Commercial real estate is frequently discussed as a concern for smaller banks, but larger banks are now showing the most noticeable signs of damage.

The stock market has not exhibited such behavior. Decreasing property values for offices, apartment complexes, and other commercial properties have been a significant concern for banks, especially smaller ones, impacting their share prices. The KBW Regional Banking Index has experienced a decline of approximately 12% this year, in contrast to the KBW Nasdaq Bank Index which has seen an increase of nearly 9% among larger lenders.

According to a recent analysis by Moody’s, regional, community, and smaller banks hold over a quarter of commercial real estate and multifamily property debt in the U.S. This is more than twice the share held by the top 25 biggest banks. There is a distinction to be made among various types of CRE loans.

When it comes to credit-card loans, there is a certain level of standardization. However, the realm of real estate tends to be more complex and less straightforward. Is it a loan for a newly constructed property or for an already existing building? Is the borrower the primary tenant of the property or are they planning to lease the building out? What type of building is it? Is it an office tower, a medical facility, a strip mall, or a warehouse? Is the loan divided among multiple banks or is it held by a single bank? And so forth.

It is crucial to thoroughly analyze performance rather than solely focusing on exposure. According to the latest data on the banking system, S&P Global Market Intelligence has compiled figures from regulatory filings for the first quarter. These figures reveal a notable difference in the proportion of loans classified as delinquent or nonaccrual, indicating that the bank does not anticipate full repayment upon maturity.

The issue lies with large banks and their loans for properties that are meant to be rented out to third parties. In the first quarter, a significant percentage of CRE loans for non-owner-occupied properties held by banks with over $100 billion in assets were delinquent or in nonaccrual status. That increased by more than 0.3 percentage point compared to the previous quarter. Meanwhile, in each of the different size categories of banks below $100 billion in assets, as well as for the owner-occupied loans of larger banks, the rate was below 1% in the first quarter.

The variation may be attributed to elevated interest rates. According to Nathan Stovall, director of financial-institutions research at S&P Global Market Intelligence, the performance of owner-occupied CRE loans is closely tied to the financial health and ability of the borrowing business to make payments. Properties available for lease, however, are significantly influenced by changes in interest rates. If the property’s income is not keeping up with the costs of paying the loan or refinancing, then the loan can become problematic. The property’s income can be affected by factors such as the occupancy rate or the latest rents.

The split may also be influenced by geographical factors, such as urban areas versus suburban regions, although it is not solely large banks that provide loans in downtown areas. Bigger banks may also have to deal with shorter-term maturities in important categories. Based on a March analysis by MSCI Real Assets, it was found that national banks held 29% of the value of the tracked office debt that matured last year, and they currently have 20% of the debt due this year. The share of regional and local banks decreased from 16% last year to 13% this year.

CRE loans typically have balloon repayments of principal at the end of their terms. Financial institutions with loans that are nearing their repayment dates should carefully assess the probability of these loans being repaid.

Several major banks have already set aside significant funds in preparation for potential losses on office loans. According to Morgan Stanley analysts, the median first-quarter reserve ratio for office loans at banks that disclosed this ratio was 8%. According to data from the Federal Deposit Insurance Corp, the loss allowance ratio across all insured banks and loan categories is significantly lower than the mentioned figure.

According to S&P Global Market Intelligence’s figures, the net charge-off rate for non-owner-occupied CRE lending at $100 billion-plus asset banks was over 1.1% in the first quarter. This was higher than the rates observed at smaller banks by about a percentage point or more. However, it is worth noting that the rate did decrease by more than a quarter point from the previous quarter.

Certainly, the challenges we face today are the same risks we encountered in the past. The key question is where these risks are currently concentrated. If a property downturn were to have a greater impact on smaller or suburban properties, or if it were to significantly affect businesses across the board, then it is possible that the smaller or regional banks that hold these loans could face some unpleasant surprises.

In contrast, a scenario of sustained higher interest rates and a stable economy may be advantageous for smaller banks. Considering the circumstances, there could be potential value in those stocks that is overshadowed by the concerns highlighted in the headlines.