Commercial Real Estate Price Drop, Potential US Debt Default Raise Risks for Regional Banking Space

Commercial real estate prices fell for the first time in over a decade last quarter, heightening the risks overexposed banks face. New data from the Fed indicates that more than two thirds of all outstanding commercial real estate lending among banks originates from institutions with less than $100 billion in assets. More than 750 banks have breached regulatory limits on commercial and construction concentration ratios, which could bring enhanced scrutiny and force the sale of discounted properties.

Even if sales aren’t conducted, it’s likely that lending to commercial ventures is likely to become more constrained as banks attempt to contain exposure. Existing mortgage and bond holdings could become increasingly risk-heavy for banks if the US debt ceiling is not raised before the Treasury runs out of cash in two weeks’ time.

Related ETFs: iShares CMBS ETF (CMBS), ProShares Short Real Estate (REK), Financial Select Sector SPDR Fund (XLF), SPDR S&P Regional Banking ETF (KRE)

While many investors are getting out of the way of a potential downturn in commercial real estate (CRE), many banks are stuck in its crosshairs. Bank of America’s latest monthly fund manager survey showed that a net 19% of managers globally were underweight the sector this month. That was the lowest level of exposure among respondents since December 2008 and according to the Financial Times, a massive reversal from April 2022 when investors’ allocations toward CRE had hit a 16-year high at 19% overweight. The souring sentiment among fund managers coincides with news that CRE prices experienced their first quarterly decline since 2011 in Q1. Moody’s data shows that the drop was equivalent to less than -1%, but Mark Zandi, Moody’s Analytics chief economist, told Bloomberg that “Lots more price declines are coming.”

As MRP has previously noted, CRE and the commercial mortgage backed securities (CMBS) market plays a critical role in the performance of the US banking sector, considering mid-sized banks – lenders with less than $250 billion in assets – account for 80% of commercial real estate lending, according to Goldman Sachs.

Per the Federal Reserve’s May 2023 Financial Stability Report, banks accounted for a narrower 60% of the $3.6 trillion in commercial real estate loans outstanding in the fourth quarter of 2022, but more than two thirds of those loans are owned by “banks other than Category I–IV banks”, meaning institutions with less than $100 billion in assets. “Compared to big banks, small banks hold…