Local Banks Making Moves To Reduce Risk From CRE Loans

Commercial real estate has been a bread and butter industry for local D.C. banks for decades.

But now, during a time of high interest rates, historically slow deal volume and plummeting real estate values, those lending institutions are looking to expand their diets.

Multiple D.C.-area banks, including EagleBank, Sandy Spring Bank and Capital Bank, are actively in the process of diversifying their portfolios, Bisnow found, veering from CRE to the other major line of business for banks: commercial and industrial, or C&I, in which they lend directly to businesses. 

“Many of these banks over the last few years have been working to increase, in particular, C&I teams, to help diversify away from just commercial real estate,” Piper Sandler Managing Director Casey Orr Whitman, who covers a number of local D.C. banks, told Bisnow.

The strategy shift comes amid mounting concern about regional banks’ ability to handle the large swaths of CRE on their books. 

Five banks failed in 2023, driven by real estate loan distress, and some experts are worried more is in store. A study from banking industry consulting firm Klaros Group in March found 282 banks with high CRE exposure might need a new investment or merger deal to avoid failure.

Earlier this month, Starwood Capital CEO Barry Sternlicht said he expects the country’s 4,000 regional and community banks to start failing at a rate of one to two per week, due to real estate losses. 

In response, regulators have upped their scrutiny on banks that are over-exposed to commercial real estate. The ratio of CRE to risk-based capital that regulators deem desirable is 300%. But one-third of banks, mostly small and regional, are above that ratio. 

“They've been operating with over 300[%] for many, many years,” Orr Whitman said.

Sandy Spring Bank, a D.C.-area regional lender particularly overexposed to CRE, had a 348% CRE-to-base-capital ratio at the end of 2023. The year before, it was at 370%, per its 2022 year-end filing. 

The bank declined a request for an interview, but executives said on its first-quarter earnings call they are looking to reduce its CRE exposure. 

“We’re basically allowing ourselves to take care of some existing clients on the CRE side of things without materially growing that portfolio,” Sandy Spring Bank President Daniel Schrider said on the April 23 call. “So over time, we like to see a shrink [in CRE exposure] as a concentration of capital.” 

While many regional banks have operated above the 300% threshold for years, in today’s economic environment, there is more pressure to reduce that risk. 

In December, the Federal Deposit Insurance Corp. put out an advisory for banks with concentrated CRE portfolios to “reemphasize the importance of strong capital and credit loss allowance levels, as well as robust credit risk management practices.” The letter updates an initial advisory on managing CRE concentrations in 2008. 

“Banks are making an effort not just in my neck of the woods, but across the country to be below that 300% ratio on commercial real estate and that 100% ratio on construction,” Stephens Managing Director Russell Gunther, an analyst who covers Sandy Spring and other local D.C. banks, told Bisnow. 

“And if that is a focal point, which it is, then what are you going to grow? The other commercial asset class: C&I,” he added. 

As of last month, there were $2.8T in outstanding C&I loans in the U.S., according to the Federal Reserve Bank of St. Louis. But most local banks have a much smaller portion of their overall portfolios in C&I than they do in real estate.

Like other local banks, Sandy Spring is looking to up that ratio.

“The emphasis is going to be in the C&I and accompanying owner-occupied lending activities as well as some uptick in consumer lending activities as we ramp up our home equity,” Sandy Spring’s Schrider said on the bank’s quarterly call. 

Bethesda-based EagleBank, with $11.6B in assets, holds a 350.4% CRE-to-base-capital ratio, according to its SEC filing, above what regulators like to see.

“If you look at our CRE ratio, yes we’ve historically been higher than that 300%, but we’ve also been controlling the growth of that ratio,” EagleBank Chief Financial Officer Eric Newell told Bisnow. 

“The CRE concentration ratio is obviously indicative of our business model, but we have risk management practices that control the risks associated with CRE,” he added. 

The bank is also undergoing a strategy to expand its C&I business, EagleBank executives said on the earnings call, as well as increasing deposits. 

“We are actively looking to enhance the level of commercial and industrial loans within our portfolio,” EagleBank Executive Vice President and Chief Real Estate Lending Officer Ryan Riel said in an interview with Bisnow. “We are actively working on bringing in a more diverse funding base from a deposit perspective.” 

Locally, EagleBank sold one multifamily loan for a newly constructed Union Market building in January. Riel said the bank has no more plans to sell CRE loans. 

“Our loan portfolio is comprised of our customers, our relationships,” Riel said.

In the past few weeks, some big banks have sold off CRE loan portfolios. Canadian Imperial Bank of Commerce sealed deals to sell $316M of U.S. office loans. New York City Bancorp announced plans to sell about $5B in mortgage warehouse loans to JPMorgan Chase. And Washington Federal is selling a $2.9B multifamily portfolio to Bank of America. 

Rather than sell off CRE loans, Rockville-based Capital Bank is lowering its real estate risk by acquiring a small bank focused on C&I loans. The bank in March announced it is acquiring Integrated Financial Holdings, Inc. for $66M. 

When completed, the acquisition will drive down the bank’s CRE ratio to 285%, below the 300% threshold, according to a Piper Sandler report.

Capital Bank, which has $2.3B in assets, had a 304% CRE to base capital ratio as of the end of the year, according to its SEC filings. 

“We do have a heavy CRE book from the exposure standpoint,” Capital Bank President Ed Barry told Bisnow, adding that the bank is actively growing its C&I portfolio. 

For all these banks, changes will take time, not just because of long-term loans stuck on their books for years, but because of the way these institutions are used to functioning. 

“The problem is, it's not something you can do overnight,” Gunther said, “Commercial real estate lenders don't turn into C&I lenders, at least not good ones, with a little bit of training. And so that shift takes time.”

In the meantime, with any new CRE loans these banks are looking at, there is more scrutiny in lending practices. 

“Now, we're kind of asking ‘What's your plan B? What's your plan C?’ And making sure those are really documented, thought all the way through,” Capital Bank’s Barry said. 

Barry said the bank, which typically does $1M to $2M loans, is more frequently telling prospective borrowers “no.”

The bank is also taking more steps to project where the market is headed, he said, trying to spot any holes or weaknesses ahead of time rather than just relying on the borrower’s equity or the income capabilities of the property.

“We've put in a new commercial loan origination system, some new construction portfolio management processes and tools, some new systems around tracking of our covenants and key milestones. Ways to spot things as they're happening more real time and get on them,” he said. 

United Bank, which is below the 300% ratio, is also being more scrupulous. 

“We continued to lend through the Fed’s rate cycles, but we got more conservative in our approach to lending. But what I mean by that is lower leverage, higher rates and more guaranteed support,” United Bankshares President Jim Consagra told Bisnow.

The banks have generally seen increases in watchlist loans, loans that the banks are monitoring more closely, but haven’t turned non-performing.

“As interest rates have gone higher we've seen some modest uptick in the watch list, nonperformers. But charge-offs for the group have remained very managed. I'd say we're coming off very low absolute levels of problem loans,” Orr Whitman said. 

While most of these banks haven’t encountered major losses on their CRE portfolios yet, EagleBank did have a $48M loan on a downtown D.C. office last quarter record a $20M charge-off — meaning that debt isn’t expected to be collected. On its quarterly earnings call, bank executives said the property’s value declined by nearly 50% over a 15-month period. The property — the bank’s largest central business district office loan — was 63% leased.

“While the loss recognition is disappointing, it’s not entirely unexpected. We expect and are preparing for additional losses recognized through the cycle,” EagleBank Senior Executive Vice President and Chief Credit Officer Jan Williams said on its earnings call.

EagleBank CEO Susan Riel said the bank expects net charge-offs for the rest of year could range between $20M-$40M.

More than 60% of banks have higher shares of performing loans on watchlists than they did before the pandemic, according to an analysis of 123 banks from financial services firm Stephens. 

That increase isn’t expected to cut into the banks’ bottom lines significantly, but it will have an impact.

Non-performing loan rates for CRE loans are currently around 1%, according to Rebel Cole, a chaired finance professor at Florida Atlantic University. By comparison, most were more than 10% in 2009. But a year from now, he expects that percentage to rise again to 10% or more. 

“So the pain it’s coming. It's just not here yet,” Cole told Bisnow.

In anticipation, banks are increasing their contingency plans. 

“Banks have been building their reserves against their commercial real estate exposure … in anticipation of continued weakness in that asset class and potential higher losses down the road,” Gunther said.

In particular, there’s more of a focus on upping reserves for certain affected asset classes like office, Piper Sandler’s Orr Whitman said. 

United Bank’s Consagra said the company has “changed some of the qualitative factors for the asset classes that you'd be more concerned about in this market.”

But despite these concerning trends, lenders are in a different world than they were during the Great Financial Crisis.

“I think there's a misconception that this credit cycle will play out like the last one. And I think banks are in a very different position than they were,” Orr Whitman said. “There's a lot more equity in these deals. The values are very different. These banks are very different. So I think not every cycle will be the same. So we're cautiously optimistic.”