Office loan worries loom large for second half of 2021

Capital Bancorp’s footprint spans Washington, D.C., and its suburbs in Maryland and Virginia. These are among the most prosperous territories in the country, but also some of the most affected by the pandemic's changes to work life.

The $2.1 billion-asset Capital, based in Rockville, Maryland, and many of its peers are likely to pull away from certain corners of commercial real estate, perhaps indefinitely, said Edward Barry, the bank's president and CEO.

Office properties have emerged as the leading concern, Barry said. Thousands of businesses — across almost all sectors — have successfully shifted to remote working arrangements. The cost savings are bound to motivate new views on the merits of office properties, including those in city centers that support surrounding retail businesses.

“There are landlords starting to get concerned,” Barry said. “People need less space, and that means more and more vacant offices.”

The average community bank is at least two times more concentrated in commercial real estate than the nation’s largest 30 lenders, according to the research and CRE data firm Trepp.

Most businesses lock into one-year or multiyear leases on office properties. Paycheck Protection Program loans during the pandemic helped many businesses pay their rents. But lending under PPP has ended, and as lease agreements expire, more businesses will want less space and demand lower rents. This will put pressure on landlords, and in turn they could struggle to pay their loans, Barry said.

This trend could play out over the second half of 2021 and well into next year, creating headaches for banks with substantial exposure to the office sector. It is likely to prove a key theme during the upcoming second quarter bank earnings season in July.

“There is going to be a new norm that involves more telecommuting and fewer people in offices,” said Damon DelMonte, an analyst at Keefe, Bruyette & Woods. “While the general sentiment is that credit quality held up really well, it’s definitely fair to have concerns about offices.”

Loan-loss levels for most banks remained low or only inched up during the pandemic, thanks in part to aggressive government stimulus programs in 2020 and a rapid recovery in economic activity this year amid successful coronavirus vaccine programs, Del Monte said. More than half of the U.S. adult population is now fully inoculated. Travel has accelerated and hotels and other once-vulnerable corners of CRE are bouncing back.

But office buildings could prove to be ticking time bombs, eventually causing loan losses even as the broader economy and banks’ overall loan books get healthier.

Moody’s Analytics projected U.S. CRE values would decline by 7% between pre-pandemic levels in early 2020 and the close of 2021.The hardest-hit categories are the office and retail sectors, with values in that span forecasted to decline 13% for offices and nearly 17% for retail.

Retail was already under heavy pressure prior to the pandemic, owing to the rise of online shopping. But the sector’s woes in 2021 may be linked to the challenges office properties face. When fewer people are flowing in and out of workplaces on a daily basis, the surrounding businesses that cater to office traffic are bound to face setbacks as well, bankers said.

“The office piece of CRE shifts slowly, but as people figure out that they need less space, it will have a ripple effect on retail,” Barry said.

Capital Bancorp pulled back on office lending and now only has a few loans to that corner of CRE. But the bank still has notable exposure to retail, Barry said, “and it’s something we’re watching closely as companies emerge from the pandemic: Who succeeds? Who is a failure to launch?”

The overall vacancy rate in D.C.’s central business district, for example, hovered around 10% before the pandemic but climbed to nearly 17% in the first quarter of 2021, according to the real estate brokerage firm Colliers International.

Nationally, office loans issued by banks in the first quarter were valued at 35% of levels in the same period of 2019, according to Trepp data. That means the cost of debt is rising for landlords as banks grow leery of office buildings.

Among loans that Trepp tracks, the office sector's delinquency rate remains low, according to Trepp analyst Maximillian Nelson. But it was the only property type to see a rise in delinquencies in the first quarter, increasing 20 basis points from the prior quarter to 0.7%. Occupancy data, Nelson said, is “cloudy.” If the clouds turn dark and occupancy rates drop, loan losses could follow.

Kevin Cummings, chairman and CEO of the $26.7 billion-asset Investors Bancorp in Short Hills, New Jersey, said “things overall look really quite good. The economic momentum, it’s building very quickly. There’s pent-up demand, and that’s ultimately good for banks.”

But, he added, the pandemic “changed things — some things maybe for a long time. There’s bound to be some challenges.”