Community Banks Rise as Office Loans Weigh on Regional Banks

In a recent analysis by Reuters, several regional banks reported notable increases in non-performing loans (NPLs) within their CRE portfolios. The culprit most of the time? Office properties, as reported by GlobeSt.

By The Numbers

Flagstar Financial (FLG), for instance, recorded a substantial $388M charge-off on its office loan portfolio, while KeyCorp (KEY) saw its NPL rate more than double in a year, reaching 5.1% in 2024 compared to 2.3% in 2023. 

This trend is concerning for regional banks, especially with office space demand declining due to remote work and hybrid work models becoming more entrenched.

Jason Benowitz, senior portfolio manager at Segall Bryant & Hamill, explained that regional banks might face continued strain in CRE due to multiple factors: reduced office demand, e-commerce’s impact on retail space, and an oversupply of warehouses that began during the pandemic.

Rooting for The Little Guy

While regional banks are struggling, community banks—those with assets under $10B —are showing considerable strength. 

According to Morningstar, these smaller institutions have not only maintained strong returns but even improved in 2024. The community bank sector delivered a 0.95% return on assets and a 9.60% return on equity in Q2 2024, with net income on the rise despite increased loan loss provisions.

Community banks’ CRE portfolios—covering multifamily, non-residential, and construction and development loans—have performed better than expected, even with inflationary pressures and fluctuating property valuations. These loans comprise roughly 46.3% of community bank loan portfolios.

Regional Regrets

The ongoing reduction in office demand has led to an increase in non-performing office loans. Mid-sized and regional banks with large office loan portfolios are particularly affected, as these banks often financed traditional office spaces that have become less profitable in the shift toward remote work. 

With leasing demand reduced and refinancing options constrained, these banks face an uphill battle to stabilize their office CRE portfolios. The limited data sample examined by Reuters, however, makes it difficult to determine if this strain is isolated to a few banks or indicative of a broader trend.

Looking Ahead

Regional banks may need to rethink their exposure to the office sector, reducing reliance on traditional office lending. Diversifying into other asset classes, such as industrial or multi-family real estate, could mitigate the risks associated with declining office demand.

Meanwhile, community banks could continue capitalizing on local market advantages, lending in sectors less affected by remote work trends and e-commerce.

As the CRE market faces further shifts, particularly in office space demand, both regional and community banks may need to adapt. Regional banks will likely need to adjust loan portfolios, while community banks can leverage their comparatively lower exposure to the office sector.