Commercial real estate emerges as latest threat to California banks

Regional lenders' outsized commercial real estate exposure triggers regulators' alarm

Commercial real estate emerges as latest threat to California banks

California, the hotspot of the regional banking turmoil last year, is now on the frontlines of the commercial real estate (CRE) downturn.

Many California banks hold notably high amounts of commercial real estate debt, raising concerns for regulators and investors. A Bloomberg analysis of federal data revealed that almost a third of the state’s 127 registered banks have CRE debts exceeding 300% of their capital, the highest in the US.

Banks like River City Bank in Sacramento have expanded aggressively in recent years. With assets doubling to $5 billion, River City’s commercial real estate loans now account for 660% of its capital – double the threshold considered risky by regulators.

Across the country, declining commercial property values (particularly office and apartment buildings) are prompting a closer look at bank holdings. 

“The Fed is particularly focused on lenders that have exposure to office space in areas where significant price declines are expected,” said Michael Barr, the Federal Reserve’s vice chair for supervision.

Higher interest rates are straining property owners and increasing banks’ losses on soured loans.

The Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC) have indicated they will closely monitor banks that have both CRE loans above 300% of capital and real estate lending that have grown by at least 50% in a three-year period.

Twenty California banks, or 16% of the state’s total, exceeded both thresholds – a greater share than anywhere but Washington, D.C. and Oregon.

California’s concentration risk

Office markets in Los Angeles and San Francisco have been hit particularly hard by pandemic-driven shifts in work patterns and slow employee returns. While property values were already high across California, the current downturn poses a risk for the state’s smaller banks focused on this sector.

“Small banks cater to specific clientele and that can lead to an age-old problem: concentration risk,” said Michael Imerman, faculty director at UC Irvine’s Paul Merage School of Business.

“Concentration in anything can kill a bank,” said Timothy Coffey, managing director at financial services firm Janney Montgomery Scott. “It doesn’t matter what the concentration is, that fact it exists is a potential problem for banks and bank regulators.”

Cautious but optimistic

Some banks are defending their strategies.

Dan Franklin, director of commercial real estate unit, claimed that River Bank’s CRE portfolio is designed to withstand market downturns.

“We’re turning down way more deals than we’re doing,” Franklin told Bloomberg. “It’s a low, low risk, low-yield game that we’re playing.”

Read more: Three strategies to mitigate risk in real estate investing in 2024

Kevin Gould, CEO of the California Bankers Association, argued that banks follow “safe and sound lending practices” that should ensure stability, even in downturns. But regulators and investors remain wary as office and apartment values tumble nationwide, making it tougher for owners to refinance.

Despite potential headwinds, close monitoring from both state and federal regulators is focused on preventing the kinds of failures seen last year. California’s Department of Financial Protection and Innovation has promised to boost oversight of large banks in the state, while federal regulators are also closely watching lenders’ CRE exposure.

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