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Bank OZK, with significant exposure to commercial real estate, is facing scrutiny as high interest rates persist. As we discuss in today's email, analysts have downgraded the bank due to concerns about its large loans, notably a $1.5 billion project in San Diego with low leasing activity. The bank maintains substantial reserves to cover potential losses, and its executives remain optimistic about their financial position despite these challenges.

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Now, let's dig in!

Is the Bank OZK Downgrade Warranted?

Many eyes have been on Bank OZK since the Fed raised interest rates. This relatively obscure bank has one of the largest exposures to commercial real estate, becoming a primary lender for large developments nationwide. Despite the high interest rates, the Arkansas-based bank continues to fund new commercial real estate loans. In March 2023, the bank had $22.06 billion in commercial lending exposure; by the same time this year, that number had grown to $28.03 billion.

Now, analysts are changing their outlook on the bank as more commercial real estate loans fall into special servicing. This week, Citi Bank analyst Benjamin Gerlinger downgraded Bank OZK from a buy to a sell due to “newfound but substantial concerns” regarding OZK's largest individual loan ($915 million) for a multi-use project in Atlanta ("Echo Street West"; $135 million loan) and life sciences construction lending in general.

Gerlinger is one of several analysts voicing concerns about the bank’s loan portfolio, but his pessimism had the most immediate impact on the company’s stock price. The stock has dropped nearly 20%, erasing about $800 million in equity. So, what are Gerlinger’s concerns, and is his theory about the company well-founded?

While Bank OZK has significant exposure to commercial development, it also has substantial reserves for potential loan losses. “Provision for credit losses was $42.9 million for the first quarter of 2024 compared to $35.8 million for the first quarter of 2023. The bank’s total allowance for credit losses (ACL) was $536.9 million on March 31, 2024, compared to $393.8 million on March 31, 2023,” a company spokesperson said during the last earnings call. These reserves could deplete quickly if several large loans encounter problems simultaneously.

One of the most concerning aspects of Bank OZK’s balance sheet, according to Gerlinger, is its large loans for a $1.5 billion project in Downtown San Diego. "We believe 0% of the 1.7 million square feet is leased—indicative of a difficult life sciences construction lending market," he said. Indeed, San Diego’s Research and Development District (RaDD) has seen little leasing activity.

A recent C&W report shows San Diego has a lot of new inventory being completed and negative net absorption. However, the same report ranks San Diego highly for underlying fundamentals in the life science property market. Bank OZK loaned $475 million to the project in 2022 and another $265 million in 2023. If both loans were nonperforming, it would deplete all of Bank OZK’s cash allowances, leaving them vulnerable to losses from other struggling loans.

The timing of the loans might favor Bank OZK. There is still time for the project to lease up before the loans come due. Developer IQHQ has many other life science projects, including a $1 billion development near Fenway Park in Boston, and shows no signs of defaulting on their loans. While Bank OZK is exposed to the risk of large-scale defaults in life sciences, its cash reserves and the financial strength of its borrowers should reassure investors that no single project is likely to cause the bank to fail.

Analysts might have turned on Bank OZK, but the executives are not sounding alarm bells yet. In the last earnings call, CEO George Gleason explained, “Higher for longer at current rates is an excellent scenario for us. It gives us time to reset that floor and keeps repayments at a fairly muted level, both of which are very helpful from a net interest income perspective.”

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