River City Bank likes to boast that it’s a midsized firm that thinks big.
The Sacramento, California-based lender has doubled assets to about $5 billion in five years with real estate loans up and down the West Coast. Its portfolio, from Los Angeles apartments to Silicon Valley storage facilities, is designed to withstand market tumult, said Dan Franklin, who oversees the bank’s property lending.
“We’re turning down way more deals than we’re doing,” Franklin said. “It’s a low, low risk, low-yield game that we’re playing.”
The rapid growth pushed River City’s commercial real estate loans to 660% of its capital as of the end of last year, more than double the level that regulators have said merits greater scrutiny. That’s the biggest share of any bank in California — but the lender has plenty of company.
California, an epicenter of last year’s regional-bank turmoil, is also at the forefront of the industry’s latest trouble spot: commercial real estate.
Almost a third of its 127 registered banks have property debt above the 300% level, the most among US states, according to a Bloomberg analysis of federal call reports that lenders filed for the end of last year.
Regulators and investors are closely watching lenders’ commercial real estate holdings as values tumble across the US, particularly for office and apartment buildings. Last week, Michael Barr, the Federal Reserve’s vice chair for supervision, likened the market’s stress to a “slow-moving train.” He said the central bank is particularly focused on lenders that have exposure to office space in areas where significant price declines are expected.
As the highest interest rates in a generation make it tougher for owners to refinance, banks are having to set aside more reserves for soured loans. It’s an issue that rippled through global markets earlier this year as companies from New York Community Bancorp Inc. to Japan’s Aozora Bank Ltd. warned of property losses — and is likely to be in focus in for the first-quarter earnings season that kicks off this week.
In California, Los Angeles and San Francisco have been hit particularly hard by office-market turmoil stemming from companies abandoning space and the slow return of workers from the pandemic. Banks’ relatively outsized share of real estate loans is partly tied to the fact that property prices have traditionally been high compared with the rest of the country.
That doesn’t necessarily translate to losses, and many lenders have portfolios that stretch far beyond the state. But the vast majority of California’s banks are relatively small and have flown under the radar of regulators — meaning some weaknesses would probably come to light only after things start to fall apart.
“The financial ecosystem in California is heavily reliant on regional and commercial banks,” said Michael Imerman, faculty director of the master of finance program at the University of California at Irvine’s Paul Merage School of Business. “Small banks cater to a specific clientele and that can lead to an age-old problem: concentration risk.”
Rapid growth
The Federal Reserve, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency have indicated that they would closely monitor banks that are within the 300% capital pool and have grown their real estate loan holdings by at least 50% in a three-year period. Twenty California banks, or 16% of those in the state, exceeded both thresholds — a greater share than anywhere but Washington, DC, and Oregon, according to the analysis. The data are based on call reports filed through March and encompass lending for traditional commercial properties, such as offices and shopping centers, as well as for multifamily buildings and construction loans.
If it were a nation, California would be the world’s fifth-largest economy, but its banking landscape is scattered. San Francisco-based Wells Fargo & Co., with $1.9 trillion in assets, is the only bank headquartered in the state that’s listed as a systemically important financial institution.
Regional banks tend to have greater exposure to commercial real estate and lack the other businesses, such as investment banking or credit cards, that can spread risk. Property loans offer relatively high yields in good times, but can magnify losses when values fall, vacancies increase and the cost of financing rises — as is happening now.
“Concentration in anything can kill a bank,” said Timothy Coffey, managing director at Janney Montgomery Scott, noting that Silicon Valley Bank was felled by its concentration of venture capital and startup clients, while San Francisco-based First Republic Bank focused on high-net-worth people with outsized balances of excess deposits. “It doesn’t matter what the concentration is, that fact it exists is a potential problem for banks and bank regulators.”
Commercial real estate, though, is a diverse industry that includes a wide array of properties, said Kevin Gould, chief executive officer of the California Bankers Association. Loans for downtown office buildings represent a “fraction” of the real estate market within bank portfolios compared with non-bank lenders, he said.
“When making CRE loans, banks follow safe and sound lending practices, including lower loan-to-value ratios and secure additional sources of collateral and loan guarantees, which we believe will be a source of stability,” Gould said.
River City had the highest exposure to commercial real estate among all US banks rated by S&P Global Ratings as of last August. But Franklin argues that concentration in and of itself isn’t necessarily a bad thing. He and CEO Steve Fleming have been piling into loans they see as safe bets, yielding a portfolio that’s conservative based on metrics such as loan-to-value and debt-service-coverage ratios. The company’s loan book of properties didn’t produce any credit losses last year.
“Our time to shine is when times aren’t so good, when there is some struggling out there and deterioration in the market,” Franklin said, noting that the company has proactively discussed its strategy with regulators. “That’s when we’re hopefully going to take minimal-to-zero losses, and we’re going to have the opportunity to keep on growing while everybody else is distracted.”
Getting tough
Banks, meanwhile, are getting tougher on delinquent borrowers.
California commercial real estate foreclosure filings almost tripled in January from a year earlier, according to data provider Attom. About a fifth of commercial loans with foreclosure filings in 2023 came from banks, with the others provided by insurers, nonbank lenders and wealthy individuals, Attom data show.
After the failures of SVB and First Republic, California’s Department of Financial Protection and Innovation promised to boost oversight hours and increase scrutiny of large banks. Mark Leyes, a spokesman for the department, declined to comment on that effort but said the regulator is watching the commercial real estate market closely.
State Senator Monique Limón, who chairs the Banking and Financial Institutions Committee, said that California’s banking oversight is increasing, but federal regulators are better equipped to oversee major institutions.
“Due to the nature of our dual banking system, California is reliant on federal regulators to establish a strong baseline for safe and sound practices within the banking industry,” she said.
Gregory Garrabrants, CEO of San Diego-based Axos Financial Inc., said California’s lengthy project approval process reduces the risk of bank losses on real estate. His company has been making big loans in the state and elsewhere in recent years, including $100 million to Trump Tower in Manhattan. Its commercial property loans equaled 245% of capital as of the fourth quarter, according to an updated call report filed last week.
While Garrabrants sees the San Francisco and Los Angeles office markets remaining challenging, California’s high barriers to entry can put a floor on values in other types of property, he said.
That “results in pricing being a lot higher,” he said. “If you are the beneficiary of owning that property, you actually have a stability because there’s supply constraints all around you.”
