Office Buildings are Suffering: Will the Free Fall End?

The work-from-home culture, which emerged in the wake of the COVID-19 pandemic, has had a profound impact on various sectors, with the commercial property market being no exception. Since the pandemic began, the U.S. commercial property market has grappled with significant challenges, including office vacancies, decreased retail activity, and higher interest rates. This stress has forced banks and other lenders to tighten their lending standards and scrutinize existing loans to mitigate potential risks.

Office Loans Under Scrutiny

Regional banks have been particularly exposed to the commercial real estate (CRE) sector, but recent second-quarter earnings reports show that even large banks have been preparing for potential defaults, primarily on office loans.

Bank of America Corp (BAC.N): The bank faced $17 million in charge-offs on its office loan exposure during the second quarter, compared to $15 million in the previous quarter. While the value of assets under review for credit risk rose by $1.7 billion, the bank’s office CRE exposure remained low at 2% of its overall loan portfolio.

Goldman Sachs Group Inc (GS.N): This investment bank reported about $305 million in net losses within a private portfolio due to markdowns on office CRE. Its debt investment revenue also declined year-on-year, largely due to “weaker performance” in real estate investments. CRE loans represented only 15% of the bank’s overall lending book, and office-related loans accounted for just 1% of the CRE loan portfolio.

JPMorgan Chase & Co (JPM.N): Although JPMorgan’s CRE revenue grew in the second quarter, the bank reported $1.1 billion in credit loss provisions driven by its office portfolio. While the portfolio was relatively small, the bank increased provisions to ensure a comfortable coverage ratio.

Wells Fargo (WFC.N): The bank experienced a $949 million increase in its allowance for credit losses, primarily in CRE office loans. Despite a rise in CRE revenue, the bank’s CEO, Charlie Scharf, expressed reservations about potential weaknesses in the office portfolio.

Citizens Financial Services (CZFS.O): Citizens’ nonaccrual loans and net charge-offs both increased due to the bank’s CRE holdings. It recorded a credit loss provision of $176 million in the second quarter, but its CEO, Bruce Van Saun, remains confident that losses are manageable and well-covered by reserves.

East West Bancorp (EWBC.O): The bank highlighted its low average loan-to-value (LTV) ratio for its CRE portfolio, with its office loans boasting a weighted average LTV of 52%. Although most of the bank’s office loans are in the troubled California market, many carry full recourse and personal guarantees from individuals with substantial net worth, which adds strength to the portfolio.

Fifth Third Bancorp (FITB.O): The regional bank’s allowance for credit losses increased partly due to its commercial mortgage loans, but it has limited office exposure. The percentage of nonperforming CRE loans declined, but the percentage of CRE loans at least 30 days delinquent grew, indicating some potential concerns.

Morgan Stanley (MS.N): The investment bank reported higher provisions for credit losses driven by deterioration in CRE during the second quarter.

Webster Financial Corp (WBS.N): The regional bank saw a slight increase in nonperforming CRE loans, and it divested $80 million in CRE loans, mainly secured by office properties. Despite this divestment, the bank reduced its office exposure by 25% over the last four quarters with minimal impact on capital.

The work-from-home culture has indeed disrupted the U.S. commercial property market, particularly impacting the office sector. As remote work continues to be embraced by companies and employees, the demand for physical office spaces has diminished, leading to increased vacancies and decreased profitability for office properties. This shift has prompted banks and lenders to reassess their exposure to CRE, tighten lending standards, and prepare for potential defaults. As the work-from-home trend continues, the real estate industry will need to adapt and find innovative solutions to navigate these challenging times and thrive in the evolving landscape.