Investors Could Miss These Commercial Real Estate Opportunities

The threat of a looming wave of commercial real estate loans coming due has been well publicized to investors, but it's possible that the measures they're using to protect themselves against risk are misguided. Many investors avoid bank stocks with high concentrations of commercial real estate (CRE) exposure. However, this measure may overlook banks that have riskier loans on their books despite lower concentrations of CRE. For this reason, investors may want to look in more detail at the types of loans held by a bank. In doing so, they may discover that some large banks are on shakier ground than their concentration in CRE suggests. Maturity wall Around 30% of CRE's outstanding debt matures between 2024 and 2026, according to data provider Trepp. When this debt comes due and homeowners seek to refinance, borrowers will face much higher debt payments due to rising interest rates, and the economic situation could become untenable, especially that the value of many office buildings has declined. Landlords may decide it's easier to just hand over the keys and walk away. Heightened concern over default risk is clearly weighing on bank stocks, which are already battling headwinds from rising interest rates. Indeed, the gap between the KBW Bank index (up around 4% since the start of the year) and the SPDR S&P Regional Banking ETF (KRE) (down 12% since the start of the year) year) compared to the S&P 500 index (up almost 14% since the start of the year)%) is even wider today than it was during the regional bank crisis in spring 2023, UBS analyst Erika Najarian wrote in a research note on Thursday. For the moment, distressed loans are contained. According to CoStar, approximately 1.23% of all outstanding CRE loans are considered subprime, but the trend could be moving in the wrong direction. At the end of the first quarter, the Federal Deposit Insurance Corp. said the amount of delinquent or non-accruing home loans stood at $35 billion, up 9% from the fourth quarter of 2023 and 59% from the same period of the year. ago, marking the highest level in 11 years. Investors have punished the actions of regional banks, particularly when the bank's exposure to commercial real estate exceeds 300% of its total equity. This is a benchmark that the Federal Reserve has deemed excessive. Stephens analyst Matt Breese said many of the Northeast and Mid-Atlantic banks he covers that have CRE concentrations above 300% are trading below their full book value. But CRE concentrations should not be the only consideration for investors. Bad Loans Stephens analysts noted that the FDIC's first quarter bank profiles found that banks with more than $250 billion in assets are the ones experiencing accelerating bad loans, despite their CRE concentrations among the weakest. The troubled loan rate in this group was 4.48% in the first quarter. Analysts said that rate was well above the rate of 1.47% at regional banks and 0.69% at community banks. This trend likely reflects the fact that some of the largest banks have exposure to large, prestigious office buildings located in major metropolitan areas. These properties have been particularly hard hit by city centers that have been hit by the pandemic and by businesses looking to reduce their real estate needs in the era of hybrid working. The Kansas City Fed also highlighted this in a report, saying the default risk of office buildings increases with the size of the building. He estimated that if a property was larger than 500,000 square feet, it had a 22% default risk, while a building smaller than 150,000 square feet could have less than a 5% default risk. In other words, community banks might be less risky than the CRE exposure figure suggests. According to Breese, there is no single metric that can be easily isolated, but investors could consider the average loan size with a bank, as well as the asset classes exposed to interest rates and some of the other negative forces at play. "I think we need to start isolating a much smaller piece of that pie," he said in an interview. In Breese's coverage area, his top stock picks are NBT Bancorp., Webster Financial and Valley National Bancorp. Although the latter two have some exposure to New York real estate, both banks benefit from strong management teams, he said. (New York real estate markets are facing both declining office values and the dynamics of rent-regulated multifamily properties.) Yet even these stocks are likely to struggle as long as interest rates remain high and that concerns about CRE will persist. Connecticut-based Webster is down more than 22% year to date, while Valley National in New Jersey is down 40%. NBT, down about 16% year to date, is faring slightly better. NBTB since the beginning of the year. Breese views NBT as both a defensive and offensive play because it has strong funding and a low CRE concentration of 203%. It also has an attractive opportunity as an upstate New York bank located in a region that is seeing a lot of investment in semiconductor manufacturing from companies like Micron Technology. UBS's Najarian said the bank analyzed stocks that were both interest rate sensitive and had the most exposure to CRE and that Citizens Financial Group, based in Providence, R.I., had "the most compelling stand-alone story.” She cited factors such as private banking. traction and reduced drag trade as two catalysts. For big banks, sentiment could improve, according to Piper Sandler analyst R. Scott Siefers. In early June, he explained that large banks had fewer wild cards in circulation and improving fundamentals such as the possibility of a recovery in net interest income and a rebound in investment banking activities even with higher interest rates. Siefers also likes Citizens Financial as well as Cleveland's KeyCorp. He is overweight both stocks. Citizens is up less than 3% year to date, while KeyCorp. shares are down nearly 7% over the same period. “Interest from purely financial investors has increased, although generalists still appear mostly disengaged,” Siefers writes.