100 billion). Although such banks collectively account for about 30 percent of total banking sector assets, they hold a much larger share (two- thirds) of overall CRE loans (Figure 2, panel 2). CRE loans also make up a significant share of US banking sector assets, constituting about 6 percent for large banks and 30 percent for small banks (Figure 2, panel 3).

A high bank exposure to CRE loans can raise financial stability concerns. In fact, high CRE loan exposures have historically been a key determinant of bank failures in the US, as observed for instance in the aftermath of the global financial crisis during which overall CRE prices declined by 30 percent (Figure 3). ⁶ The high concentration of CRE loans in smaller banks is also a cause for concern, as these banks tend to have a lower capacity to raise external funds especially during episodes of market stress (Kashyap and Stein 2000). Given that these banks have more geographically concentrated exposures, ⁷ stress in these banks could have important regional implications.

CRE Price Changes and Bank Stability

The empirical analysis shows that a decline in CRE prices has a significant impact on bank CRE loans, revenues and capital. ⁸ Following a decline in CRE prices, banks with ex-ante higher CRE loan exposures experience significantly higher CRE non-performing loan ratios and CRE loan charge-off rates (Figure 4, panel 1a). As CRE loans underperform and the resulting provisioning expenses are higher for banks with a greater CRE exposure, they experience a stronger decline in pre-provision net revenues and regulatory capital (Figure 4, panel 2a).

Quantitatively, following a one standard deviation decline in local CRE prices over an eight quarter horizon— which corresponds to a 16 percent cumulative decline in CRE prices—banks at the 75^th percentile of the distribution of CRE loan exposure experience an 8 percentage points higher non-performing CRE loan ratio and a 3 percentage points higher CRE loan charge-offs rate (compared to banks with no CRE loan exposure).⁹ Following these, their pre-provision net revenues and total regulatory capital are lower (by 12 percent and 5 percent, respectively). Banks with low CRE loan exposure experience milder effects, while still performing worse than banks with no CRE loan exposure.

These results are broadly similar in the sample that considers only small banks, for which the price and location of CRE assets can be captured more accurately (Figure 4, panels 1b and 2b), and when a shorter horizon (four quarters) is considered for the CRE price decline (Figure 4, panels 1c and 2c).

Bank Capital Adequacy Under CRE Sector Stress

Using the sensitivities of banks’ CRE loan charge-offs rates and pre-provision net revenues to CRE price changes estimated previously, this section analyzes how bank capital adequacy could be affected if CRE prices were to drop persistently. ¹⁰ To do so, two approaches are followed. First, the marginal impact of bank CRE loan exposures on bank capital adequacy is reported, without considering the impact of other macroeconomic factors. Second, macroeconomic factors are also incorporated into the picture, by taking into account time-varying location-specific effects.

The exercise is conducted with two stressed CRE price scenarios, where the price paths are derived from the valuation model in IMF (2021). The first scenario, labeled as “mild”, assumes a cumulative one-standard-deviation decline in CRE prices after eight quarters and corresponds to a 1¼ percent permanent increase in the CRE vacancy rate. The second scenario, labeled as “severe”, assumes a CRE price path consistent with a permanent increase in the CRE vacancy rate by 5 percentage points (which corresponds to the rate observed during the global financial crisis), and implies a decline in CRE prices by about 30 percent in the long-run. For simplicity, projected price paths are considered to be common across all metropolitan statistical areas (MSAs) (Figure 5, panel 1).

The results presented in Figure 5 show that while the average projected drop in capital adequacy is mild (0.14 percentage point on average), there is noticeable heterogeneity across banks (driven primarily by the variation in banks’ CRE loan exposures). Projected credit and revenue losses could reach more than 1 percent of pre-shock total risk-weighted assets for banks with very high CRE loan exposures (that is, those in the top 3 percent of CRE loan exposure). Nearly all banks in the left tail (5 th percentile of the distribution of loss ratio) are small or community banks. ¹¹ Moreover, a permanently high CRE vacancy rate implies significantly higher losses, with average capital losses almost twice as large as under the mild (first) scenario.

Next, macroeconomic effects are incorporated into the analysis by taking into account location-specific effects (as described in the Annex). The average decline in capital adequacy ratio turns out to be larger in this case, reaching 1.4 percentage points (Figure 6, panel 1). ¹² This stronger effect is hardly surprising given that CRE price declines, especially when they are steep, coincide with lower economic activity and market stress (for example, lower GDP, higher unemployment, higher stock market volatility). Consistent with the findings discussed previously, the results also show that banks at the left tail of the distribution of losses are small or community banks (panel 1), and that their losses reach 1.5 percentage points in this scenario (panel 2).

Structural Shifts in the CRE Sector and Bank Provisioning

The effect of structural shifts in the CRE sector, such as those related to the rise of e-commerce and teleworking, on CRE market valuations could be stronger in areas that are more densely populated or with a higher share of less contact-intensive jobs that can be performed remotely. In turn, local banks operating in such regions could also be more adversely affected, potentially due to greater non-performing CRE loans. While a lack of publicly available disaggregated data does not permit a direct testing of this hypothesis, simple correlations of provision expenses to CRE loan exposures provide supportive evidence. Community banks in very densely populated areas or in areas with a higher share of teleworkable jobs seem to have increased their provisions more strongly during 2020 than other banks (Figure 7).

Concluding Remarks

The COVID-19 crisis has hit the commercial real estate sector hard in the US. The structural shifts in CRE demand pose considerable uncertainly around the outlook for the sector and suggest that further price declines may be possible, at least in some CRE segments. This note shows that such price declines may potentially be a source of stress for banks, especially for smaller and community banks with higher CRE loan exposures.

So far, the banking sector in the US has been largely resilient to the developments in the CRE sector during the COVID-19 crisis because of strong bank capital buffers and the unprecedented policy support and regulatory responses during the crisis. ¹³ Large banks have also been more prudent in their CRE lending compared to the pre-global financial crisis period, with their exposures declining notably. Going forward, maintaining the frequency of stress tests for small/community banks, particularly for those with high levels of exposures to riskier CRE segments, would be beneficial to assess the risks to financial stability in a timely fashion.

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