Commercial real estate is a hot topic right now. The perception of increasing risk within the banking system surrounding real estate loans is prevalent. This might be an area within your bank that you will want to look at closely right now to catch any early warning signs of any deterioration.
How we got here
Prior to the pandemic, commercial real estate was benefiting from stable tenancy rates, good cash flows and low interest rates. Outside of a bit of stress in retail real estate, overall, the market was strong with low cap rates and impressive net operating income on most properties. This prompted many banks to offer five-to-seven-year balloons with longer amortizations and higher loan-to-values.
The pandemic adjusted most tenant business models, in some cases, decreasing the necessity of large amounts of floor space for workers. The move to remote workspaces made many companies rethink their real estate needs.
As lease agreements matured from 2021 into 2023, a great deal of tenants either cut back or abandoned their locations driving down total revenue on a good number of properties. Combined office/retail properties were hit the hardest. Further, locations that were once quite attractive became less so as crime and other societal issues arose.
The rise in interest rates from historical lows in 2020, cut into the net income of many real estate projects. An endeavor that was viable at an interest rate of 4% will now struggle at 9%. The rapidity of the interest rate increases did not allow the owners to adjust rents to offset the higher debt carrying costs when the existing loans mature. Inflation also created an issue for owners as operating costs rose dramatically on expenses not covered by the tenants. Between lower revenues and increased costs, net operating income has plummeted in many projects leaving real estate values in significant doubt.
In response to the rapid changes, larger banks began pulling out of the real estate market in 2021. From January of 2022 to the first quarter of 2023, commercial real estate loans in all banks rose by 15%. Community banks’ holdings in commercial real estate increased by 20% during the same period. The larger banks had held a total of 35% of all commercial real estate loans at the start of 2022. That percentage has now dropped to 32%. Most every community bank is holding a level of commercial real estate loans well in excess of their total capital level.
What to do now
Before your next regulatory exam or the level of maturing real estate loans begins to overwhelm your resources, now is the time to take action. You will want to catch a hint of where the problems exist in your portfolio now. Please recognize that a past due payment is not going to be an early warning sign, it will be a sign that your options are limited, and it may be too late to do much if anything at all.
This is a great time to have the file reviewed by legal counsel, this can be completed by either your internal legal counsel or an external source that is proficient in loan documentation. This will assure you have your ducks in a row and that there are no deficiencies. If the files do become problem loans, the last thing you want is a documentation issue.
For each property, the next step is to complete a site inspection. This should include assessing the condition of the property as well as noting all tenants and vacancies that exist. Your staff should be getting updated rent rolls and lease agreements. Your bank should have some sort of Excel spreadsheet to perform a quick and dirty updated valuation on the property using the updated cash flow, net operating income and current cap rates.
Based on the updated information that is received, the current risk rating should be assessed and defended.
Depending on the result of your re-valuation this will be the right time to recalculate the loan to value to assure that it's still acceptable. Based on the existing amortization will the loan be considered a High Volatility Commercial Real Estate Loan (HVCRE)? Because of the possible decline in values along with having a long amortization where the principal balance has not fallen much since inception, many banks could be facing a requirement to enhance their loan loss reserve significantly.
Having identified the problem real estate loans, it is now time to set up action plans for each account in anticipation of their coming maturities. This will include determining which are worth saving, which require a pay down before renewing, how some can be restructured, and which need to be exited. Now is the time to start the action plans. Your clients deserve to be informed so they also have options.
By acting now and reviewing your real estate portfolio, identifying where the problems may be, and working on them well before the maturity date, you will find that both you and your clients have options that may disappear if you decide to wait.
Brad Stevens is the principal and founder of Stevens Risk Management, LLC. Stevens Risk Management specializes in credit analysis, work out, loan review, and credit policy training and consultation. Reach Brad at 616-751-7982 or Brad.Stevens@srmallc.net.