Time for Banks to Face CRE Loan Realities

Key Takeaways: 

• The recent news of additional rate hikes by the Federal Reserve means that banks need to abandon their wait-and-see approaches and take an inventory of their CRE loans and underlying collateral amid growing regulatory scrutiny. 
• Bank failures and rising interest rates are already fueling loan sales. With hundreds of billions of dollars of current and potential CRE market distress in the system, banks and investors need to address these challenges.
• Loan sales will help reduce the inventory of troubled loans and clear troubled assets from the system. A reset in property values will not occur until sometime in 2025.

Coming into 2023, banks and other CRE lenders believed interest rates would plateau in the summer and decline in the fall. In turn, values would stabilize, marking the beginning of the CRE reset. The Federal Reserve’s rate-hike pause in June buoyed those expectations. The optimism did not last long. Fed Chairman Jerome Powell was quick to indicate that at least two more federal fund rate hikes are likely this year. As a result, banks must now take a more realistic view of their CRE loan portfolios. Many of these portfolios have grown more than 27 percent to $1.8 trillion over the last five years, according to BankRegData.

Banks should be thoughtfully assessing their portfolios and address any potential issue before it becomes magnified. A loan may be currently performing, but performance can deteriorate quickly if the economy falters. Additionally, refinance devaluation risk and lower leverage have the potential to require sponsors to make significant capital injections. Many borrowers may not have the financial capacity to address a shortfall and be forced to sell an asset.

Over the last twelve months, the collateral value underlying many loans has dropped. CRE prices have declined by an average of 14.2% in May from the prior year, ranging from a 9% slide for warehouses to a 26% drop for apartments, reports Green Street.  Distressed CRE assets total $64 billion with an additional $154.9 billion in assets facing potential distress, according to MSCI Real Assets. Therefore, if rates remain at current levels for the next year with limited trades, owners may have no choice but to sell at lower valuations.

Over the next few months, investors will learn where the market stands as refinancing increases. More than $270 billion of CRE bank loans are scheduled to mature this year: $79.3 billion in the office sector, $64.2 billion in the multifamily category, and $52.7 billion in the retail sector, Trepp reports. Lodging, industrial, and other property types account for the remainder of the balance. Additionally, there are $331.2 billion in mortgages held by non-banks set to mature this year. By the end of 2025, there will be an another $1.5 trillion in CRE loans that are slated to hit maturity.  SSA anticipates refinancing to be difficult for borrowers for the remainder of 2024 and 2025 due to tighter underwriting standards.

Loan Dispositions Emerge

PacWest Bancorp’s sale of $2.6 billion in multi-family construction loans at only a slight discount indicates that some banks are electing to sell their best-rated debt to avoid significant write-downs. Then there are the forced sales. Silicon Valley Bank’s $72 billion in assets, which included $2.6 billion in CRE loans and about $13 billion in other real estate loans, received seventy-seven cents on the dollar for their loans.

The evidence suggests buyers are not necessarily jumping at opportunities. In its purchase of Signature Bank, New York Community Bancorp (NYBC) rejected the performing CRE loans totaling $34 billion – $11 billion of which are secured by rent-stabilized apartments in New York City. Banks are focused on maintaining liquidity for their banking customers and protecting themselves from an SVB – run on the bank. Meanwhile, investors are focused on making sure that any potential acquisition/purchase of a single asset/portfolio – collateral/note value is priced properly to meet return expectations. Investors also want to make sure they have the resources to execute the proper strategy (i.e. – pursue a discounted payoff – foreclosure) associated with each loan.

Loan metrics-performance such as loan-to-value, debt service coverage, collateral type, and geography are just a few factors that will influence banks on which loans they decide to keep or sell. Most banks are not equipped to manage troubled loans to optimize recovery. In SSA’s opinion, it would be best for banks to sell these loans to maximize proceeds. Banks will try to optimize these transactions by selling troubled and performing loans together to offset potential losses.

Self-Directed or Forced?

The next question is: Will the bulk of sales happen by choice or regulatory pressure? Nearly 765 regional banks hold CRE or construction loans that exceed total capital thresholds, according to Trepp. Those thresholds – were established by the FDIC and other regulators in 2006 and include 300% for CRE loans and 100% for construction loans.. In April 2022, regulators reminded banks of those thresholds in a policy paper amid the rapid rise in CRE debt holdings at the institutions.

However, rather than enforce the rules immediately, regulators are giving banks time to explore their options. In late June, they updated the guidance introduced during the 2009 credit crisis that encourages banks to work with creditworthy borrowers in times of distress. Among other discussions, the regulators recognize that banks may need to provide simpler short-term loan accommodations before a loan is ready for a complex, long-term workout.

Given the reduction in property values that has occurred over the last year – some – if not all the equity securing these properties has been significantly reduced or wiped out. As a result, borrowers will need to recapitalize properties by asking limited partners to contribute more cash, borrow additional funds from mezzanine or preferred equity providers, or some other source of rescue capital to modify loans. Therefore, new, and existing players in the private credit, private equity, and debt fund space will be in control, potentially creating outsized returns for their investors in the short to medium term.

The Timing Riddle

Occasionally, clients ask SSA: “When do you think the CRE market will bottom out?” It is a hard question to answer. Looking at the previous cycle, CRE values peaked in the third quarter of 2007 leading up to the financial crisis and bottomed out in the fourth quarter of 2009. Depending on whose data is cited, it took between four and seven years for prices to fully rebound.

In this cycle, prices peaked in late 2022. Yet there is one big difference between then and now. The Federal Reserve took two years to raise the federal funds rate four percentage points to 5.25 percent during the run-up in values leading to the financial crisis before quickly taking it to zero in 2008 in response to the turmoil. The FED took the same drastic rate-cutting action upon the onset of the pandemic lockdowns – in fact, it began cutting the rate midway through 2019. But the FED then raised rates by five percentage points in just 14 months, in conjunction with the slowing economic demand.

In SSA’s opinion, the markets have not reached bottom. SSA believes that the markets will begin to see a higher volume of note sales both par and at discounts in the fall. Followed by a pickup in property sales activity towards the end of the year, as sellers’ expectations reset. By the year-end, SSA would hope to see better price discovery and cap rates adjusting to higher rates, which are here for a while. Over the next 12-18 months, Banks and debt funds with legacy portfolios may face difficulty and uncertainty.

History suggests that a rate cut would once again help spark CRE investment activity. As noted earlier, many believed that the market would begin to stabilize by the end of this year. But with the news of more rate hikes on the horizon, that date has been pushed back – potentially to as far out as sometime in 2025. The problem is that banks do not have the luxury of waiting for a rate cut that may or may not happen for 24 months. Therefore, if they have not done so already, banks must create a plan to survive the current credit disruption. The game plan for success includes recognizing the situation, assessing the value of underlying collateral, and developing a resolution that positions the bank for future financial strength.