KRE ETF: Regional Banks Unlikely To Deliver Alpha (NYSEARCA:KRE)

Main Thesis & Background

The purpose of this article is to evaluate the SPDR S&P Regional Banking ETF (NYSEARCA:KRE) as an investment option at its current market price. This is a fund with an objective to “provide investment results that, before fees and expenses, correspond generally to the total return performance of the S&P Regional Banks Select Industry Index”.

The regional banking sector once was a boring place to me, but recent bank failures and other macro-headlines have impacted the sector in a profound way. It has become a volatile sector – offering both opportunity and risks. When 2024 got underway, I reviewed KRE to see if this was an area I’d like to take a chance at generating some “alpha”. Ultimately I viewed the underlying sector as too risky and urged my followers to be careful with regional bank exposure:

As we march closer to the mid-year point, it has become time for me to take another look at this sector. KRE’s weakness has been apparent, but perhaps it is time to start looking forward with more optimism as the valuation gap between it and the rest of the market widens.

After review, I see this valuation gap as justified and not a reason to buy-in just yet. Regional banks are continuing to feel pressure from their consumer base shifting to their larger scale competitors, the headwind of office vacancy rates and defaulting loans is real, and interest rate volatility is making the outlook more clouded going forward. All of this adds up to continued reasons for caution, and I am reaffirming my “hold” rating for now.

CRE Loans – Regional Banks Most At Risk

Perhaps the primary reason I remain neutral on this sector has to do with its exposure to commercial real estate. This is important to understand because on the surface KRE is a “bank” play. The fund is a sub-sector of the wider banking industry in that it only holds smaller, regional banks in the US. This can make it a great tool for diversification and help to balance out portfolios that are large-cap or Tech heavy (as many are due to the S&P 500’s dominance):

So this is a regional bank fund – got it. That is important and I’m not suggesting otherwise. But the underlying companies (which are banks) are exposed to other sectors because their clients (whom they lend money to) are in all corners of the economy. Further, regional banks in particular have been big lenders to commercial real estate firms – those companies that own and/or manage office space here in the US. This is an area that tends to be financed heavily, setting those same banks up to be tied-in closely with the rises and falls of commercial property values.

This relative point is one I really want to emphasize. While falling commercial real estate values and rises in delinquency statistics are generally bad for all lenders and the broader US economy, the impact isn’t even. The holders of this debt will feel the brunt of the impact, even if the rest of it trickles throughout the market. To understand why this is such a unique headwind for the regional/smaller banking players, view the chart below:

The takeaway for me is simple. The threat of further pressure in the commercial real estate sector is not even across the banking world. Smaller and regional players are most at risk, putting them in a less favorable position than the bigger banks. This is a major headwind for funds like KRE – since this ETF only holds the smaller and regional players. Not a great balance in this climate.

Office Vacancies Present Rising Risk

Expanding on the above discussion, I will steer the conversation to where it gets more tricky and serious for regional banks. Right now, urban office space in particular is not where most people want to be invested. Vacancies rates are climbing and valuations plunging – causing some borrowers to demand concessions or are choosing to go into default. This has a headwind I discussed in January as a reason to avoid this sector – and KRE by extension. The problem is that things have gotten worse, not better, since then:

As you can see, vacancy rates are rising and that makes more properties prone to both default or delinquency. Worse, the likelihood of a loan on a property falling into arrears is rising based on the property size. This means that the larger the office space (and perhaps then the valuation on the property) the more at-risk it is, all other things because equal:

The thesis here makes sense because if commercial space is seeing a decrease in demand, naturally those buildings with the most space could become the least desirable. There are exceptions, of course, with prime space and buildings with extra amenities still attracting quality tenants. But as companies downsize, the need for ever larger buildings is declining. This puts some of the biggest loans on the potential chopping block – a major headwind for bank balance sheets.

My conclusion on this is I don’t see merit to a bullish outlook. Yes, things are bad and could get better. That is how bargain hunting works. But for something to be a bargain there has to be a justifiable reason for why the market is wrong and the contrarian play is right – and that isn’t what I see here. Instead, I view this as a worsening backdrop for an already volatile sector. What I say to that is: “no thanks”.

Earnings Highlight The Challenges

It should be fairly clear I am not a bull on US commercial office space and that extends to regional banks that hold the debt backing those same properties. This is a stance I took when 2024 got underway and I am still committed to that outlook for the time being. But readers shouldn’t just take my word for it. I believe my opinion is well supported – but you don’t have to go on my opinion alone. Just take a look at how earnings have been dropping (on a year-over-year comparison) for some of the top names in this sub-sector.

Recent reports (Q1) for some of the same companies that make-up KRE’s top holdings list don’t leave much room for confidence in my view:

To be fair, office space woes are only part of the problem. Another is the short-term elevated interest rate environment. This is putting pressure on regional players as their cost of deposits remains high (in relative terms). While the biggest banks (i.e. JPMorgan Chase (JPM), Bank of America (BAC), etc.) don’t have to compete very hard for deposits, regional banks do. That means the latter tends to offer more competitive interest rates for savings accounts to attract customers.

The net effect is higher rates from the Fed means higher rates paid to savers by the bank, something the biggest (non-regional) players don’t see as acutely. In an investment environment where I can put my money anywhere, if I was going to select the banking sector I would stick with the big players, not the small ones. This is why I own JPM and I’m not drawn to funds like KRE. These smaller, regional players face a heightened risk profile at a time when the market is already full of risk. Not the best investment case in my eyes.

Earnings Growth Is Strong Elsewhere

The earnings bit is an area that I think deserves an emphasis. While it is a different animal that the CRE loan discussion, it is just as important because of the relativity aspect. What I mean is, an earnings decline is not so bad in isolation if the rest of the market is also struggling. Some of the banks mentioned in the last paragraph had earnings drops, yes, but the drops weren’t terrible and could be viewed as just a bad quarter in a tough environment. If that were so, I wouldn’t rule out this sector going forward because better times may be ahead.

The challenge is that isn’t what is happening with the majority of the market. The Mag 7 continues to blow past earnings from last year and the broader S&P 500 is also seeing gains. While the gains are less than the Mag 7, they are still positive, highlighting the disconnect between KRE’s underlying holdings and the average large-cap US company:

The takeaway for me here is that many US corporations are seemingly thriving in the new normal. While higher borrowing and input costs are a concern, clearly the average large-cap company is passing on enough of those costs to their customers. Regional banks, by contrast, are having earnings challenges that are not consistent with the rest of the market. For me, this means finding “alpha” is going to mean looking past KRE.

What Could Prove Me Wrong?

While it should be clear from this article so far that I will not be a buyer of KRE, readers should also note I am not “bearish” either. The hold rating is important to understand because there are attributes for this sector that could send the underlying shares higher. In this light, I understand the bull case (even if I don’t agree with it), and I want to discuss a couple of reasons why others may be bullish on this sector to balance on the review.

A big factor comes in the form of good news that regional banks have become “cheap” in relative terms. KRE trades at under 11 times earnings, less than half the S&P 500 at current valuations. This is due to lack of investor enthusiasm about the sector and a widening performance gap between KRE and the broader market:

In addition, while I painted a fairly bleak picture of commercial real estate and its impact on the banking sector, that doesn’t necessarily mean things will actually get worse from here. Vacancy rates and valuations could stabilize, and that will shore up investor confidence in a big way.

Further, US banks have been planning for this for a while. What I mean is, loan loss reserves have been built up substantially from 2020 levels – in anticipation of Covid-related delinquencies. Since then, reserves have remained elevated and are currently well above charge-off levels for total loans:

The summation here is all might not be as bad as it seems. Regional banks in particular are attractively priced and they have reserves to cushion themselves against further loan losses. While more bad loans hitting the books is not a scenario anyone wants to see happen, but it is comforting to know banks are prepared for it. This is a positive attribute all things considered, and will provide a boost to the balance sheets for the sector in the future if the loan loss reserves are not utilized and that money is brought back to be used more productively (new loans, etc.)

Bottom-line

As 2024 has gone on, regional banks, and KRE by extension, have under-performed the wider market. The S&P 500 is posting gains that well exceed how banks (on average) have been delivering:

With CRE loans souring, property values declining, and Q1 earnings for regional banks disappointing, I cannot get excited for KRE as an investment right now and I expect this under-performance highlighted above to continue. There are too many major headwinds that I cannot look past – especially when I see attractive opportunities elsewhere. This leads me to maintain my “hold” rating on KRE and I would caution my followers to be very selective with any new positions going forward.