Banks and Commercial Real Estate

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

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

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: Bloomberg

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

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

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

IMPORTANT DISCLOSURE

Availability of this document and products and services provided by MacKay Shields LLC may be limited by applicable laws and regulations in certain jurisdictions and this document is provided only for persons to whom this document and the products and services of MacKay Shields LLC may otherwise lawfully be issued or made available. None of the products and services provided by MacKay Shields LLC are offered to any person in any jurisdiction where such offering would be contrary to local law or regulation. This document is provided for information purposes only. It does not constitute investment or tax advice and should not be construed as an offer to buy securities. The contents of this document have not been reviewed by any regulatory authority in any jurisdiction.

This material contains the opinions of certain professionals at MacKay Shields but not necessarily those of MacKay Shields LLC. The opinions expressed herein are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and opinions contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Any forward-looking statements speak only as of the date they are made and MacKay Shields assumes no duty and does not undertake to update forward-looking statements. No part of this document may be reproduced in any form, or referred to in any other publication, without express written permission of MacKay Shields LLC. ©2024, MacKay Shields LLC. All Rights Reserved. 

Information included herein should not be considered predicative of future transactions or commitments made by MacKay Shields LLC nor as an indication of current or future profitability. There is no assurance investment objectives will be met. 

Information included herein should not be considered predicative of future transactions or commitments made by MacKay Shields LLC nor as an indication of current or future profitability. There is no assurance investment objectives will be met. Past performance is not indicative of future results.

Past performance is not indicative of future results.

SOURCE INFORMATION

“Bloomberg®”, “Bloomberg Indices^®”, Bloomberg Fixed Income Indices, Bloomberg Equity Indices and all other Bloomberg indices referenced herein are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by MacKay Shields LLC (“MacKay Shields”). Bloomberg is not affiliated with MacKay Shields, and Bloomberg does not approve, endorse, review, or recommend MacKay Shields or any products, funds or services described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to MacKay Shields or any products, funds or services described herein.

NOTE TO UK AND EUROPEAN AUDIENCE

This document is intended only for the use of professional investors as defined in the Alternative Investment Fund Manager’s Directive and/or the UK Financial Conduct Authority’s Conduct of Business Sourcebook. To the extent this document has been issued in the United Kingdom, it has been issued by MacKay Shields UK LLP, 80 Coleman Street, London, UK EC2R 5BJ, which is authorised and regulated by the UK Financial Conduct Authority. To the extent this document has been issued in the EEA, it has been issued by MacKay Shields Europe Investment Management Limited, Hamilton House, 28 Fitzwilliam Place, Dublin 2 Ireland, which is authorised and regulated by the Central Bank of Ireland.

NOTE TO CANADIAN AUDIENCE

The information in these materials is not an offer to sell securities or a solicitation of an offer to buy securities in any jurisdiction of Canada. In Canada, any offer or sale of securities or the provision of any advisory or investment fund manager services will be made only in accordance with applicable Canadian securities laws. More specifically, any offer or sale of securities will be made in accordance with applicable exemptions to dealer and investment fund manager registration requirements, as well as under an exemption from the requirement to file a prospectus, and any advice given on securities will be made in reliance on applicable exemptions to adviser registration requirements.