(Bloomberg) — Falling office real estate values are rippling through U.S. banks, with smaller lenders in particular increasingly turning to loan modifications in their commercial real estate portfolios.
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The average bank with less than $100 billion in assets changed 0.32% of its CRE loans in the first nine months of the year, according to a report from Moody’s Ratings. That’s a big increase from the first half of 2024, when it was only about 0.1%.
But it’s also a much lower rate than other types of lenders adjusted: For medium-sized banks, the share was 1.93% in the first nine months, and for the largest it was 0.79%, the report found. The difference is likely not due to smaller lenders making better loans, but rather to the fact that they have been slower to cope with falling commercial real estate prices.
Adjustments are typically sought by struggling landlords who want to defer payments and get short-term extensions on loans. Their increased use is the latest sign of mounting troubles in the CRE lending industry as a wave of loans need to be refinanced.
The focus is largely on regional banks, which are particularly vulnerable because they often made lower deposits than their larger counterparts in the years leading up to rate hikes that begin in 2022. That means they have less cushion before they lose after the value of offices and apartment complexes fell by at least 20% since the peak.
At the same time, larger U.S. lenders, which are subject to stress tests and other forms of intense scrutiny, have so far set aside more money to cover bad loans than smaller banks, said Rebel Cole, a Florida finance professor. Atlantic University, which also advises Oaktree Capital Management LP.
Concerns about future losses have contributed to share price underperformance for smaller banks, with the KBW Regional Banking Index gaining about 17% this year, compared with about 30% for the KBW Nasdaq Global Bank Index.
About $500 billion in CRE mortgages will mature in the coming year “and a significant portion of that will default,” said Cole of Florida Atlantic University. “There will be fire sales. They are going to put more downward pressure on commercial real estate prices across the board.”
Federal Deposit Insurance Corp. Chairman Martin Gruenberg warned Thursday that weaknesses in some loan portfolios in the banking system, including office and multifamily properties, continue to warrant close scrutiny.
Office lending will continue to plague public mortgage REITs and the vast majority of banks for a long time, Mike Comparato, president of Franklin BSP Realty Trust Inc., told analysts last month. These assets are trading “at levels that were simply unfathomable just a few years ago. We also hear anecdotes of lenders being unwilling to take ownership of office assets to avoid the market value reality.”
Adding to the pain for lenders, this year’s interest rate cuts by the Federal Reserve have not led to lower long-term borrowing costs. That makes it more difficult for landlords to refinance their debts at a level that can be covered by rental income.
“There’s starting to be some capitulation,” said Robin Potts, chief investment officer at the real estate arm of special situations investor Canyon Partners LLC. “Borrowers who don’t pay can’t renew forever.”
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