Understanding Banking Exposures in Commercial Real Estate

Banks & Exposure to CRE: After a big freeze in the past 18 months, CRE lending opportunities are beginning to open as financial conditions have begun to ease, despite the stubbornly high SOFR base rate. Sponsors and Property Owners have anxiously waited for a more friendly backdrop to extend loans or take out new loans. Private credit managers are happy to make new CRE loans at wider spreads, competitive LTVs, acknowledging higher cap rates, a condition that leads to a more favorable IRRs & debt yields for the lender. Banks, on the other hand, are far less sanguine, given their existing exposure to CRE at a time when their CRE loan book appears to be on a trajectory towards 8-10% default rates. CRE loans represent ~25% of Bank assets with an aggregate balance that exceeds ~$2.7 trillion. Most CRE loans are held by small/regional banks. A new report from the National Bureau of Economic Research, Working Paper Series studies Monetary Tightening, CRE and Bank Fragility highlights the looming problem: excessive exposure to CRE by small & regional banks. The four largest banks hold ~11% CRE loan exposure (not a problem at all), while regional and small banks have ~38% exposure to CRE. In the U.S., there are ~4,200 small/regional banks. With DQ rates trending above 6% (less than 2%, just 18 months ago), several banks are on a collision course with reality. As seen in this bar chart (below), nearly 300 banks will become insolvent if DQ rates rise to 10%. Stricter regulations by the Fed/OCC/FDIC and higher capital charges mandated under Basel 3 Endgame (note: this applies to top 30 banks with >$100B assets) presents a huge opportunity for Private Credit Managers with expertise in Real Estate as banks reduce CRE exposure in the coming years. This void comes at a time when more than $2 Trillion in CRE loans mature in the next four years. RE Sponsors/Operators will need capital, and while construction and acquisition allow managers to deploy capital, playing defense is now job #1; the need to finance existing properties is at its most critical juncture. This likely requires a fresh capital injection by the equity holder to properly size the loan given the lower V when computing today’s LTV. Portfolio sales, senior loans, A/B structures, mezz debt, NPLs, and credit risk transfers represent solutions my team is focused on. While CRE property sales remain dormant, private credit lenders are willing and able to transact. Good luck out there to our friends in the real estate community, the banks and we are rooting for you. Number of Insolvent U.S. Banks vs. CRE Default Rates:

The COVID-19 pandemic has ushered in significant transformations in consumption and work behaviors, profoundly impacting the commercial real estate (CRE) market encompassing office, retail, industrial, and multifamily sectors. Key Developments: Remote Work Impact: The ability to work from home (WFH) has triggered a decrease in demand for office spaces, with a return-to-office trend stalling in 2023 and office occupancy lingering at approximately 50% of pre-pandemic levels. E-commerce Effect: The surge in e-commerce has negatively impacted traditional brick-and-mortar businesses, particularly regional malls, within the retail sector. Multifamily Challenges: The multifamily real estate market is contending with rising operating costs, slower rent growth, and increased costs of refinancing, driven by factors including rising interest rates. Concerns from the Federal Reserve: Institutions like the Board of Governors of the Federal Reserve System have expressed concerns about downside risks in the CRE market, citing weak long-run fundamentals due to WFH, elevated valuations, leverage, and rising interest rates. Leverage Concerns: Analysis of an index of CRE debt and CRE prices reveals a decline in prices alongside constant debt levels, indicating a potential rise in leverage within the CRE sector, posing solvency issues and potential defaults. Exposure Breakdown: Banks and thrifts emerge as the largest direct holders of CRE debt, accounting for nearly 40%, while an additional 34% is held in mortgage-backed securities. When considering both direct and indirect holdings, banking institutions are exposed to 40%-75% of all CRE debt. Banks and CRE Risks: Variable Exposures: Not all banks share equal exposure to CRE risks. Banks exhibit diverse business models and lending focuses, influencing their susceptibility to CRE market fluctuations. Bank Characteristics: Banks with larger CRE exposures tend to be smaller in terms of assets, have lower liquidity ratios, lower tier 1 capital ratios, fewer loan-loss provisions, and lower market returns since 2019:Q4. Size Matters: Large banks, with assets exceeding $100 billion, exhibit significantly lower CRE exposure than the average commercial bank in the U.S., indicating that risks from a potential CRE downturn are concentrated in smaller banks. Potential Systemic Impact: While risks may seem concentrated in smaller banks, the 2007-08 Financial Crisis underscores the potential for significant disruptions in financial markets and the broader economy, even from the failures of smaller institutions. In summary, the CRE market is navigating a complex landscape shaped by remote work trends, e-commerce growth, and economic challenges. Concerns about leverage and exposure levels, particularly among smaller banks, underscore the need for ongoing monitoring and proactive risk management in the financial sector. #cre #cref #cmbs #economy #banks #federalreserve

Commercial real estate. A follow up to yesterday's podcast on the topic and found in the WSJ this morning. Seems more are talking about some of the potential future issues in the market. I'm not sure I'd use "meltdown" - a bit of click bait there - more extend and pretend. "With the commercial real-estate market now in meltdown, those trillions of dollars in loans and investments are a looming threat for the banking industry—and potentially the broader economy. Banks' exposure is even bigger than commonly reported. The banks are in danger of setting off a doom-loop scenario where losses on the loans trigger banks to cut lending, which leads to further drops in property prices and yet more losses" "Banks roughly doubled their lending to landlords from 2015 to 2022, to $2.2 trillion. Small and medium-size banks originated many of those loans, and all that lending helped push up property prices" "banks also increased their exposure to commercial real estate in ways that aren't usually counted in their tallies. They lent to financial companies that make loans to some of those same landlords, and they bought bonds backed by the same types of properties" "That indirect lending—along with foreclosed properties, trading portfolios and other assets linked to commercial properties—brings banks' total exposure to commercial real estate to $3.6 trillion, according to a Wall Street Journal analysis. That's equivalent to about 20% of their deposits" "Real-estate investors that are unable to refinance their debt, or can only do it at high rates, are defaulting. The lenders, no longer getting the debt payments, often have to write down the value of those mortgages. Sometimes the bank ends up owning the property" Office. "He had a $240 million mortgage coming due on a 33-story office building in lower Manhattan. Vacancies were high, renovating or converting the building would be expensive and the cost of a new mortgage was way up. He ran the numbers and decided to default on the loan" "Between 2015 and 2022, banks more than doubled their indirect real-estate exposure. " "Regulators' playbook for banks now is similar to its strategy after the 2008 financial crisis: allow banks to work with struggling borrowers and allow them to keep mortgages on their books at face value in many cases" "All of a sudden banks have borrowers who are saying, holy crap, I was paying at 3.5% and now I'm paying 7.5%," he said. "If borrowers aren't able to service their debt then banks have to recognize this as a bad loan." #cre #commercialrealestate #credit #office https://lnkd.in/gjWSbSCr

Hugely important banking story in Financial Times showing that major banks are facing trouble in their loan loss provisions due to unanticipated high vacancy rates. This can be managed! Let's dive in. 🏦 New evidence shows that the biggest banks in the U.S. find themselves grappling with a surge in bad commercial real estate (CRE) loans. "The average reserves at JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, Goldman Sachs, and Morgan Stanley have fallen from $1.60 to 90 cents for every dollar of commercial real estate debt on which a borrower is at least 30 days late," according to new filings from the FDIC. 📈 A Surge in Delinquencies This downturn in reserves has unfolded over the past year, with delinquent commercial property debt for these six major banks nearly tripling to $9.3bn. The scenario is similarly grim across banks with the value of delinquent loans tied to offices, malls, apartments, and other commercial properties more than doubling last year to $24.3bn. “We have been closely focused on banks’ CRE lending,” said Michael Barr at the Federal Reserve. 🔍 The Reserve Dilemma Bank models of balance sheet risk have missed a major elephant in the room and failed to anticipate risk. “There are banks that may have looked fine six months ago, that are going to look not so good next quarter,” said Bill Moreland of BankRegData. Allowances for loan losses across the industry need substantial increases to address the growing risk. The reliance on historical loss rates for provisioning against CRE loans is now under huge scrutiny and banks have not adapted to CECL guidelines. "I know that the historical loss rates are low, but we need to see if the banks have been forward-looking in predicting expected losses, and not just relied on what has happened in the past," said João Granja, a coauthor at UChicago. 🏗️ Optimism Amidst Uncertainty Despite the concerning trends, some bank leaders remain confident in their institutions' resilience. Bank of America’s CEO, Brian Moynihan, in December pointed out the relatively small portion of their CRE debt tied to vulnerable market sectors, underscoring a sense of preparedness: "It’s such a small part of the table... We feel good." However, this optimism is tempered by caution. "Any downturn in provisions... would fundamentally be the wrong behaviour," said Richard Barkham, global chief economist at CBRE. Banks could face up to $60bn in losses from soured CRE loans in the next five years—roughly double what they've currently reserved for these losses. 📊 The coming months will likely reveal the full impact of the surge in CRE loan delinquencies and whether the banks' strategies will be sufficient to weather the potential storm. But rather than waiting for the storm, banks should bet ahead of the curve. This is exactly the modeling we do in Dainamic - see comments for a CECL whitepaper. #CommercialRealEstate #BankingCrisis #FinTech #RiskManagement #FinancialStability

Bank CRE Loan Sales ahead in 2024 Those banks, like a Synovus, that got ahead of this in 2023, achieved more recovery than those banks just getting started in 2024. Now with the Fed back on "Higher for Longer" message post their Dec "Rate Cuts Ahead" teaser, CRE values will decline further in 1H 2024. Investors should be patient (bigger discounts are coming), and more scrutinizing by property type and market. Follow the growth from likes of UHaul moving report, and steer clear of declining and problematic states and MSAs like CA, Colorado, NY. Ask what the situation is for taxes, homeless, housing affordability, and household and workforce growth at the MSA level before you consider investment in any state or MSA for a purchase of a loan portfolio. Go study the 2023 sale of a medical office portfolio by Synovus for what to know and evaluate in the pricing. They did it right going back to the original underwriting of each loan to highlighting the appeal to an investor. And pay attention to rising property insurance and the re-tenanting costs for 30%60% empty buildings. Both can eat up your pro forma ROI guesstimate. Note the following from this article: More banks are exploring loan sales Banks and other lenders generally aren't eager to seize the real estate assets that collateralize their debt. Foreclosures can take months or longer and owning property is costly, requiring lenders to cover maintenance, insurance, and other operating charges. #cre #ccim #naiop #sior #irem #uli #office #banks #loansales #trepp #commercialrealestate https://lnkd.in/gYSRCRCC

Last week, I had a discussion with Dominic Chu at @CNBC about the misperception that distress in commercial real estate poses a risk to capital markets, the banking system, and the wider economy. Unfortunately, the sector is often seen through the lens of the office market, which indeed confronts numerous hurdles. Yet even there, we see a divided landscape: modern, smaller, suburban office buildings show an average vacancy rate of 11.5%, in contrast to large, older, urban constructions which approach 25%.   It's important to remember that there is a substantial variation across commercial real estate asset classes and as such, I continue to point to the varied conditions among different product types, their rent and occupancy profiles, and the degree of loan performance-related distress.   The rapid rise in interest rates and the unlikely scenario that rates will revert to near zero mean price adjustments. However, the degree of re-valuation must be based on each market, product type, and situation. We are seeing examples of situational distress caused by maturing loans in all property types, where our team is helping owners raise equity, recapitalize, or restructure deals or execute sales. Although there are growing opportunities for astute buyers, a wave of fire sale-priced quality assets is unlikely.    For more insights, the full conversation is available at: https://lnkd.in/gUSXwiJZ

Konrad Putzier of The Wall Street Journal writes about the flashing warning signs of the commercial real estate credit crunch: many office landlords cannot pay back their debt and are now struggling to secure new loans. This is due to a confluence of factors including high office vacancies, high interest rates, devaluation of real estate and banks seeking to limit their exposure to the challenged office sector. With more than $1.5 trillion of CRE loans due before the end of 2025, borrowers must be granted more time to restructure their debt with lenders to avoid more defaults and the far-reaching economic impact that will follow.