US large bank CRE risks could be understated, say researchers

Market participants and regulators may be understating the risk that commercial real estate (CRE) poses for the largest banks in the US, according to a paper by a team of academic researchers.

“Most people, when thinking about commercial real estate, only consider the risks associated with loans on banks’ balance sheets,” says Viral Acharya, a professor at New York University’s Stern School of Business, and a co-author of the paper, Shadow always touches the feet: implications of bank credit lines to non-bank financial intermediaries.

“But, in reality, banks and non-banks are always connected – you can’t fully grasp the size of the looming CRE crisis without considering non-banks drawing down their credit lines from banks.”

The idea that all banks are in one silo inside the regulatory perimeter and non-banks are in another outside – it is not a helpful way to look at the world

Viral Acharya, paper co-author

To date, concerns about CRE exposure have focused on US community banks, which hold a higher proportion of direct loans than the large banks with more than $100 billion in assets. However, the new study, released today (May 30), shows that large banks also have significant indirect exposure via credit lines to non-financial institutions – specifically real estate investment trusts (REITs). These credit lines only appear on banks’ balance sheets in full once they are drawn, and the associated credit risk is therefore easier to underestimate.

Specifically, the study finds that CRE exposures at the nine largest US banks more than double when factoring in credit lines to REITs. Among the top 50 US banks, a further dozen or so banks show similar increases in exposure once the indirect risk is factored in.

The study is written by Acharya – who is a former deputy governor of the Reserve Bank of India, and resident scholar at the Federal Reserve Bank of New York – together with Manasa Gopal of the Georgia Institute of Technology, and Maximilian Jager and Sascha Steffen, both at the Frankfurt School of Finance & Management.

Acharya says the research is not meant to imply that large banks’ CRE exposure poses a major risk to their solvency, but he worries that it is not receiving the attention or the capital that it needs.

“In my experience of financial fragility, what we get hit by is blind spots … You just kept the system capitalised for risks XYZ, and there was a W that you completely ignored – that’s what happened with interest rate risk last year,” he says. “Even now, the narrative out there that I read every day is that large banks are not significantly exposed to CRE.”

Rapid growth

REITs are investment companies that typically purchase physical properties – known as equity REITs, which constitute 90% of the market – or mortgage-backed securities (known as mREITs). The study finds that credit lines to REITS have grown faster than to other categories of borrowers – by around 86% in the decade to 2022. Around 50% of REIT financing comes from the banking sector.

To gauge the systemic risk of this exposure, the researchers applied the stress-test framework designed by NYU Stern to assess how incorporating commitments to REIT credit lines influences the market-derived capital adequacy for banks. This stress test is based on equity market valuations because the researchers do not have access to the granular asset composition data available to the Fed when it conducts the annual comprehensive capital analysis and review (CCAR).

The analysis shows that the required capital for the top 10 largest US banks surged by 75% from $39 billion to $69 billion once the indirect REIT exposures were factored in. The new study also finds that banks with more REIT credit line commitments experience lower stock returns during crises, without compensating higher returns in favourable market conditions.

This is because REITs are more sensitive to market stress compared with other non-financial borrowers. To analyse drawdown risks, the researchers cite the case of the giant Blackstone REIT (BREIT), which had assets of $113 billion as at March 31, 2024. In November 2022, faced with large redemption requests amid the sharp rise in interest rates and declining real estate prices, BREIT capped redemptions at 2% a month, and maintained this limit for the subsequent 16 months.

At the same time, the researchers found from third-party vendor datasets and BREIT’s regulatory filings that Blackstone had negotiated an increase in the amount of committed credits from $6.5 billion in Q2 2022 to $13 billion in Q3. It had also substantially increased the credit drawn from those commitments, rising from $1.1 billion to $6.3 billion over the course of 2022.

Significantly, the new credit facilities were offered by the banks at the same pricing as before, despite the obvious increase in risk and drawn exposure. Equally important is the fact that BREIT is not publicly traded, and it therefore maintains the right to limit redemptions. In contrast, for public funds that do not have this right, the researchers expect the implications for drawdowns to be even stronger.

“I was surprised that the upheaval of BREIT did not get much attention,” says Acharya, suggesting it should have served as a warning for the banking sector.

Wrong-way risk

Crucially, REITs are required by law to distribute at least 90% of their income to investors as dividends. As a result, they cannot use the income to increase their liquidity buffers if a downturn in CRE is expected.

Consequently, if a fall in CRE valuations drives higher redemptions, the REITs are likely to have to draw down on their credit lines to meet redemption and dividend obligations. This creates a kind of wrong-way risk, where banks’ drawn exposures rise precisely when the value of the underlying collateral is falling.

“In good times, the spread at which they borrow is usually lower than the spread on the line of credit, so the drawdowns happen when uncertainty in the market rises,” says Acharya. “Then the credit spreads widen, and then you could reach a point where the rollover finance is costlier than drawing down on your credit line.”

According to Moody’s Ratings, US and Canadian equity REITs’ refinancing risk is continuing to rise, with maturities climbing from a low of $40 billion this year to a peak of $110 billion in 2026. About 68% of REIT bank debt is due in the next two years, driven largely by revolver expiration. Many REITs are likely to have to refinance at a higher cost, and some in challenged sectors, such as office space, may be unable to renew their revolving credit facilities at the current size.

The research paper notes that CRE valuations fell 21% in the wake of the Fed’s monetary tightening in 2022, wiping out gains during the recovery from the Covid pandemic and leaving prices 10% lower than before the start of lockdowns in 2020. Acharya notes that since the Fed’s models for CCAR remain something of a “black box”, it is unclear if regulators have already taken this factor into account.

Factored-in

The extent to which the stress test adequately factors in the contingent risk of credit line drawdowns is something only the Fed can tell. However, several former regulators believe the prudential agencies are alive to the risk posed by CRE, even indirectly via REITs.

Kris Mclntire, who was a national bank examiner at the US’s Office of the Comptroller of the Currency until 2019, says he agrees “conceptually” with the idea that indirect exposures should be considered when evaluating an institution’s concentrations and overall risk profile.

You can’t fully grasp the size of the looming CRE crisis without considering non-banks drawing down their credit lines from banks

Viral Acharya, paper co-author

“The OCC, and other federal banking agencies, I’m sure, most definitely take into account both direct and indirect exposures,” he tells Risk.net.

Til Schuermann, a partner at consultancy Oliver Wyman, and former architect of the CCAR while a bank supervisor at the New York Fed, points out that the 2024 stress test included an assumption that the CRE index would fall 40% peak-to-trough.

“Credit exposures that have commercial real estate as collateral should have been evaluated against that hypothetical drop, and that should include loans to REITs,” he says.

Ron Cathcart, former head of enterprise risk supervision at the New York Fed, says the REIT market is “definitely in trouble”, citing the recent decision by Starwood REIT to limit share repurchases to 0.33% of net asset value from May 2024. In addition, there have been recent news reports that investors in the AAA-rated tranche of a commercial mortgage-backed security issue suffered a haircut, for the first time since the 2008 financial crisis.

In this context, Cathcart says the new research paper “raises some interesting points and provides some good analysis”. However, he cautions that bank exposures to REITs are very difficult to model because the terms and conditions on individual credit lines vary widely.

There may be ratings triggers that make drawdowns unavailable to the REIT. This would “provide an off switch in the event of [credit] deterioration”, says Cathcart. Alternatively, the exposure could be specifically secured against individual properties at conservative loan-to-value ratios, or there could be default covenants that allow banks to seize control of the REIT in the event of certain triggers being breached.

“The difficulty with analysing REITs at this level is that these terms are not generally available publicly,” says Cathcart.

Acharya says the study seeks to convey a general message to regulators and the industry. Namely, he urges greater attention on the evolving and increasingly interconnected relationship between banks and non-banks over the next five years or so, and for banks to develop appropriate risk management strategies accordingly.

“The idea that all banks are in one silo inside the regulatory perimeter and non-banks are in another outside – it is not a helpful way to look at the world,” says Acharya.

“Even if large banks are not at risk of failure, if their capital erodes, to me, that is systemic risk because that’s going to affect the level of intermediation to the rest of the economy.”

Editing by Philip Alexander