If you are a large bank, the share of commercial real estate (CRE) as a percentage of your balance sheet is likely slightly less than 5%. However, if you are a community bank, the share is likely over 20%, and growing. Even when viewed as a percentage of Tier-1 capital, larger banks hold about four times for commercial real estate exposure. That is a pretty big difference and CEOs (plus risk managers) should at least be asking the question as to why.
One answer is that CRE is a risky asset class when judged along two dimensions. The delinquency rate for CRE, as of last quarter, was 1.43% compared to an average of 1.19% for all asset classes, including construction and credit cards. The other aspect of CRE is that it is more volatile than other sectors. We charted CRE against C&I loans, and you can clearly see the swings are larger in CRE compared to C&I. Numerically, the standard deviation, or volatility of CRE non-performance is 1.72% or 72% greater than the variability around C&I. Below is also a graph of two standard deviations (our normal downside stress test scenario), and as you can see, CRE is one of the banking industry’s riskier asset classes. While CRE is well behind construction and 1-4 residential housing in terms of risk, it is almost as risky as multifamily and has more volatility than the other six most common asset classes.
Making matters worse is pricing. If you subtract the credit and interest rate risk, the average total risk-adjusted relationship pricing on CRE for the month of March was about 13%. This compares to 17% for C&I. Multifamily and construction is the only other asset class that has a worse risk/reward profile.
Outside of risk and pricing, there is also the issue of cross-correlations. CRE tends to be 80%+ correlated to the general economy and about 97% correlated to other real estate related asset classes such as construction, residential real estate and multifamily. As such, the more CRE you hold, the more non-correlative credits should compose your portfolio. This means agriculture and consumer credit are preferred as are C&I credits to particular industries such as healthcare, technology and consumer products. Large banks understand this and also maintain more diversified asset classes on their balance sheet that have low cross-correlations.
To mitigate this risk, community banks should consider increasing their capital and loan loss allowance related to commercial real estate. If you consider the current standard deviations above, current levels are much too low given the fact that we are at or near the top of the credit cycle. In addition, community banks should be careful not to be adversely selective with pricing, as banks with a concentration in CRE at least should fill their portfolio with the most creditworthy borrowers.
Finally, more diversification is needed. At CenterState, we use our C&I program as a means to diversify into sectors that have low or negative correlations to commercial real estate. We are also making sure we continue to expand our agriculture and consumer loan effort. Finally, we are careful to price and market in particular parts of the State of Florida that offers us some geographic diversification in our CRE portfolio.
Current CRE concentration levels are worrisome and currently pose a threat to the future of community banking. Large banks understand this and are well positioned for the next downturn, while many community banks are not. If you are one of those banks that shrug their shoulders and rationalize your concentrations by saying “that is what our market is,” then you are short-changing the entire process of strategic planning and ignoring the concept of free will. Your bank can be anything it wants over time, and at a minimum, to survive, it should likely be more diversified away from commercial real estate.
Submitted by Chris Nichols on May 19, 2015