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What's Bad About CRE?
Bank management teams that concentrate heavily in commercial real estate have been hit for at least a year now with questions about their business models from investors and regulators. Some banks are telling me that regulators are pushing them to reduce their concentrations.
The last financial crisis exposed some of the risks of a heavy reliance on CRE loans. And higher interest rates could stress borrowers when their loans reset at a higher rate.
Still, some of the top performing banks in the country are highly concentrated in commercial real estate, per Bank Director’s 2024 RankingBanking analysis earlier this year. We wrote about Five Star Bancorp in Rancho Cordova, California, Great Southern Bancorp in Springfield, Missouri, and Little Rock, Arkansas-based Bank OZK. So far, CRE has worked well for them. But questions linger about whether top CRE performers can maintain superior performance in the coming years.
“In most cases, having a concentration is a really good thing, because when you have a concentration in something, that means you've developed an expertise in it,” says Adam Mustafa, CEO and cofounder of the advisory firm Invictus Group. “If you're only doing one or two things really well, as opposed to trying to be all things to all people, that's usually a better strategy, no matter what business you're in.”
Mustafa took to LinkedIn last month to publicize his complaint. “I am tired of the term ‘concentration’ being … a negative when it comes to CRE,” he wrote.
The danger is that banks under pressure to diversify may grow in areas they don’t know well and don’t properly invest in. For many community banks, there aren’t a lot of good alternatives to CRE. Big banks and mortgage giants command the mortgage business. Community banks don’t have the size and scale to compete in consumer lending. Commercial and industrial lending is an opportunity, but it has higher loss rates. It also requires a special skill set to underwrite loans based on inventory and accounts receivable rather than real estate collateral. In other words, C&I loans bring their own risk.
Some CRE banks will undoubtedly falter. But others will excel. Warren Buffett once described his views on investment portfolios by saying diversification was fine for people who don’t know how to value companies. “Diversification is protection against ignorance. It makes little sense if you know what you’re doing.”
• Naomi Snyder, editor-in-chief for Bank Director
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