Obviously, the market is worried about banks. I do not need to restate the events of the past few weeks, but this sector is an important market indicator as banks usually outperform early in a recovery cycle. Bank stocks outperformed late in 2020 as the US recovered from the COVID shutdown, but then the Fed started its tightening cycle and the yield curve inverted in October. Bank margins were squeezed despite improving loan demand. Bank stock underperformance began in May of 2021. The bank runs this year were different than the typical bank run which is most often triggered by bad loans and the resulting fear of bank viability. If we have a recession, we may see more bank distress, but at this point, bank loan losses are low with very little acceleration in problem loans, and banks are well reserved. If the only bank problem this cycle turns out to be the industry’s bond investments trading at losses, the solution is the Fed window that just opened for these securities and the passage of time, because we know that Treasury bonds will mature at par. The move down in interest rates in the past week will help too.
So why are bank stocks still trading at significant discounts to their valuations of a month ago? Clearly, the market is expecting more distress and here is where analysis fails. No one can analyze a bank loan portfolio very accurately without re-appraising the underlying value of the collateral. In the case of commercial, industrial or residential real estate, re-appraisal would be an impossible task, even for the bank who carries the loan on their books. Thus, even an experienced banker does not know which loans will fail, nor can they predict what might cause them to fail. So this explains why analysts are creating lists of banks with a high percentage of their assets in commercial real estate loans, anticipating the next shoe to drop.
If banking is to be at the heart of the coming economic downturn, the problem is likely to be in loan portfolios. If we drill down and take a closer look at real estate which is usually the collateral behind commercial and industrial loans, we may get a little insight as to the stability of bank loan portfolios and thus, the economy and the stock market.
Real estate is estimated to be about 10% of overall GDP. If the industry’s related goods and services are included, real estate is about 15%+ of our economy. Commercial real estate includes office buildings, retail space, industrial property and multifamily. Estimates of the contribution of Commercial RE to annual GDP is about 5%. Residential real estate contributes about another 5%. Interest rates change the Return on Investment (ROI) calculation for real estate directly, impacting prices because most real estate is leveraged. After a decade of low interest rates, the sudden change in the cost of funds has injected a healthy note of realism into real estate purchase decisions.
If you think about a bank’s RE portfolio, it may own both amortizing RE loans and non-amortizing loans. The amortizing loans (mostly residential) are probably more secure as they have a higher proportion of owner equity, and residential real estate remains slightly undersupplied today, as opposed to conditions in 2008 and 2009. So, investor focus is rightly on the commercial RE portion of the banking industry portfolios.
Looking at the sectors of commercial real estate, the office market vacancy rate exceeded 18% last quarter for the first time on record. Office property vacancies have worsened for 13 straight quarters. About 30% of US markets ended the year with a vacancy rate above 30%. This trend will probably continue for a while, but construction has slowed and rents also seem to be peaking. A better picture seems to be developing for retail space where the vacancy rate is just over 4% and seems to be improving a bit. The vacancy rate for retail space has been in decline since the global financial crisis peak at nearly 8% and vacancies appear to be stable now around 4.2%. As we have all noticed, retail landlords have re-positioned former retail space to medical office or restaurants or other ancillary retail formats like urgent care centers. The same pattern is true for apartments. This segment seemed to hit peak vacancy rates just after the global financial crisis and have been stable around 6% for the past several years. However, we do have record apartment units expected to be completed in 2023, so that plus a recession may push vacancies up. Industrial (composed of warehousing, manufacturing, distribution, etc.) vacancy rates peaked in 2010 at just over 10%, then declined until COVID hit when rates popped up again to about 7% and are holding today around 4%.
All of the above suggests that the most likely potential problem area is office space. In that arena there are the haves and the have nots also, reflecting strength in the sunbelt and low tax states and the problem areas in cities where employees have decamped with the advent of work from home. San Francisco is the poster child of the have nots, with an office vacancy rate of nearly 30% versus 4% pre-COVID. What does this mean for banks? Investors are rightly concerned about banks with large office property portfolios, particularly those banks in less attractive geographic areas. How high will vacancy rates go from the current new high of 18%, no one knows, but it pays to be cautious. Most banks have diversified portfolios that can probably withstand further distress in commercial real estate. It is healthy to see regulators talking about pushing “stress testing” down to smaller banks. Because small banks are about half of US banking, they should be held to rigorous standards, the same as larger banks, but recognize that the failure of a small bank carries significantly less contagion risk than problems in large banks.
It is probably too early to draw conclusions, but it is encouraging that bank stocks are not making new lows after the initial reaction to the Silicon Valley Bank collapse. The stock market has also stabilized, but we will see what additional damage the dramatic increase in interest rates will bring. Our guess is that if we have a recession coming this year, it will not be centered around banks, but more likely a result of a nervous consumer who reels in spending. As long as unemployment remains relatively low, a recession would probably be short and shallow. But we will see! The current valuations of the strongest banks in the country suggest upside potential for the longer term, but the near term is anyone’s guess.
Maris A. Ogg, CFA 610-260-2216