We do not see the current stress period as a repeat of the Great Financial Crisis residential mortgage meltdown. US banks’ holdings of CRE loans are just 13% of their total assets. At the end of 2007, banks held 17% of their total assets in single-family mortgages.

Contagion risk is limited. The CRE funding markets are made up of a diverse number of participants; there are no one or two large leveraged players that fueled a boom as was the case in the residential mortgage crisis. Commercial properties are heterogeneous as real estate is a local business.

The CRE loan maturity wall is well known and spans several years, allowing participants to work through the current stresses. Banks are incentivized to work with borrowers. We take comfort that sophisticated private investors are looking to commit more capital to the sector to take advantage of price dislocation.

The banking sector’s most recent stress test is CRE, which is dealing with the effects of higher interest rates and changes in demand for property types, notably office.

Commercial real estate is typically a long-cycle asset, and CRE loans are typically 5- and 10-year maturities. This means the loan maturity schedule is well known and as loans come up for refinancing over the next few years, we expect lenders to work with borrowers.

A Series of Stress Tests

Over the last 24 months US banks have been through several rounds of challenges, each of which has tested different aspects of their wherewithal. Except for a few (special) well known cases, banks have survived them all.

The latest challenge is commercial real estate (CRE). Upfront, we expect the larger banks to also pass this latest round, though the round will likely be an extended one as CRE is a long-cycle asset. The larger banks’ relatively lower exposure to more stressed segments of the CRE markets (office and multifamily loans), higher profitability and higher loan loss reserves support our more sanguine view that the banking sector is expected to weather its latest travail. We draw conviction for our view by reflecting on how the sector coped with its most recent stress events.

We started in Round #1 with rapidly rising interest rates creating large unrealized losses in banks’ securities and loan portfolios. These had the impact of pressuring smaller banks’ capital ratios. The effects were felt most by those banks that had rapidly grown their securities and loan portfolios in the prior period of low interest rates as they put to work large inflows of low-cost deposits.

Round #2 quickly followed and could be characterized as a funding stress.  Higher interest rates motivated depositors to switch deposits from no- and low-rate deposit accounts to higher-rate accounts. The reshuffling also amplified concerns around the viability of smaller regional banks, which pushed more deposits to the money center and larger regional banks.

Round #3 could be characterized as a profitably stress. To attract and retain deposits, banks were forced to pay an increasing percentage of the higher interest rates to depositors. As a result, bank profitability suffered as the difference between the yield banks received on their earning assets and the interest rate paid to fund those assets shrank. As one would expect, banks more reliant on paying up to attract deposits to fund their loan and securities portfolios experienced the most profit pressure.

After a bruising three rounds, banks are still standing. However, we are now entering the fourth round where banks must reckon with their exposure to CRE.


Figure 1:  Banks have come through a series of stress tests

Source:  MacKay Shields LLC

Sizing the Commercial Real Estate Market

We start off sizing-up banks’ exposure to the CRE market. The CRE financing sector is large, standing at approximately $4.5 trillion.1 Importantly, the market is diverse across investor type, property category, lenders and borrowers.

Banks and thrifts hold the largest share of CRE financing at around 40% through a mix of owner –occupied and non-owner occupied loans.


Figure 2: Diverse Types of Lenders in the $4.5 Trillion Commercial Real Estate Market

Source: Moody’s

Bank Share of the CRE Market Varies

The money center and larger regional banks hold around a quarter of the market for CRE loans. When compared to their respective asset bases, the smaller regional and community banks have greater exposures. Some of this can be understood as smaller banks are local lenders and are likely better placed to lend in their local geographies. At the same time, the larger banks have been subject to greater regulatory scrutiny which has discouraged them from expanding their CRE loan books.


Figure 3: Smaller banks have greater CRE loan book exposure

Source: Goldman Sachs

Asset Quality is Weakening

Asset quality metrics for CRE loans have weakened, with the ratio of delinquent loans now exceeding 2014 levels, suggesting further deterioration if interest rates remain high. This increase in delinquencies, especially in the office sector where occupancy rates haven't rebounded to pre-pandemic levels, indicates that some borrowers struggle with loan payments due to lower property cash flows.


Figure 4:  CRE delinquency rates expected to go higher

Source: St. Louis Federal Reserve

Delinquency Rates Expected to Increase as Banks Markdown Loan Values 

Banks regularly review their loan books to adjust the appraised values of collateral properties, with some increasing appraisal frequency due to rising transaction volumes. Notably, office property values have dropped by 20-40% in the last two years, elevating loan-to-value (LTV) ratios for these loans. Consequently, even loans with timely interest payments are being marked as 'criticized' in bank asset quality evaluations due to higher LTV ratios, reflecting increased risk.


Figure 5: CRE Price Index has Fallen 21% From Recent Peak 

Source: Green Street

Loan defaults are expected to increase. Commercial real estate loans are typically 5- to 10-years in tenor. Many loans that were taken out in the low interest rate periods of 2015/16 or 2020/21 are now up for renewal, or soon will be, in an environment where interest rates are materially higher.

Multifamily loans is another area we are monitoring. During the Covid-19 pandemic, investors were attracted to owning multi-family properties as occupancy rates were high. Building profitability is measured by a property’s annual net operating income (excluding interest) divided by its asset value (also known as the capitalization or “cap” rate). Investors who bought multi-family properties during that period with cap rates of 4.5% to 6% and interest rates on loans (debt yields) at or below 2.5% did well. However, things have changed rapidly.

Debt yields are considerably higher today. The increase reflects both higher interest rates and wider credit spreads charged by banks and others in the CRE lending space. In the office space, money center banks have, for example, widened lending spreads from 150-225bp in Q4 2021 to 175-600bp currently to account for the increase in risk, according to Jones Lang LaSalle Incorporated (JLL).


Figure 6:  Financing has become more  expensive for  commercial real estate including office products as both interest rates and credit spreads are higher across lender type

Source: Bloomberg

A debt yield today of 6.5% makes the economics of owning property materially less attractive if rents cannot be increased to offset the higher interest costs. Figure 6 shows how much cap rates need to increase across property types in order to at least break-even.

New York City is a case in point. A law passed in 2019 limits how much owners of rent stabilized apartments, which compromise 44% of New York City’s rental housing units, can increase rents. The inability to increase rents to cover higher interest and maintenance expense is weighing on both the owners of these properties and their lenders.


Figure 7:  Changes in Cap Rates: Q2 2022 to Q3 2023. Rental income may not rise enough to offset higher costs for many landlords | Cap Rates

Source: JP Morgan

Asset quality may also suffer as borrowers may simply walk away from properties if the economics are sufficiently unattractive. We anticipate an increase in defaults in the syndicated loan market as investors may hesitate to fund the refinancing of economically unviable buildings due to current interest rates.

To that point, borrowers may be required to put in more equity to refinance their loans as banks typically only lend a certain percentage of a buildings value (they also look at a building’s debt service coverage ratios: i.e. by how much rental income covers the cost of financing). If a building’s loan-to-value ratio has risen due to a decline in the value of the building, banks are likely to reduce the size of loans they are willing to extend. This could mean borrowers would need to find additional capital to support a building’s financing. New capital could enter the sector as rescue financing.

We take comfort in several observations.

We expect the banking sector to manage through the latest round of stress. Several factors provide us with a level of comfort.

First, we expect to see additional bank failures, but more likely among the smaller banks which have outsized CRE exposures. In fact, recently, Federal Reserve Chairman Jerome Powell specifically noted he expects to see smaller banks fail due to their exposure to the CRE sector, but not the larger banks.

Failures among the large banks are not expected as they generally have less exposure to CRE (office exposure in particular), higher loan loss reserving and higher profitability to cover any additional reserving needs.


Figure 8:  Larger banks have less CRE exposure in their loan book and more reserving vs. smaller peers

Source: Morgan Stanley

Second, CRE lending is a local story with each loan having unique characteristics. Accordingly, unlike the Global Financial Crisis where entire sections of cities had clusters of residential properties in foreclosure, we expect CRE defaults to exhibit much greater dispersion across the country, reflecting each loan’s special features. Also, because of diversity across funding markets, property types and investor groups, the potential for contagion from individual property defaults is likely limited.

Third, it is not hard to see stress coming in the CRE market, which should mean fewer surprises. CRE is typically a long duration asset and CRE loans are typically 5-years or longer, meaning that the loan maturity schedule and liquidity needs of borrowers over the next few years is well known.


Figure 9: Commercial Mortgages Maturities by Lender ($bn) Maturity Wall

Source: Mortgage Bankers Association

Over the next four years, almost $3 trillion of CRE loans mature and will likely need to be rolled over. We take comfort that the majority of loans maturing over the next few years were originated in the 2013-2018 period. Property prices likely have dropped by 15-20% from recent peaks. However, CRE prices are still 10% above 2014 levels, which suggests properties with 10-year loans that are being rolled may have appreciated in value. At the same time, rent growth for some assets, notably multi-family and industrial properties, has been strong over the last decade. These features should help borrowers get needed financing.

Lastly, as loans mature, we expect lenders to work with borrowers to get loans refinanced. Banks look at the totality of the borrowing relationship and not just individual loans. This means banks could be willing to accept pledges of collateral to refinance a loan, modify the interest rate on a loan, extend the term of a loan, or some combination thereof. Banks could also offer A/B note structures where junior debtors are equitized to allow the loan-to-value metrics of a loan to remain within tolerance bands. The point is, banks do not wish to own real estate, so it is in their interest to work with borrowers to preserve the value of the property and the value of the relationship.

At risk of stating the obvious, the path of interest rates plays an important role in the outcome of all of the above. Lower interest rates could provide relief from a host of vexing issues.

Portfolio Positioning

The CRE clearing process is a multi-year event. As more transactions occur, buyers’ and sellers’ price expectations become more aligned. We believe the larger banks are better positioned to weather this process. We continue to see value in larger regional banks, including those with relatively larger CRE exposures as we view these banks as having sufficient profitability to build additional reserves if needed to cover loses on CRE loans. We also believe these banks have sufficient institutional expertise to manage their loan portfolios across varying economic and interest rate cycles. Yes, there will be CRE losses, but not of the magnitude to threaten the larger better capitalized and profitable banks.

1. Mortgage Bankers Association


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