Navigating the new normal

The current commercial real estate (CRE) lending landscape has been shaped by government funding during the Covid-19 pandemic and relaxed credit standards in the past decade. 

Emergency financial support injected substantial capital into the markets, not only bolstering the CRE sector but also boosting liquidity and risk appetite. Concurrently, easing credit standards facilitated access to financing, fueling CRE investments. 

Regional and commercial banks originated hundreds of billions in CRE loans between 2017 and 2020, according to FRED¹. A large portion of these loans is set to mature between 2022 and 2025. 

This extended period of leniency calls for a reassessment of lending practices and risk management to ensure both stability and resilience. Concerns about the present state of CRE lending are on the rise. 

Source: Colliers Knowledge Leader²

Furthermore, with the US Federal Reserve (Fed) initiating interest rate hikes in early 2022 to combat inflation, CRE lending faces a distinct set of hurdles amid ongoing economic uncertainty.

This article examines the key challenges to CRE lending and explores possible solutions.

Rising interest rates make CRE borrowing expensive

The Fed’s series of rate hikes since early 2022 has made borrowing costlier for property owners and developers. 

Existing borrowers in the CRE sector are finding it difficult to refinance loans owing to the higher rates, which affect financial covenants such as debt service coverage ratio and maximum loan-to-value (LTV) ratio. 

Many CRE borrowers are concerned about their capacity to increase tenant rents promptly in response to rising interest rates, which can lead to cash-flow issues, especially in the context of loan refinance. 

Increasing interest rates are also prompting banks to reassess underwriting standards and risk models for loans, potentially leading to a more cautious and stringent approach to credit in the market. 

Moreover, the 5-year and 10-year US treasury yields are at their peak this year, after hitting rock bottom in March 2020, driven by the US Fed's rate-hiking campaign amid dwindling inflation.

Declining CRE appraisal values impacting LTVs and lending conditions

CRE lending is grappling with the consequences of diminishing property appraisal values across the US. 

A report from the National Association of Realtors states that commercial property prices declined 1.5% in the first quarter of 2023, marking the first decrease since the final quarter of 2020. 

The office sector, especially Class B and Class C properties, and the retail sector have been hit the hardest. 

According to McKinsey Global Institute, the adoption of hybrid and remote working models has reduced office space demand by 30% from pre-pandemic levels. Meanwhile, the growth of e-commerce has decreased retail space demand by 10-20% from pre-pandemic levels.

The recent downturn in CRE prices is exerting a notable impact on LTV ratios. 

In an ascending market, borrowers can obtain CRE loans with LTVs of 80% or even higher. However, in a descending market, financial institutions tend to insist on larger down-payments from borrowers, thereby reducing the LTV. 

A recent report from the Mortgage Bankers Association reveals that the average LTV for CRE loans completed by US banks fell to 68.5% in the first quarter of 2023 from 72.4% in the previous quarter. 

The decline in LTV was driven by various factors, including escalating cost of debt, a weakening economy, and growing risk of default.

CRE loan concentration of banks in a changing market environment

The number of US banks exceeding regulatory guidance on CRE loan concentration increased steadily to 567 in the last quarter of 2022 from 421 in the corresponding quarter in 2021, as per S&P Global³.

The list below shows the top US banks exceeding one or more of the 2006 CRE guidance criteria.

Banks subject to this regulation may face heightened regulatory scrutiny, potentially prompting them to scale back their CRE lending or exit their portfolios to facilitate turnover.

Largest US banks exceeding 2006 CRE guidance as of December 31, 2022

Data compiled Feb 21, 2023. CRE = commercial real estate; C&D = construction and development; ALLL = allowance for loan and lease losses

Analysis represents the 20 largest US banks and thrifts by total assets as of Dec 31, 2022, that met at least one of the two CRE guidance criteria: CRE loans greater than or equal to 300% of Tier 1 capital + ALLL and growth in CRE loans greater than or equal to 50% over the last 36 months; or C&D loans greater than or equal to 100% of Tier 1 capital + ALLL.

¹ Under the new community bank leverage ratio framework, qualified community banks that elect to use the framework are not required to report Tier 2 capital; hence, to calculate credit concentration ratios such as for CRE, regulators recommend using Tier 1 plus the entire ALLL. For banks that have adopted the current credit loss model, Tier 1 capital plus the portion of allowance for credit losses attributed to loans and leases is used.

² 36-month CRE loan growth is calculated based on the call report filing as of Dec 31, 2022, relative to the call report filing as of Dec 31, 2019.

³ ServisFirst Bank's C&D loans to Tier 1 capital plus ALLL for the quarter ended Dec 31, 2022, was 99.99%.

³ Includes operating and historical US commercial banks, savings banks, and savings and loan associations. Non-depository trusts and companies with a foreign banking organization charter are excluded.
Data based on regulatory filings

Source: S&P Global³

Adapting to the evolving CRE lending landscape

Following the collapse of three regional US banks in the first quarter, numerous regional and commercial banks have shifted their attention toward deposit growth and portfolio management. 

Smaller banks continue to dominate the CRE lending space, accounting for two-thirds of the total US CRE loans this year, compared with 52% in 2005. 

Banks with larger loan portfolios are enticing depositors with higher interest rates and extending greater insurance coverage beyond the Federal Deposit Insurance Corporation's limit of $250,000 per account.

Financial institutions are prioritizing data integrity, utilizing automation and actively managing their existing CRE loan portfolios through internal or vendor resources. 

The key aspects of portfolio management include risk rating evaluation, collateral and covenant monitoring, and cash-flow analysis. 

For collateral monitoring, financial institutions are working on verifying property valuations, as commercial property values across the US have fluctuated in response to evolving economic conditions. 

In addition, they are assessing early warning indicator systems to determine which portfolios carry higher risks. 

Source: FRED ^4,5,6

Conclusion

The CRE lending industry must embrace proactive strategies to thrive amid the evolving dynamics, such as rising interest rates, decreasing property appraisal values and heightened regulatory scrutiny.

Regional and commercial banks should adopt credit data-driven insights, leverage automation, and carefully and proactively manage existing CRE loan portfolios.

These steps will enable them to navigate the headwinds and position themselves for stability and success in the dynamic landscape of CRE lending.

References:

¹ https://fred.stlouisfed.org/series/CREACBM027NBOG
² https://knowledge-leader.colliers.com/aaron-jodka/colliers-quick-hits-loan-maturities-are-here/
³ https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/commercial-real-estate-loan-delinquency-rate-at-us-banks-sours-in-q4-22-74508846
⁴ https://fred.stlouisfed.org/series/CREACBM027NBOG
⁵ https://fred.stlouisfed.org/series/CRESCBM027NBOG
⁶ https://fred.stlouisfed.org/series/CRELCBM027NBOG

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