Alarm bells for CRE lenders after Bank OZK's bad quarter

Bank OZK in Little Rock, Ark., did more than stub its toe when it reported lower profit tied to two big chargeoffs.

The $22 billion-asset company may have lost the confidence of investors for the foreseeable future, even though management used an earnings call to passionately defend its heavy reliance on commercial real estate lending, where the chargeoffs took place.

At least that was the view of several analysts who cover Bank OZK, which has faced criticism in the past for its CRE exposure. Shareholders also responded negatively to the news; the company's shares fell by roughly 27% on Friday.

"With defenses penetrated, no matter how small a breach, confidence in the OZK mystique [has] evaporated," Michael Rose, an analyst at Raymond James wrote in a note to clients.

The lesson for other banks is clear: Expect investor angst if a risky business such as CRE shows any sign of credit cracks at this stage of the economic cycle. The fact that one of the chargeoffs is tied to a Sears-anchored shopping center in South Carolina could serve as a warning for other banks that have similar loans outstanding.

The other loan is tied to a residential development in North Carolina. In all, Bank OZK charged off nearly $46 million in the third quarter to partially write down the loans. The chargeoffs contributed to a 23% decline in Bank OZK's third-quarter earnings from a year earlier, to $74.2 million.

“It is very easy to make the case that these are one-offs ... and the rest of the portfolio looks nothing like this,” Catherine Mealor an analyst at Keefe, Bruyette & Woods, wrote in a note to her clients.

“That said, at this point in the cycle, we don’t believe it matters," Mealor added. “The market is going to shoot first and ask questions later, in our view."

Bank OZK provided unprecedented details about its CRE lending in an effort to settle nervous investors, noting that the loans were made before the financial crisis and were categorized as substandard last year.

The company, as it has on prior conference calls, emphasized that its CRE loans have relatively low loan-to-value ratios. While its annualized net chargeoff ratio still remains low, at 0.49%, it is up significantly from 0.06% a year earlier.

While regulators have been raising concerns about CRE concentrations for years, Bank OZK has insisted that its expertise has earned it some leeway to maintain levels that far exceed those that receive added attention from examiners. At Sept. 30, loans in its national real estate specialities group portfolio totaled $8.6 billion — equal to roughly half of total loans and 240% of shareholders equity.

Gleason, for his part, assured analysts that no other shoes are about to drop.

“Properties are regularly and frequently appraised, so we feel confident in the quality of the portfolio," he said during the call.

Concerns about Bank OZK's commercial real estate portfolio first surfaced in 2016 when Carson Block, founder of Muddy Waters Research, sparked a brief selloff in the company's shares by questioning the strategy. Bank OZK has since been a periodic target of short sellers that have been waiting for a bad quarter.

It could take some time before investors show renewed confidence in Bank OZK, particularly at a time when many believe credit issues can only worsen from where they stand today.

“Unfortunately, with the credit blip seen in 3Q along with a significantly depressed outlook on near-term loan growth, we think that the shares may wallow until the next credit cycle proves out this business model one way or another,” Stephen Scouten, an analyst at Sandler O’Neill, wrote in a note to clients.