Commercial Real Estate Threatens to Crack Current Calm

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While credit quality at banks remains high, it may not stay there. 

At the end of the year, noncurrent and net charge-off rates at the nation’s banks had “increased modestly,” but they and other credit quality metrics remained below their pre-pandemic levels, according to the Federal Deposit Insurance Corp. However, rising interest rates have made credit more expensive for borrowers with floating rate loans or loans that have a rate reset built into the duration. 

Commercial real estate, or CRE, is of particular focus for banks, given changes to some types of CRE markets since the start of the pandemic, namely office and retail real estate markets. Rising interest rates have increased the monthly debt service costs for some CRE borrowers. An estimated $270.4 billion in commercial mortgages held at banks will mature in 2023, according to a March report from Trepp, a data and analytics firm. 

“If you’ve been able to increase your rents and your cash flow, then you should be able to offset the impact of higher financing costs,” says Jon Winick, CEO of Clark Street Capital, a firm that helps lenders sell loans. “But when the cash flow stays the same or gets worse and there’s a dramatically higher payment, you can run into problems.”

Some buildings are producing less income, in the form of leases or rent, and their values have declined. Office and traditional retail valuations may have fallen up to 40% from their purchase price, creating loan-to-value ratios that exceed 100%, Chris Nichols, director of capital markets for SouthState Bank, pointed out in a recent article. SouthState Bank is a unit of Winter Haven, Florida-based SouthState Corp., which has $44 billion in assets. If rates stay at their mid-April levels, some office building borrowers whose rates renew in the next two years could see interest rates grow 350 to 450 basis points from their initial level, Nichols writes, citing Morgan Stanley data.  

JPMorgan & Co.’s Chairman and CEO Jamie Dimon said during the bank’s first quarter 2023 earnings call that he is advising clients to fix exposure to floating rates or address refinance risk.

“People need to be prepared for the potential of higher rates for longer,” he said.

Banks are the largest category of CRE lenders and made 38.6% of all CRE loans, according to Moody’s Analytics. Within that, 9.6% of those loans are made by community banks with $1 billion to $10 billion in assets. CRE exposure is highest among banks of that size, making up over 24% of total assets at the 829 banks that have between $1 billion and $10 billion in assets. It’s high for smaller banks too, constituting about 18.3% of total assets for banks with $100 million to $1 billion in assets. 

“Not surprisingly, we’re seeing delinquency rates for office loans starting to increase. … [It’s] still moderately low, but you can see the trend has been rising,” says Matthew Anderson, managing director of applied data and research at Trepp, speaking both about year-end bank data and more current info about the commercial mortgage-backed securities market. He’s also seen banks begin increasing their credit risk ratings for CRE segments, notably in the office sector.

Bank boards and management teams will want to avoid credit surprises and be prepared to act to address losses. Anderson recommends directors at banks with meaningful CRE exposure start getting a handle on the portfolio, the borrowers and the different markets where the bank has exposure. They should also make sure their risk ratings on CRE credits are up-to-date so the bank can identify potential problem credits and workout strategies ahead of borrower defaults. 

They will also want to consider their institution’s capacity for working out troubled credits and explore what kind of pricing they could get for loans on the secondary market. While banks may have more capital to absorb losses, Winick says they may not have the staffing to manage a large and rapid increase in troubled credits. 

Working ahead of potential increases in credit losses is especially important for banks with a concentration in the space, which the FDIC defines as CRE that makes up more than 300% of a bank’s total capital or construction loans in excess of 100% of total capital.

“If a bank has a CRE concentration, they’re definitely going to get more scrutiny from the regulators,” Anderson says. “Any regulator worth their salt is going to be asking pointed questions about office exposure, and then beyond that, interest rate exposure and refinancing risk for all forms of real estate.”

Risk issues like these will be covered during Bank Director’s Bank Audit & Risk Conference in Chicago June 12-14, 2023.

A Multifaceted Approach to Managing CRE Concentration Risk

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Concentration risk is drawing scrutiny from financial regulators, who are focusing on lenders’ commercial real estate (CRE) concentrations. Financial services organizations are responding to this by looking for ways to improve their CRE risk management and credit portfolio management capabilities.

Lending institutions with high CRE credit concentrations and weak risk management practices are exposed to a greater risk of loss. If regulators determine a bank lacks adequate policies, credit portfolio management, or risk management practices, they may require it to develop more robust practices to measure, monitor, and manage CRE concentration risk.

For several years, federal regulatory agencies have issued updated guidance to help banks understand the risks. In 2006, the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency issued a guidance related to CRE concentrations followed by a statement in 2015 titled “Statement on Prudent Risk Management for Commercial Real Estate Lending.” Noting that CRE asset and lending markets are experiencing substantial growth, the 2015 guidance pointed out that “increased competitive pressures are contributing significantly to historically low capitalization rates and rising property values” and said “many institutions’ CRE concentration levels have been rising.”

Since the 2006 guidance, additional regulatory publications related to CRE concentrations have been released. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) in 2010 began a shift, as banks with less than $10 billion in assets were exempt from more stringent requirements, according to a Crowe timeline analysis.

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Looking forward, the 2020 transition to the current expected credit loss (CECL) model for estimating credit losses will likely affect loan portfolio concentrations as well.

At the community bank level, CRE concentrations have been increasing. In 2016, CRE concentrations in smaller organizations had reached levels similar to mid-2007, according to Crowe’s analysis.

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These trends led regulators to sharpen their focus on CRE concentrations.

In one Crowe webinar earlier this year, 76 percent of the participants said their banks had some concern over how to better mitigate the risks associated with growing CRE concentrations.

In addition, 77 percent reported they received feedback within the past two years from regulators or auditors about CRE concentrations. The number of banks concerned about CRE concentration growth will likely continue to rise.

Approach to CRE Concentration Risk
The most effective methods for addressing concentration risk involve an integrated, holistic approach, which encompasses four steps:

  1. Validate CRE data. Banks must examine loan portfolio databases and verify the information is classified correctly. Coding errors and other inaccuracies often present a distorted picture of CRE concentrations.
  2. Analyze concentration risk. Banks can perform a risk analysis to expose both portfolio and loan sensitivity. Well-planned and carefully executed loan stratification can help management have a deeper understanding of their concentrations. Banks, even those not required to perform stress testing, should incorporate stress testing at the loan and portfolio levels.
  3. Mitigate CRE risk. Banks should establish policies and processes to monitor CRE loan performance and to adjust the mix of the portfolio as their risk appetite changes. Oversight of credit portfolio management is critical, as is an effective management information system.
  4. Report to management and the board. Reporting on a regular basis should include an update on mitigation efforts for any identified concentrations. Banks with higher levels of CRE loan activity might invest in dashboard reporting systems. The loan review and internal audit departments also should present additional reporting.

Loan Review and Stress Testing
Benefits can be gained by implementing a more dynamic loan review function that takes advantage of technology to identify portfolio themes and trends. The loan review function should identify if management reporting lacks granularity or other forms of risk associated with appraisal quality and underwriting practices.

Stress-testing practices can offer additional understanding of the effects economic variables might have on the portfolio. Tweaking several inputs can reveal how sensitive the bank’s models are to various scenarios. Stress testing can help facilitate discussions to better understand the loan portfolio and to identify better-performing borrowers and segments.

Other Best Practices
Other effective practices include establishing a CRE committee, creating a CRE dashboard, and adapting reporting functions to incorporate the loan pipeline. This approach can help management envision what concentrations will look like in the future if potential opportunities are funded. As CRE concentrations continue to attract regulatory scrutiny, risk management practices will become even more important to banking organizations.

Do Strategic Plans Still Make Sense?

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chess.jpgIn his 1980 song “Beautiful Boy (Darling Boy),” the late John Lennon wrote a line that captures the challenge common to strategic planners (and the rest of the human race) everywhere: “Life is what happens to you while you’re busy making other plans.”

It was relatively easy for community bank CEOs and their boards to make a strategic plan five years ago when the economy was booming and it wasn’t hard for lenders to put their institution’s money to work. Then “life happened” in 2008 when the U.S. economy tanked and the fuel that drove bank earnings through the middle part of the previous decade – commercial real estate – became too dangerous and unstable for banks to use.

While the U.S. economy has posted five consecutive quarters of GDP growth through the third quarter of 2010, it seems that many business borrowers lack faith in the recovery because loan demand remains slack. The commercial real estate market is still pretty toxic, and bank regulators have been putting pressure on a lot of banks to downsize their CRE portfolios anyway.

So what’s the plan when no one wants your biggest product?

One could argue that the regulators have been driving the planning process at many banks. “They have told banks to reduce [their] CRE [exposure] by ‘X’ percent,” says Michelle Gula, president and CEO at mrae associates inc., a consulting firm that works exclusively with community banks. “They’ll come down on you if you’re not in the zone where they want you to be.”

Gula makes the fair point that for many troubled institutions today, the “strategic plan” ends up focusing on an immediate problem that has come under regulatory scrutiny and must be fixed. “Now the strategic plan needs to be very targeted,” says Gula.  “You have to identify exactly how you’re going to get it done.”

And yet banks still must find a way to grow, and if they have been too reliant on CRE lending, that could require a change in their business model. How should they do that?

Back in the late 1980s I left magazine journalism to work as a speech writer at insurance broker Marsh & McLennan Inc. One of my duties was to write the annual business plan. (It sounds more impressive than it actually was. I was just the writer. Others were the thinkers.) Marsh’s strategic plan came together in what I would describe as a bottom-up process.  Every significant Marsh business unit throughout the country had to submit its own plan for the coming year and present it to senior management. Eventually this deliberate process yielded a company-wide plan that was a distillation of the best opportunities – and best ideas – from throughout the firm. In other words, Marsh’s local markets and individual business units drove its strategy. There were top-down initiatives as well. But Marsh never strayed too far away from its markets and the people who knew them best.

In this context, the only difference between Marsh and a community bank is that Marsh had many markets and a local bank just one. But this is exactly where Geri Forehand, the national director of strategic services at Sheshunoff Consulting + Solutions, says banks should be looking for new growth ideas.

As they moved away from CRE, several of Forehand’s bank clients have developed new industry or business niches based on opportunities in their markets. One bank has concentrated on property management companies, another has zeroed in on local governments and non-profit organizations, while others have placed more emphasis on trust and investment management as their customers shift from spending to saving. Often, it’s necessary for the bank to hire experienced lenders and relationship managers who understand the new business sector, although Forehand says this is a good time to hire talented people from other banks.

“You have to evaluate the market and what it’s going to give you,” says Forehand. “And you have to evaluate people and determine whether you have the right ones. Managing the human capital side is as important as anything right now.”

I would argue that given the many challenges banks face today, including the decline of the CRE market, strategic planning is more important than ever. Find a niche or specialty in your market that is underserved, develop a strategy for attacking that market, hire the necessary talent and go for it.

Life happens, but that’s no reason to stop making plans.