US commercial real estate and banking systems which proved fragile in previous crises – those in Europe and Japan in particular – are in focus. Carrier weighs the vulnerabilities and the implications for the economy and portfolios.

Carrier believes that US commercial real estate has become a hot topic among market participants. CRE relies heavily on small and midsize banks for financing, which happen to be the most stressed financial institutions. “Overall, the commercial property industry in the US owes $1.9 trillion to these banks, or twice what it owes to large banks ($0.9 trillion), according to the Mortgage Brokers Association. Small and midsize banks are heavily exposed to CRE, which accounts for as much as 43 per cent of their outstanding loans,” she said.

Structural and cyclical issues are darkening CRE’s prospects, Carrier continued. “Office real estate is suffering from high vacancy rates due to the post-pandemic aversion to commuting to a job and the practicalities of the work-from-home trend. The shift to online shopping accentuated by waves of lockdowns has also reduced foot traffic at many bricks-and-mortar retail locations,” she added. Cyclical factors such as the layoffs in tech industry dominated areas are compounding these challenges. The US office vacancy rate reached 12.5 per cent in the fourth quarter of 2022, just below the level seen in the aftermath of the global financial crisis in 2008, according to data provider CoStar.

“By nature, CRE involves a high degree of debt and tends to struggle in a rising interest rate environment,” she said. “Lower vacancy rates translate into lower rents. Landlords often have difficulty refinancing as the value of their buildings slips below that of the loan granted to purchase the properties. Some may have no other option than to offload their properties at steep discounts or face bankruptcy,” Carrier continued.

This would be an additional, unwelcome challenge for those small banks currently under stress, which are already losing deposits to their larger competitors and higher-paying money market funds.

A manageable risk
Still, Carrier sees reasons to believe that the risk of any additional problems at small and midsize banks due to CRE defaults could be contained. “For one, small banks’ lending contributes less than 3 per cent of US GDP, and US commercial real estate mortgages constitute less than 20 per cent of all mortgages it’s the residential market that’s the key,” she said. 

Any CRE default would likely be isolated to a few US regional banks and smaller lenders, in her view, negatively impacting individual communities. She thinks that the direct damage to the US economy would be limited, though defaults would likely lead lenders to tighten lending standards further.

In an environment in which investors are already anxious, she believes that any further meaningful stress on some small and midsize banks could drag down equities and bond yields, with potential spillover effects for global financial markets.

How soft are European and Japanese banks’ soft spots?
“Banks in Europe and Japan are also under scrutiny from market participants as they both have proven fragile in the past. Both countries’ banking channels are outsized, with profitability challenged by the negative interest rate environment in which they’ve operated for years,” she said.

“In Europe, similar to the US, the concerns centre around a potential increase in the stock of bad loans and deposit flight which would likely weaken banks substantially,” Carrier added.

“Yet European banks do not share the same issues as US regional banks. Regulation in Europe has made all banks there buy hedges to protect them against the risk of higher interest rates decreasing the value of their loans,” she continued. “Liquidity coverage ratios are also much higher in Europe. The sector is less exposed than its American counterpart to CRE loans and has strong capital buffers to absorb potential losses. Core equity has surged close to 15 per cent of risk-weighted assets, up from 5 per cent in 2011,” she said.

“Overall, the increase in European regulatory oversight and the balance sheet clean-up efforts which took place after the 2008 financial crisis and the European sovereign debt crisis four years later have put the sector on firmer footing,” Carrier continued.

But as she sees it, tightening lending standards over the past few months will likely crimp revenue growth somewhat. RBC Capital Markets believes that the primary market remains effectively shut for banks, a worry at a time when funding costs are expected by most observers to rise. Following Credit Suisse’s demise, Carrier thinks investors in Additional Tier 1 bonds will likely demand a higher return.

“As for Japanese banks, the concern is the effect a sharp increase in the 10-year Japanese government bond yield would have on capital adequacy ratios, should inflation prove stubborn. Regional banks and Shinkin banks, cooperative financial institutions serving small and medium-sized enterprises and local residents, would then have uncomfortably low capital adequacy ratios,” she said. Such a development would bear monitoring, in her view. “Mega institutions, however, would likely cope better, given their healthy capital adequacy ratios of close to 11 percent, according to S&P Global,” Carrier added.

Quality is key
She sees good reasons to believe that the risks facing US CRE and European and Japanese banking systems can be contained. But the ongoing tightening in lending standards in both the US and Europe may be accentuated should these pressure points flare up. Carrier recommends that investors focus on quality in portfolios; she prefers companies with business models that are not sensitive to the business cycle.