By Saeed Azhar and Matt Tracy

NEW YORK (Reuters) – Small U.S. lenders that have outsized exposure to office loans could become the next group to face strains after bank failures roiled financial markets this month, according to analysts.

Rising interest rates, a slowdown in the commercial real estate (CRE) market and the proliferation of remote work pose challenges for smaller firms that made risky loans to finance office buildings, the analysts said.

For banks with assets between $1 billion to $10 billion, CRE loans comprised about 33% of the total held on their books, according to estimates by ratings agency Fitch. At the end of last year, CRE only made up about 6% of loans held by larger banks that had total assets of more than $250 billion, it said.

Goldman Sachs economists estimate the combined share of small and mid-sized banks, including lenders with less than $250 billion in assets, is 80% of the overall stock of commercial mortgage loans, it said in a note.

Both Goldman and Fitch did not specify which small lenders were most vulnerable.

Julie Solar, a credit officer at Fitch Ratings, said the office sector faces asset quality deterioration, putting smaller banks at risk due their relatively larger exposure as a percentage of their assets.

“Banks will be primarily exposed to CRE through bank loans on the balance sheet,” she said. The total exposure of the U.S. banking system to CRE loans was $2.5 trillion at the end of December, Fitch said.

CRE leases tend to be long-term, which give lenders time to deal with any potential problem loans, but a wall of maturities are due for both loans and commercial-backed mortgage securities in coming months, investors and analysts said.

“Coupled with higher funding costs, elevated funding needs, and tighter lending standards, this implies a challenging fundamental backdrop in upcoming months,” Vinay Viswanathan, an analyst at Goldman Sachs Group Inc wrote in a note. 

The S&P 1500 Regional bank index is down 30% month to date.

HEADWINDS

The CRE market faces headwinds that could hobble small banks. After the global pandemic sent droves of employees to work from home, many have returned on hybrid arrangements or not at all, spurring vacancies in office buildings.

    Rising interest rates have also depressed demand for CRE loans, while weighing on real estate investment trusts (REITs).

Goldman’s Viswanathan cited several indicators that reflected a weakening market for office real estate: declining occupancy rates, falling appraisal values and rising defaults.

  Last month, a subsidiary of asset manager Brookfield Corp defaulted on loans linked to two buildings in Los Angeles, according to a regulatory filing.

More cautious underwriting will probably lead to a further slowdown in real estate markets, Wells Fargo & Co analysts wrote, citing Federal Reserve data that showed tightening lending standards for CRE in the first quarter.

    CRE borrowers are grappling with higher costs for refinancing and hedging at a time where it’s also getting more expensive to pay back their debts, said Viswanathan at Goldman.

   Declining occupancy rates will probably force office landlords to cut rents for tenants who are also seeking less space as they negotiate new leases, he said.

Morgan Stanley expressed a more bleak outlook for CRE lenders this week.

    “Don’t roll the riskiest loans when they come due,” Morgan Stanley analysts led by Betsy Graseck wrote in a note. “Banks should tread carefully as they can be left with the keys” of properties they don’t want.

Big cities will bear the brunt of the CRE woes.

“You’re looking at the larger metro areas – LA (Los Angeles), New York, Chicago – where there is an abundance of office space that is now being severely challenged,” said Michael Donelan, senior managing director and portfolio manager at SLC Management.

CRE “is the next shoe to drop,” said Edward Campbell, co-head of the multi-asset team at PGIM Quantitative Solutions, a unit of insurer Prudential Financial Inc.

“The smaller banks are especially vulnerable,” he said.

(Reporting by Saeed Azhar in New York and Matt Tracy in Washington; Editing by Lananh Nguyen and Nick Zieminski)

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