The Impact of Higher Rates on Commercial Real Estate Lending

One of the scariest statistics to learn this year was that small banks hold about 70% of the U.S. Commercial Real Estate debt. While commercial real estate continues to face challenges amid higher rates with increasing vacancy rates, there are still many concerns about the liquidity of these banks, especially after the recent collapse earlier of the two regional banks. But, one favorable step has already been taken with the Federal Reserve pausing its interest rate hikes even though an additional hike may follow by the end of the year. This pause will give the Fed some time to assess the impact of higher rates on the economy and the market. 

Here is what the data shows so far: 

1. Tighter Standards and Weaker Demand for all CRE loans   

The Federal Reserve monitors changes in the standards and terms of the banks’ lending and the state of business and household demand for loans. The Senior Loan Officer Opinion Survey on Bank Lending Practices survey is conducted quarterly, surveying up to 80 large domestic banks and 24 U.S. branches and agencies of foreign banks. In the last several years, this survey has provided critical information on a number of important banking topics. Recent special questions have addressed issues in rapidly changing credit markets, including banks’ lending terms and outlook for commercial real estate lending standards and demand, banks’ assessments of the levels of their lending standards relative to longer-term norms, and banks’ expectations about changes in asset quality and credit standards over the coming year. 

According to the latest report (Q2 2023), tighter standards and weaker demand for commercial and industrial (C&I) loans were reported. Among the following CRE loan types-construction and land development loans, loans secured by multi-family residential properties, and loans secured by nonfarm nonresidential properties-construction and land development loans were most affected. For example, more than 70% of the banks reported that the standards for thee loans had tightened somewhat or considerably compared to 50% a year ago. 

In addition, demand for CRE loans has weakened in the last three months, especially for loans that are secured by nonfarm nonresidential of small and mid-sized banks. More than 75% of the small and mid-sized banks reported moderately or substantially weaker demand for these loans in the second quarter of the year compared to 16% a year ago.

Unfortunately, even tighter standards are expected for the year’s 4th and final Quarter.  We are betting to see this unchanged and perhaps increasing as more tenants are defaulting on their lease obligations, inflation is still ticking, costs of good continue to increase, the office market and CRE loans around those office buildings continue to weaken. 

   2. Commercial Real Estate is Increasing

Despite reports of tighter lending standards, commercial real estate debt continues to grow. In fact, the CRE debt continues to grow. In fact, the CRE debt is currently larger than before the collapse of the two regional banks. In August, the CRE debt of small domestically chartered commercial banks fell to $1.788 trillion, while now it is $1.95 trillion, nearly 3% higher than in February of 2023. As for CRE debt held by large domestically charted banks, it seems that the volume of CRE loans is slightly lower-near $880 billion-than it was before the collapse of the two regional banks. 

The decline in the CRE market has been aggravated by two additional factors. First, the values of commercial real estate increased significantly between 2005 and 2007, driven by many of the same factors behind the residential housing bubble, resulting in many properties either purchased or refinanced at inflated values. Prices have declined about 24 percent since their peak in the fall of 2007 and market participants expect significant further declines. Second, the market for securitized commercial mortgages (CMBS), which accounts for roughly one-fourth of outstanding commercial mortgages, has been largely dormant since early 2008 while many banks have substantially tightened credit. The decline in property values and higher underwriting standards in place at banks will increase the potential that borrowers will find it difficult to refinance their maturing outstanding debt, which often includes substantial balloon payments.

The higher vacancy levels and significant decline in value of existing properties has also placed pressure on new construction projects. As a result, the construction market has experienced sharp declines in both the demand for and the supply of new construction loans since peaking in 2007.

The negative fundamentals in the commercial real estate property markets have broadly affected the credit performance of loans in banks’ portfolios and loans in commercial mortgage backed securities. At the end of the first quarter of 2009, there was approximately $3.5 trillion of outstanding debt associated with commercial real estate. Of this, $1.8 trillion was held on the books of banks, and an additional $900 billion represented collateral for CMBS. At the end of the first quarter, about seven percent of commercial real estate loans on banks’ books were considered delinquent. This was almost double from the level a year earlier. The loan performance problems were the most striking for construction and land development loans, especially for those that finance residential development. Notably, a high proportion of small and medium-sized institutions continue to have sizable exposure to commercial real estate, including land development and construction loans, built up earlier this decade, with some having concentrations equal to several multiples of their capital.

The current fundamentals in CRE markets are exacerbated by a lack of demand for CMBS, previously a financing vehicle for about 30 percent of originations. New CMBS issuance has come to a halt as risk spreads widened to prohibitively high levels in response to the increase in CRE specific risk and the general lack of liquidity in structured debt markets. There has been virtually no new issuance since the middle of 2008. Increases in credit risk have significantly softened demand in the secondary trading markets for all but the most highly rated tranches of these securities. Delinquencies of mortgages in CMBS have increased markedly in recent months and market participants anticipate these rates will climb higher by the end of this year, driven not only by negative fundamentals but also borrowers’ difficulty in rolling-over maturing debt. In addition, the decline in CMBS prices has generated significant stresses on the balance sheets of institutions that must mark these securities to market.

*Source Vanguard and Mortgage Bankers Association August 2023 

    3. Increasing CRE delinquency Rates but still Historically Low

Another measure that the Federal Reserve release is the delinquency rates for CRE and residential loans. According to the data, commercial loans continue to have lower delinquency rates that residential loans. However, while the residential delinquency rate is moving downwards, the number of delinquent commercial real estate loans has been increasing since the last quarter of last year. The CRE delinquency rate was 0.65% in Q3 2022, while now it’s 0.88%.  

The bottom line is that most of the recent concern lies in office-related CMBS and any banks exposed to mortgages on office buildings.

Beyond offices, loans on retail buildings remain stressed too, but let’s be clear: This is not a new development. The decline of the local mall and the concurrent rise of internet shopping have been underway for years. We believe the market has priced in these trends, which are limited to a few segments of the retail property landscape. Not all retail is deteriorating; in fact, most is performing as expected given the strength of the consumer.

 

How Do We Weather the Storm? There Is Some Optimism and Opportunities!