Real Estate

Billions of Dollars of Bad Real-Estate Debt Could Mean Big Bank Losses

  • Lenders, including major banks, are expanding their provisions to guard against loan losses.
  • The rapidly growing reserves reflect concerns about the health of commercial-real-estate debt.
  • The provisions put a drag on earnings, curtail lending, and could spur a cash crunch for some banks.

This earnings season, some major banks bucked tumult in the sector by raking in record revenues and surpassing Wall Street expectations.

But a blemish is building on the balance sheets of a growing number of financial institutions, in the form of cash reserves that banks and other lenders are required to collect against expected loan losses — including souring debts tied to commercial real estate. 

The reserves, stagnant money that doesn’t earn a return, place a drag on earnings, curtail lending, and show how hundreds of billions of dollars of problem real-estate assets, such as office buildings, are beginning to inflict wider financial damage.

The US’s four largest banks, Wells Fargo, JPMorgan Chase, Bank of America, and Citibank, together now have $62.9 billion of such loss provisions, according to the debt-tracking firm Trepp’s analysis of their recent first-quarter financial statements.

That’s a $12.6 billion increase in their reserves from six months ago, Trepp said.

Some of the uptick is attributable to expected losses connected to commercial real estate.

In its earnings release on April 14, Wells Fargo, for instance, said it had gathered $643 million in additional loss provisions during the quarter, in part, “for commercial real estate loans, primarily office loans.” The bank separately disclosed $725 million of “non-accrual loans” tied to office assets — debts that are already delinquent on payments. That was a nearly fourfold increase in dollar volume of bad office loans over the previous quarter held by the bank.

“The office market continues to show signs of weakness due to lower demand, higher financing costs, and challenging capital-market conditions,” Wells Fargo’s chief financial officer, Mike Santomassimo, said during the bank’s earnings call. “While we haven’t seen this translate to meaningful loss content yet, we expect to see more stress over time.”

Wells Fargo, JPMorgan Chase, and Bank of America are the nation’s largest commercial-real-estate lenders in that order, and Citibank is the 16th biggest, according to a list compiled by Insider last month.

“We’re only in the early stages of a real-estate downturn, and we’re starting to see a meaningful increase in loan-loss reserves,” Matthew Anderson, a managing director at Trepp, said. “Unlike other cycles, where the market dipped and then began to recover, this is something that could continue for years.”

This time, provisions are expected to translate to losses 

At the start of the pandemic, when lockdowns sparked widespread fears of a dramatic economic downturn, bank provisions industrywide surged about threefold to $161 billion. The four aforementioned big banks, alone, held $97.6 billion of provisions between them at the end of the second quarter in 2020, according to Trepp. The provisioning, however, soon receded as the US economy surged despite the virus crisis. 

“Losses didn’t actually materialize,” Anderson said. 

As banks again ramp up their provisioning, there’s a greater likelihood that it’ll be needed this time, Anderson said, in part because of the brewing problems in the commercial-real-estate sector. 

No area of the market is as troubled as the office segment, where the widespread adoption of remote work is crushing tenant demand. That, combined with rising interest rates and falling building values, has led to a growing wave of defaults, many triggered by expiring mortgages that have become impossible to replace with commensurate levels of debt. Green Street, a real-estate-data firm, estimated that top-tier office property values nationally had fallen at least 25% on average over the past year.  

Even some loans tied the nation’s robust market for apartment buildings have faltered recently. 

Anderson said about $760 billion of office loans were held by banks, which amounts to roughly 35% of their commercial-real-estate debt. According to Trepp, $80 billion of those mortgages are set to expire this year and about $400 billion will mature over the next five years — more than any other segment of commercial real estate.

There is about $1.2 trillion of office debt in total when factoring in securitized loans and mortgages held by investment funds and specialty lenders, Anderson said — suggesting the exposure reached beyond banks.

Lenders expect big losses tied to office buildings

“We will not be immune from credit impact, especially in the office market,” Katie Keenan, the CEO of Blackstone Mortgage Trust, said in an earnings call on Wednesday. The company said it had earned $118 million during the quarter, 18% more than the same period a year ago. 

It also raised its loan-loss provisions by $9.8 million during the quarter to $352.3 million because of a single impaired office loan in Brooklyn, New York. Last year, the company added $211.5 million to its loss reserves.

Keenan suggested that the company’s provisioning could continue to rise. Thirteen percent of its office loans are due to mature in 2023, and 7% of its loan book, totaling roughly $1.7 billion in debt, is connected to office assets that Keenan identified as having an elevated risk of sustaining losses.

“We think it’s certainly possible that we could see more reserves over time,” Keenan said.

Blackstone Mortgage Trust’s reserves amount to about 1.5% of its portfolio, the company’s chief financial officer, Anthony Marone, noted during the call.

That was slightly less than the roughly 2% average reserve rates that banks have been stashing to cover their commercial real estate loan portfolios, according to an analyst on the call.

Rising provisions could spark a new crisis for banks  

Other lenders have disclosed reserves that represent a higher percentage of their portfolios. These provisions are especially elevated for loans connected to office assets. 

The Columbus, Ohio, bank Huntington Bancshares, for instance, said it had provisions totaling 3% of its $16.6 billion portfolio of commercial-real-estate loans but held even larger reserves, amounting to 8% of the value of its loans tied to office properties. 

“Eight percent is a level of provisioning that’s a lot higher than we’ve seen during the past decade,” Rebel Cole, a finance professor at Florida Atlantic University, said. 

Provisions don’t always translate to losses, and banks can drain down the reserves if the threat of loan defaults passes – as they did when the economic fears brought by the pandemic subsided. But the hefty reserves can cause problems by themselves, especially as banks have seen depositor flight, Cole said. Banks with heavy reserves may find themselves capital-constrained, which could prompt further instability in the banking system. 

“It’s a problem,” Cole said. “It’s the kind of situation where in the next year, you could certainly see multiple lenders, including large regional banks, fail.”