Bank OZK Prepares For ‘Credit Deterioration’ While Growing CRE Loan Book

Bank OZK posted growing net charge-offs in the second quarter as its pool of nonperforming loans grew to $81M, its highest volume since at least 2009. 

But the Arkansas-based bank, which reported its second-quarter earnings on Wednesday and held its earnings call Thursday morning, continues to aggressively expand its real estate lending portfolio, the majority of which continues to perform.

The firm’s real estate loan portfolio grew $670M in the last three months to $28.5B, and its net interest income in the second quarter was a record $388M.  

Even as the bank posts seven consecutive quarters of record net income, a handful of troubled loans on its balance sheet has drawn negative attention from analysts.

Bank OZK had $11.8M in net charge-offs in the second quarter, up from $7.3M at the end of March, according to management comments included with the earnings report. The bank grew its provision for credit losses by $49M in the second quarter and increased its total allowance for credit losses by $37M to $574M, nearly 2% of the bank's total loan balance.

While the bank is building up reserves in case of trouble, its net charge-offs, provisions for credit losses and ratio of non-performing loans all outperform peers in the industry.

Executives said the growing ACL primarily reflected changes in economic assumptions, including risks associated with Federal Reserve interest targets and a heavier weighting towards a downside economic scenario. 

The steady growth of the ACL “is the expectation there would be some credit deterioration,” CEO George Gleason said during the earnings call. “That's not an indication of any sort of serious weakness in the portfolio. It's just a reflection of the fact that these high interest rates cause stress, and some of that stress is going to translate through into losses.”

Bank OZK's real estate debt portfolio is 365% larger than its available capital, well ahead of the 300% cap that regulators look for, said Catherine Mealor, an analyst who covers Bank OZK at Keefe, Bruyette & Woods. 

The bank hasn't faced extra scrutiny from regulators, and executives at the bank highlighted the quality of its sponsors and its limited loss history. 

But considering widespread analysis that underlying losses on banks' real estate books could lead some to fail, analysts see Bank OZK's construction loan exposure as a potential pain point. 

“That's the whole bear case,” Mealor said. ”It's why you have 14% short interest on the stock today, because of overexposure to commercial real estate.” 

The bank is looking to relieve some concerns through diversification, making investments to expand its corporate and institutional banking division to offset real estate debt volume. Real estate debt accounts for 64% of Bank OZK's portfolio while its corporate and institutional division grew to 7% with $500M in loans this quarter.

“They’re highly concentrated in [real estate], and while their returns are excellent in that line of business, they create a lot of risk,” Mealor said. “It's probably why they trade where they do. It's prudent to diversify.”

Two large loans moved off Bank OZK’s balance sheet in the second quarter. Extell Development secured $1.2B from JVP Management to refinance an $840M construction loan from Bank OZK for its Central Park Tower. JDL Development and Wanxiang America Real Estate also refinanced a $475M loan with Wells Fargo for the mixed-use One Chicago project.

The movement of that debt pushed Q2 paydowns to $1.8B, more than double the $790M seen in the first quarter. Gleason expects that volume to moderate, with more borrowers opting to keep their loans with Bank OZK past maturity while waiting for the debt environment to improve.

“Loans may stay on books longer, but those loans are structured in a way that we feel good about them staying on the books longer. We’re making substantial profits on those,” Gleason said. 

The bank is open to negotiating extensions with clients because sponsors are paying upsized fees and being required to add equity into the property to secure new terms, Gleason said.

“Equity is equity, equity has equity responsibilities,” he said on the call. “We’re the senior secured loan, we don't have equity responsibilities. The equity has to do the equity lifting on these things.” 

Earnings came in roughly in line with analysts estimates, while revenue beat predictions at a record $279M, up 7.7% year-over-year. The bank's board also authorized a $200M stock buyback program, a pivot from the Q1 earnings call when executives said the firm was unlikely to repurchase stock and would instead focus on growth. 

Executives acknowledged in the second quarter management notes that the bank was facing headwinds at four projects. Some of those properties were flagged by Citigroup analyst Benjamin Gerlinger when he changed his outlook and cut his target price for the stock. His downgrade led to its biggest slide since 2020, although it has mostly recovered.

The bank’s nonperforming loans increased to 0.28% of its total debt at the end of June, up eight basis points from March and nearly double the rate a year earlier. 

An entirely vacant 1.7M SF life science project called the Research and Development District in San Diego that Bank OZK provided construction financing for was flagged by Gerlinger as a potential drag on profits. 

The $915M loan to developer IQHQ was originated in 2022 and is set to mature in 2026. Bank OZK disclosed as part of its earnings report that the sponsor had recently added an additional $87M to the loan reserves held by the bank to help offset any lag in the project’s occupancy.

“This thing should have never gotten the attention it did,” Gleason said. “If it takes two years to lease — or three years to lease, or five years to lease — those guys will get to the finish line on it.”

Bank OZK also disclosed three substandard-rated credits totaling $181M. 

A Seattle office was transferred to foreclosure with $13M in outstanding carrying value. The bank expects to reduce its exposure to $9.1M through the recovery of some available funds ahead of a sale of the property.

The principal on a $32M loan for a development in Lake Tahoe that’s been at substandard status since 2019 was brought down by $11M through the sale of the development’s amenities. 

The third troubled loan is $128M in debt for a project in the Chicago area that has seen its loan-to-value ratio increase to 107% after a June appraisal. The sponsor contributed $8M in equity to extend maturity to October. 

The bank didn’t disclose the name of the property, but Bank OZK provided a $125M loan to Sterling Bay in 2021 to build an eight-story life science project in Lincoln Yards. 

Despite challenges at some properties, Gleason said all of the bank’s loans were current and performing. 

The bank continues to see opportunities in South Florida, growing its outstanding debt portfolio there to just under $5B. The region surpassed New York, with $3.6B in outstanding loans, as Bank OZK’s most active market earlier this year.

Its largest loan of the quarter was $425M, provided to Property Markets Group to begin construction of the supertall Waldorf Astoria Hotel & Residences in Miami.

“We continue to find opportunities to originate high-quality, low-leverage loans to strong sponsors on marquee assets in this market,” executives said in the management comments.

The broader banking sector had a largely positive second quarter, with investment banking boosting profits even as lower-income customers are being squeezed, the Wall Street Journal reported. 

Morgan Stanley’s Q2 profit surged 41% year-over-year to $3.1B, helped by a boost in activity on Wall Street. JPMorgan Chase also topped analyst estimates with a 20% increase in revenue to $51B.   

Goldman Sachs saw second-quarter profits jump 150% year-over-year to $3B, but less investment-focused banks posted more modest results, with Bank of America reporting $25.5B in revenue but a 7% drop in year-over-year profits to $6.9B. 

For Bank OZK, an interest rate cut is likely to eat into the firm’s income from interest payments as more sponsors refinance their debt. Bank OZK’s loan portfolio has swelled as sponsors push off refinancing in the near term, which has fueled the record revenue the bank has enjoyed for nearly two years. 

“Their balance sheet ballooned for a couple years because the projects are just taking longer to naturally move off the book,” Mealor said. “As the economy heals, and as interest rates go down, we think that will accelerate. That's natural and that's expected. It's not necessarily a negative, but it's just an earnings headwind.”

CORRECTION, JULY 19, 11:45 A.M. ET: A previous version of this story misstated Bank OZK’s portfolio diversity and misstated its total allowance for credit losses, which are $574M. This story has been updated.