(Bloomberg) — Declining office property values are roiling U.S. banks, and smaller lenders in particular are ramping up the use of loan modifications on their commercial real estate books.
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A conventional bank with less than $100 billion in assets modified 0.32% of its CRE loans in the first nine months of the year, Moody’s Ratings said, up from about 0 in the first half of 2024 was 1%.
But it’s also a much lower percentage than other types of modified lenders. Mid-sized banks’ share was 1.93% in the first nine months, compared to 0.79% for the largest, the report found.The difference is likely not because smaller lenders made better loans, but because they have been slower to withstand falling commercial property prices.
Modifications are typically sought by homeowners who want to delay payments and get short-term extensions on their loans.
The focus is on regional banks, which are particularly vulnerable because they have often taken lower rates than their larger counterparts in the years leading up to the rate hikes starting in 2022. That means they have less of a buffer before taking losses and after apartment complex values have fallen at least 20% since the peak.
Meanwhile, larger U.S. lenders, which are subject to stress tests and other forms of intense regulatory scrutiny, have so far set aside more money to cover bad loans than smaller banks, according to Rebel Cole, a finance professor at Florida Atlantic University also advises Oaktree Capital Management LP.
Worries about future losses have contributed to the underperformance of smaller banks’ share prices, with the KBW Regional Bank Index up 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 next year, “and a significant portion of them will go into default,” said Florida Atlantic University’s Cole. “There will be fire sales. They will put further downward pressure on commercial real estate prices in general.”
Federal Deposit Insurance Corp. President Martin Gruenberg warned Thursday that weaknesses in some loan portfolios in the banking system, including offices and multifamily, continue to need close monitoring.
Office loans will continue to plague public mortgage REITs and the vast majority of banks, Mike Copparato, president of Franklin BSP Realty Trust Inc., told analysts last month.Those assets are trading at “levels that were simply unimaginable a few years ago. We also hear anecdotes of lenders not wanting to foreclose on office assets to avoid the market realities of the market.”
Adding to the pain for lenders, the Federal Reserve’s rate cuts this year have not reduced long-term borrowing costs, making it more difficult for homeowners to refinance their debt at a level that can be covered by rental income.
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