Troubled U.S. office sector a drag on Big Six: DBRS

The troubled U.S. office real estate sector will weigh on Canadian banks’ earnings and credit quality, but the impact should be manageable, says Morningstar DBRS.

In a report, the rating agency examined the ailing U.S. office sector, which is struggling amid weak demand, rising vacancy levels and declining property prices.

That weakness is important for the big Canadian banks with operations in the U.S., as office real estate makes up a greater share of their U.S. commercial real estate loan portfolios compared with their loan books in other markets.

“Headwinds in U.S. commercial real estate, largely driven by the office sector, have become a main driver of credit quality deterioration,” the report said, noting that gross impaired loans have been rising since the second quarter of 2023 — accounting for 22% of impaired loans in the fourth quarter of 2023, up from 7.6% at the end of 2022.

As a result, the banks’ provisions for credit losses have also increased over the past three quarters, DBRS said.

Looking ahead, the prospects for the U.S. commercial real estate sector “remain challenging, despite anticipated interest rate cuts in 2024 and the expectations of a soft landing for the economy,” the report said.

Property prices are likely to remain under pressure in the year ahead, it noted, with growing quantities of debt maturing “at a time when vacancy rates are at decades-high levels and valuations have declined, leaving many borrowers needing to add equity to refinance.”

As a result, the banks’ earnings are expected to face pressure from higher delinquencies, provisions and losses in U.S. commercial real estate.

That said, DBRS expects the effects to prove manageable, given that the banks’ total exposure to the global office sector is “generally well diversified” and only represents approximately 10% of total commercial real estate loans, and about 1% of total loans.

Additionally, the big banks have healthy capital buffers and sufficient internal capital generation capabilities to absorb incremental losses, it said.

If losses prove larger than expected, the Office of the Superintendent of Financial Institutions could also lower the domestic stability buffer, giving the banks the ability to soak up heftier losses.

“With interest rates likely having peaked, banks may explore selling U.S. office debt in an effort to lower commercial real estate exposure. However, any office loan sales may be at a sizeable discount given valuation challenges,” the report noted.