Small and regional U.S. banks hold about 80 percent of all commercial real estate loans in the country, totaling around $2.3 trillion, according to data service Trepp.
Typically, a bank bundles its loans into packets called “commercial mortgage-backed securities” and sells those packets to investors, spreading the risk more widely through the financial system.
First Republic Bank, now near to collapse, holds the ninth largest commercial real estate loan portfolio in the U.S.; Signature, before it failed, held the tenth largest.
These banks, their loans, and mortgage-backed securities are foundation stones of the $2.3-trillion U.S. commercial real estate market.
A record number of those loans, about $270 billion worth, are coming due this year at a time when commercial property values are plunging, interest rates have risen precipitously, and the banking industry already is in turmoil.
Most of those loans are held by banks with less than $250 billion in assets, Trepp said.
Commercial real estate loans make up a median 38 percent of the loan portfolio among U.S. banks, KBW Research estimates.
About 46 percent of loans against retail properties in 2022 were made by regional and local banks, according to MSCI Real Assets, a research firm.
Twenty-seven regional banks have high enough concentrations of those loans that the banks could face danger in a recession, a 2022 report by Moody’s Analytics said.
The size of the maturing debt, the slide in property values, and the bank sector’s wobbles have analysts increasingly concerned about the impact of those loans—many of which could default—on American banks.
If a sizable majority of those loans are paid as agreed, property prices could firm and the banking sector would avoid another crisis, The Wall Street Journal noted.
However, if the default rate spikes, banks would have to write down the value of those loans and likely would write down the value of similar loans even if they have not failed, which could drive the banking sector into a new round of turbulence.
The latter is a growing possibility as many lenders will struggle to pay off their loans or to refinance properties with lowered values at higher interest rates, Thomasz Piskorski, professor of real estate at Columbia Business School, told the WSJ.
“The destruction of value” in commercial properties “is quite big,” he said.
In a recent study, Piskorski and colleagues estimated that the outstanding loans in the overall U.S. real estate market are worth as much as $2.2 trillion less than their book value, with commercial properties comprising more than $500 billion of the deficit.
Hit with that wave of write-downs or defaults, 186 U.S. banks would be pushed to the cusp of failure if skittish depositors yanked out their money, the study concluded.
The concern is acute regarding loans against office buildings: the sector has seen about a 20-percent reduction in market value as companies succumbed to the work-from-anywhere revolution and scaled back their office-space needs.
Already, high-profile investors including Columbia Property Trust and Brookfield have defaulted on office tower mortgages, as we reported in “Top Private Equity Firm Defaults on Two Office Tower Loans” (21 Feb 2023) and “Office Tower Owner Defaults on $1.7 Billion in Mortgages” (28 Feb 2023).
Higher interest rates also have chewed up operating margins for many landlords; variable-rate mortgages are common in the industry, taken out when rates were a fraction of what they are now.
Owners with fixed-rate mortgages will feel the same pain when they need to refinance their loans or take new ones for property maintenance and improvements.
Malls may fare even worse, according to a Bloomberg analysis.
Retail real estate will show the highest rates of delinquencies among commercial real estate loans that have been bundled into securities, Fitch Ratings predicted in November.
From a 5.7-percent delinquency rate in October, troubled loans on retail space could virtually double to 11.3 percent by the end of this year, Fitch estimated.
“The bulk of maturing loans” on smaller malls and those poorly located “will likely default as access to capital gets harder,” Bloomberg reported, “and that was before banking troubles sent a shudder through markets.”
Options market players are putting more money into short bets on publicly-traded commercial landlords, expecting their holdings to shrink further in value and their businesses to be worth less, CNN reported.
As the banking industry prepares for a darker future in commercial real estate, the dollar volume of new loan applications in the sector grew by 18 percent in 2022’s final quarter, Trepp noted.
However, as early as January, lenders had begun to reduce the number of loans they were making in the sector as higher interest rates began squeezing out less-qualified borrowers and banks tightened lending criteria.
In addition, banks are cutting back lending to stockpile cash ahead of future Fed rate increases to protect their pad between assets and liabilities.
Larger cash reserves also may be required by more stringent federal oversight and regulations following this month’s multi-bank debacle.
“You will see banks pull back on commercial real estate commitments more rapidly in a world [where] they’re more focused on liquidity,” Goldman Sachs analysts wrote in a 24 March note.
As a result, the rate of growth in commercial real estate loans is half of what it was a year ago, Trepp calculated, and the number of new commercial mortgage-backed securities being issued has plunged by 78 percent.
Bank funding may dry up for commercial real estate loans; but if existing loans start to sour, there are guardrails in place that can keep banks from going over the financial edge.
While many commercial properties have shrunk in value, most are still worth more than their loan balances, giving landlords “a decent-size financial cushion,” Piper Sandler analyst Frank Schiraldi told the WSJ.
Also, regulations adopted during the Great Recession give banks ways to avoid showing losses even if failing loans have to be restructured and refinanced.
In September, the U.S. Federal Reserve announced it would review its guidance around restructuring loans on commercial real estate.
Doing so “is timely in the post-[COVID] era as trends such as increased remote working may shift historic patterns in ways that adversely affect the financial condition and repayment capacity” of landlords, the Fed said.
TREND FORECAST: With more than 125 million square feet of new office space still under construction, the market for office buildings will continue to crumble: as far into the future as we can see, demand for central offices will not return to its 2019 level.
The “Pall on the Malls,” which Gerald Celente first predicted 23 years ago in his bestselling book, “Trends 2000,” will continue as shopping malls continue to die their slow death; even warehouses are losing their value as shoppers sit on their cash while inflation and recession concerns play out.
Asset managers will cherry-pick the market and buy niche properties with unique value. However, many commercial real estate sectors will remain a losing investment for the foreseeable future… and may well be the spark that ignites a stock market crash.