Texas banks in no small part have made possible Austin’s building boom, providing the financing needed to build the office parks, retail, hotels, and downtown commercial spaces used by the city’s growing tech and business services industries.
Success in real estate lending has helped to drive Texas banks’ profitability higher in the past two years, tracking above the national average. But in banking, as in stock picking, risk and reward tend to move together. The more a bank concentrates on a particular industry, the more it stands to profit from good loan performance in that industry, and the more it stands to lose from underperformance.
For now, the risk is mostly abstract: delinquency rates for commercial real estate loans are only 0.5% nationally. But some observers both in Texas and nationally are voicing concern over banks’ overexposure to commercial real estate.
“The commercial real estate sector remains a potential source of instability for the banking sector,” says Pablo D’Erasmo, an economist at the Federal Reserve Bank of Philadelphia. As commercial property prices have returned to levels not seen since the 2008 financial crisis, investors’ returns are starting to fall, he says. “This fall suggests that commercial real estate prices could be poised to tumble again, potentially causing large numbers of CRE (commercial real estate) borrowers to default, and leaving banks with steeply devalued CRE mortgages on their books and too little capital to match their liabilities.”
Bank monitors at the Federal Reserve Bank of Dallas agree that this is a risk for Texas banks. In a quarterly publication released Friday, Amy Chapel, a macrosurveillance manager in the Dallas Fed’s banking supervision department, and Kelsey Reichow, a financial industry analyst, cite concern over increasing commercial real estate concentrations at some of the region’s banks over the past three years. “Relative to some other assets, CRE (commercial real estate)… assets can be more volatile and have greater potential to lose value during an economic downturn.”
“Bank loan diversification is important, given a significant correlation between loan portfolio concentrations—particularly CRE—and bank failures.”
The trend toward concentration may be accelerating over the past year as appetite from property developers remains high even as industrial and consumer lending volumes have flattened or dipped amid trade tensions. In each of the past three quarters, the Dallas Fed noted growth in CRE loan volumes in its “beige book” reports, which summarize anecdotal information reported to the bank by surveyed business leaders.
Financial records of publicly traded Texas banks corroborate this picture. San Antonio-headquartered Frost Bank held $5.8 billion in commercial real estate loans at the end of the first quarter of 2019, about 40% of its total loan portfolio of $14.4 billion, an increase from prior years. “We may be adversely affected by weaknesses in the commercial real estate market,” the bank acknowledged in its most recent annual report.
Likewise, Dallas-headquartered Hilltop Holdings, parent company of PlainsCapital Bank, held $2.9 billion in commercial real estate loans at the end of the first quarter, more than 40% of it $7 billion gross loan portfolio. Similarly, about half of Texas Capital Bancshare’s total investment portfolio is in real estate, including over $3.2 billion in commercial and “market risk” real estate loans (“market risk” includes loans for medical buildings, apartments, shopping centers, and certain other types of real estate).
The company acknowledges, “Our real estate lending activities, and our exposure to fluctuations in real estate collateral values, are significant… If the value of real estate serving as collateral for our loans declines materially, a significant part of our loan portfolio could become under-collateralized and losses incurred upon borrower defaults would increase.”
Chapel and Reichow cite another gauge of risk for banks – the ratio of commercial real estate loan concentrations to total bank capital. Of the banks in Texas and neighboring southern New Mexico and northern Louisiana (the area covered by the Dallas Fed), 27% have a ratio above 200%, the same as the national average, while 7% have a ratio above 300%.
Some Texas banks’ loan portfolios, in addition to being industry-concentrated, are geographically concentrated, particularly in Dallas/Fort Worth. About a tenth of Texas Capital Bancshares’ market risk loans are in Austin, while 27% are in Dallas/Fort Worth. Frost’s commercial real estate loans are 26% in San Antonio and about a tenth in Austin.
One way that banks try to reduce commercial real estate risk is by collateralizing loans not just with buildings and properties but also with cash flows from the businesses operating those properties. Frost Bank, in its latest quarterly SEC filing, says that its commercial real estate mortgages “are viewed primarily as cash flow loans and secondarily as loans secured by real estate.” What this means is that these loans must undergo the analysis and underwriting process of a commercial and industrial loan, as well as that of a real estate loan, to determine the business strength of the borrower. This provides the bank with some additional security in case the real property collateralizing the loan unexpectedly drops in value in a downturn.
However, this type of collateral is vulnerable to economic fluctuations too and may not be “readily marketable” – meaning it would be illiquid in a crisis – according to Texas Capital Bancshares. “Due to the greater proportion of these commercial loans in our portfolio and because the balances of these loans are, on average, larger than other categories of loans, losses incurred on a relatively small number of commercial loans could have a materially adverse impact on our results of operations and financial condition,” the company says in a recent SEC filing.
Some observers believe that the banking sector is better positioned today to deal with a downturn than it was in 2008. Jonathon Adams-Kane, an economist at the Milken Institute, a nonpartisan think tank, wrote in a briefing last year, “The continuing rise in the concentration of bank exposure to CRE loans is likely to be less risky than a similar rise before the crisis. Back then, the locally concentrated banks… were highly exposed to highly volatile and very cyclical construction lending. Many of these banks do not exist anymore—they failed or were absorbed by other banks in the wake of the crisis.”
Adams-Kane explains that surviving banks have adapted by shifting their balance sheets from construction to less-risky types of CRE loans. He cautions, however, that “concentrations in CRE lending remain an important contributor to banks’ vulnerability and a key predictor of future bank failure. Fortunately, concentrated CRE balance sheets are generally found among smaller banks that are not systemically important. Nevertheless, their failure may cause substantial shocks to the local economies in which they operate.”
Photo: Frost Bank Tower, Austin (CC BY 3.0 – Trey Perry)
