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Predicting CRE Trouble
Community banks love making commercial real estate loans. No wonder. They're easier to understand and collateralize than some other types of lending, such as commercial and industrial loans.
CRE is a tried-and-true asset class for banks that understand it well — but a potential explosive device for those that don’t. Over a decade of low rates lulled some banks into taking more interest rate risk than they should. CRE borrowers may struggle to refinance at higher rates with properties that no longer generate positive cash flow.
Indeed, investor and market reports lately focus on a particular set of banks that have high concentrations of CRE compared to total capital.
It’s hard for investors to differentiate banks based on risk management measures that include strong underwriting practices. Instead, investors have painted the wider group of CRE-laden banks with a broad brush, says Piper Sandler & Co. Managing Director Andrew Liesch. CRE-heavy banks have been trading at lower multiples to book value than banking indexes such as the KBW Nasdaq Bank Index, which had a whopping 1-year return of 37.6% as of mid-Thursday, following a handful of big bank earnings reports.
Contrast that with some of the best banks in the country in terms of past performance, many of which have high levels of CRE. Take $36 billion Little Rock, Arkansas-based Bank OZK, which depends heavily on construction and development loans, a potentially riskier subset of CRE. Bank OZK was up 6.5% in the same time frame. It had a 2.28% core return on average equity last year and strong asset quality. As of Tuesday, it was trading about book value. The $6 billion Great Southern Bancorp in Springfield, Missouri, has more than 300% of its capital in CRE. It, too, has underperformed the market, although a recent earnings report sent the stock up 7% during the week as of mid-Thursday. It had a 1.25% core return on average assets as of 2023 and maintains a low level of nonperforming assets.
Are investors right about those banks? Maybe.
There are banks that manage CRE well and others that don’t. What the market doesn’t understand, it will punish.
• Naomi Snyder, editor-in-chief for Bank Director
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