Community Bank Stocks: Overlooked and Undervalued?

As remote and hybrid work models become more entrenched, a regular stream of headlines about distressed sales or foreclosures of large urban office towers has led investors to shun stocks of smaller banks. That’s because on average, smaller banks’ loan portfolios tend to hold twice the share of commercial real estate (CRE) loans as large regional banks. As a result, the stocks of small regional banks and community banks have posted only modest gains this year even after rebounding somewhat in July and August, while hovering well below their pre-pandemic valuation multiples.

Conversely, the largest US bank stocks have performed quite well (Display). JPMorganChase has posted a total return of 25% year to date, and even the large regional banks have posted a median return of 20%. That may surprise some investors, given that cohort included all three regional banks that failed in 2023. (Note that large regional banks are generally defined as those above $100 billion of assets, while community banks have less than $10 billion of assets, and small regionals fall in the middle.)

 

Quality, Not Quantity, Matters

Dire predictions by pundits—including a warning by one industry commentator that CRE troubles could cause the failure of one or even two regional banks per week—appear increasingly divorced from reality, as no regional bank has failed in 72 straight weeks. Yet these warnings continue to make investors skittish.

While it’s true that community banks have twice the share of CRE loans, the quality of their CRE loans has outperformed those held by large regional banks and the commercial mortgage-backed securities (CMBS) markets by a factor of more than five times, by multiple measures.

What’s more, the performance of CRE loans varies greatly. Large office loans in some central business districts have showed significant distress, as have transitional CRE loans on large unstabilized properties made by private credit lenders. The small “main street” CRE loans made by community banks, however, continue to hold up well.

This outperformance is largely attributable to the smaller sizes of CRE loans made by community banks, which are constrained by their lower capital bases. In this cycle, we believe smaller CRE loan size is a key driver of credit quality, as seen clearly in the CMBS market (Display). The largest loans are much more likely to be tied to properties located in large central business districts and more acutely bear the structural challenge presented by the shift to remote work.

 

Beyond loan size, outperformance of community bank CRE loans could result from any combination of the following factors:

• Owner-occupied businesses: Nearly 50% of micro community bank CRE loans are made to businesses that occupy most of a property and may sublease a portion to other tenants. The loan is secured by the property and classified as a CRE loan, but it’s primarily underwritten based on the owner’s business, and their creditworthiness will generally be a function of economic conditions rather than interest rates.
• Recourse lending: Community bank CRE loans are primarily made with full recourse to the borrower—some combination of personal guarantees and cross-collateralization to other properties. This makes it less likely that a borrower will choose to walk away if a loan becomes stressed.
• Relationships matter: Most community bank CRE loans are made within the local communities where the bank operates, and there is an intangible relationship that has value. For example, some borrowers have direct access to the community bank’s CEO, if needed.
• Types of office properties: For community banks, many of the non-owner-occupied office loans are medical office buildings, which don’t face the same structural challenge from the shift to remote work. The balance of community bank office loans is generally one- or two-story structures with tenants skewed towards professional services firms, such as lawyers, accountants, and financial advisors.

An Extraordinary Entry Point

Community bank stocks are trading at rarefied valuations, particularly the micro-cap community banks—those with assets below $1 billion. The micro community banks are trading at an average discount of about 20% to their tangible book value (TBV)—near their trough valuation level during the pandemic, around the range they covered during the Great Financial Crisis (GFC), and far below their lowest point during the early ‘00s recession (Display). Micro community bank stocks are discounting an outcome similar to the GFC, when banks lost money and saw their book values contract. Fortunately, the fundamental prospects for community bank stocks appear brighter today.

We think there are many community bank stocks that could double within three years—if they do not sell before that time—through a combination of valuation recapture and above-normal tangible book value growth:

• Valuation Upside: Unlike the mega-capitalization banks, micro community banks potentially have 50% upside should they recapture their December 2019 valuation multiples.

• Above-Normal TBV Growth Potential: Community banks are profitable and are currently growing book values through retained earnings. But book value growth today is being supplemented by another tailwind: the accrual unwinding of bond markdowns. As these bonds pull-to-par over time, that’s worth about 4% annually assuming rates remain stable (more if rates fall). This phenomenon is not well understood by investors, in our view.

• Powerful Compounding Effect: Between book value growth (35%-40% for the average community bank over the next three years) and the simultaneous re-capture of pre-pandemic valuation multiples, the compounded growth in stock price could be closer to 110%-120%.

Lower Interest Rates and Increased Mergers

Following the Fed’s long-anticipated pivot, we expect lower short rates will be modestly accretive to earnings for the average community bank. This should enhance book value growth rates, while also serving as a “macro catalyst” to help reinvigorate community bank valuations.

Meanwhile, we are witnessing the beginning stage of a major wave of consolidation that we expect to unfold over the next several years, which could further benefit investors in smaller banks. The US banking industry remains fragmented, with more than 4,500 banks, and consolidation has been a persistent secular trend since the mid-1990s. A spike in long-term interest rates interrupted this trend in 2023, but M&A activity has since resumed, and we expect the industry to return to its 4% “cruising pace” (1 in 25 banks selling each year) within the next couple of quarters.

What’s more, based on our observations of current activity, we believe portfolios of specific community bank stocks may see more elevated rates of M&A take-out over the next couple years of perhaps 20% (or 5x the industry’s pace). The average one-day premium on sales of public banks this year has been 39%. That means the potential return stream from M&A events in a portfolio of community bank stocks could approach 8% annually for several years.

Ultimately, we believe fears related to commercial real estate will prove misguided. And investors who take advantage of the gap between perception and reality could benefit from what’s shaping up to be the best entry point into community bank stocks in the last 30 years.