Canadian banks are facing risk to their earnings due to their exposure to commercial real estate, particularly the office segment, according to Gabriel Dechaine, an analyst at National Bank Financial. While commercial real estate loans only represent around 10% of the lending portfolios of Canada’s six largest banks, they are the second-largest lending exposure after residential real estate. Dechaine warned that these loans could pose a high risk to earnings due to the challenges brought by rising interest rates and remote work, which have left many office buildings under-utilized and hurt rent prospects.
Dechaine stated that office exposures represent 12% of the average Big Six commercial real estate book and are particularly worrisome. In the past seven years, the commercial real estate portfolio has grown faster than the overall wholesale portfolio. Dechaine ran scenarios using the historical precedents of the 2008 financial crisis and the recession and real estate downturn in the early 1990s as proxies and concluded downside earnings per share risk could be in the high single digits or “well over” 20%, though “likely at the lower end” of that range.
Dechaine calculated that the Bank of Montreal, Toronto-Dominion Bank, and National Bank have approximately 10% exposure to office real estate, while the Royal Bank of Canada has almost 20%. However, despite the potential earnings impact, Dechaine stated that none of the large banks would fall below the minimum capital cushions required by regulators. Impaired commercial real estate loans are not rising significantly for Canadian banks, except for some exposure in the US.
Canadian financial institutions do not disclose as much as their US counterparts when it comes to set-aside provisions in their commercial real estate books, where US banks have flagged provisions of two to three percent. “Despite the stellar credit metrics today, investors are undoubtedly questioning coverage ratios in the event of an actual commercial real estate downturn (particularly in the office category),” Dechaine said.
However, other market watchers have expressed less concern about the ability of Canadian banks to weather exposure to commercial real estate. In an April 5 column, CPA Canada chief economist David-Alexandre Brassard stated that the big banks were “well positioned” to deal with historically high vacancy rates and higher interest rates, noting that commercial real estate represents only 2% of their overall assets, compared to 13% for US banks.
Dechaine concluded that with the commercial real estate overhang and ongoing turbulence in the US regional banking sector that could trigger a recession, most investors will likely maintain a cautious stance towards the Big Six banks.