Commercial Real Estate and Regional Banks: Should You Worry?

Susan Dziubinski: Let’s talk about Morningstar’s updated take on regional banks in light of what’s been going on with New York Community Bank, which is ticker NYCB. Now, the stock has plummeted. Update viewers on what the story is here.

David Sekera: At the end of January, New York Community Bank reported a very large net loss for the fourth quarter. And the loss was driven by a couple of things. First and foremost in everyone’s mind was an increase in provisions for loan losses, specifically for their office and their multifamily exposure. And as you would expect for a company called New York Community Bank, a lot of that exposure is concentrated in New York, but they also had to increase their capital levels in order to satisfy some higher regulatory levels.

And we also saw a decline in their core profitability as such between all of these. The bank did cut its dividend all the way down to $0.05 a share in order to help it be able to build up some capital over time. In addition to the stock having just crashed since that earnings report, I also looked to see that the company’s bonds—so they have some November 2028 bonds outstanding—those have also fallen from trading in the mid-90s down to $0.77 on the dollar. Back of the envelope, that equates to about a 15.3% yield. So, those bonds are also now trading well into distressed-debt territory. Now, for people that aren’t familiar with how bonds trade, to put this in context: These bonds are no longer trading on what I considered to be a yield basis but really trading on a dollar basis.

Traders, when they’re thinking about how they trade these bonds, they’re thinking about it on a probability-weighted average between whether or not the bank survives, and these bonds do get repaid at full at maturity, or if the bank fails, and the bonds then trade to whatever the assumed recovery value is for this bank in bankruptcy.

Dziubinski: Morningstar’s equity analysts don’t officially cover NYCB, but can you give viewers some idea of what the possible outcomes could be for the bank?

Sekera: There are only three potential outcomes that I see here. First, maybe New York Community Bank is just able to limp along long enough to be able to earn enough income to cover its losses and rebuild the capital to where it needs to be. If it doesn’t lose a lot of deposits and it’s able to earn enough to cover up and build that capital to cover those commercial real estate losses, it could survive as an ongoing entity in its current shape.

Second, I do think there’s a good possibility we could see a large capital infusion here. We could see a large investor come in, make a big capital infusion through some sort of equity preferred or subordinated debt investment. The intent here really would be to instill enough confidence in depositors and investors to keep this bank going.

But depending on how that’s structured, it could be very dilutive to existing equityholders. And third, it could fail. So if we do see significant deposit flight here in the short term, and it just loses the ability to fund itself, the FDIC could come in here and close it down and take control.

Dziubinski: Of the regional banks that Morningstar covers, which have the most exposure to commercial real estate? And do we think these banks are at risk?

Sekera: Well, as you mentioned, we don’t cover New York Community Bank, but our analyst team really did take a deep dive and looked into what was going on here to see if there are implications for the other regional banks under our coverage. And our view here is that we do think New York Community Bank was just really in that uniquely risky position.

It did have materially higher commercial real estate exposure than any other bank as compared to our coverage. And it also had a more severe deterioration in its core profitability than what we’ve seen versus the banks under our coverage. So, while many of the banks under our coverage have seen some pressure on profits, it’s just a lot more pressure than what we’re seeing at New York Community Bank than the rest of our coverage.

When I take a look at our coverage here of the banks that we cover, two that I would highlight are going to be Zions ZION and M&T Bank MTB. They have the highest amount of commercial real estate exposure as compared to the amount of capital that they have. They also have very high amounts of office space exposure.

Yet we’re not as concerned as we are with the commercial real estate exposure as what we see at New York Community Bank. When I look at the numbers here, their exposure is really about half as compared to their capital on a relative basis. And then when I look at the office loans, it’s a lot less as compared to their capital than what we saw at New York Community Bank.

Dziubinski: To summarize, then, Morningstar thinks that this is largely a New York Community Bank issue and not something that we expect to spread to other regional banks we cover, even those that have maybe a little bit more exposure to commercial real estate. If that’s the case, Dave, is this a buying opportunity among regional banks today?

Sekera: We think so. Now, there certainly could be more volatility here in the short term just depending on how the situation at New York Community Bank plays out. But as you mentioned, a lot of the other regional banks did get pushed down over the course of the past two weeks as well. The one that actually has fallen the most, it’s down 10.8%, is Zions.

And that’s one where I might shy away from this one. It is a 4-star-rated stock, trades at a 28% discount to fair value, but doesn’t have an economic moat. This is the one that is still going to be the riskiest. It does have the highest amount of exposure to commercial real estate with the high amount of office exposure.

Of the banks that we do like that have fallen, the one I would highlight first is going to be U.S. Bank, ticker USB. That one did fall 6.5%. It’s a 4-star-rated stock and trades at a 23% discount. And this has really been kind of our go-to stock in the regional bank space. This is the only one that we do rate with a wide economic moat, and it’s one that we also rate with Medium Uncertainty.

And then two others that investors might want to take a look at are going to be Comerica, ticker CMA, and Truist Bank, ticker TFC. Those are both 4-star-rated stocks. Both are banks that we rate with a narrow economic moat.

Now, Comerica does have high commercial real estate exposure, but I would say it has a pretty low exposure to the office space. And then Truist does have moderate commercial real estate exposure as well but a low amount of office exposure. But that is one that does have a high amount of losses in its hold-to-maturity book. So, again, both of these do have maybe a little bit more risk to them. But we do think that at 4-star levels, you are buying those at a pretty good margin of safety from their intrinsic value.

This is an excerpt from the Feb. 12, 2024, episode of Monday Morning Markets with Morningstar’s Dave Sekera. Watch the full episode, “2 Stocks to Buy, 1 Stock to Watch, and 2 Stocks to Sell After Earnings.” See a list of previous episodes here.