Thomas Curley 0:00

This is Ahead of the Curve: A Banker’s Podcast

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Thomas Curley 0:11

Welcome to this episode of Ahead of the Curve: A Banker’s Podcast, I’m your host Thomas Curley and I am here with Rob Newberry. Rob is a veteran of the podcast so far and so we’re excited to have him back on. He’s a Senior Advisor on Abrigo’s Advisory Services team and he’s currently a faculty member at the Graduate School of Banking at the University Of Wisconsin Madison. And over the last ten years he has been focused on working with financial institution leaders and regulators to develop a suite of credit administration tools for financial institutions and maybe most importantly for today’s conversation, I know he grew up on a dairy farm.

Rob Newberry 0:52

That’s right Thomas, yes. That’s why I’m an ag expert, I milk cows for many years. Glad to be in the business world not on a dairy farm.

Thomas Curley 1:04

Well we’re certainly excited to have you on the talk ag lending. I know it’s a bit more niche topic than some of the ones that I know you’ve jumped in on in the past, but I think it’s an important one especially for many community financial institutions out there. So I wanted to jump right in and Rob, you know, I know we’ve got high inflation across the board potentially meaning, you know, some high input cost. And my assumption is that there might be some increases in loan demand for ag banks. Is that kind of true on your end? You know what’s going on in the market?

Rob Newberry 1:35

Yeah, so a couple things going on with that comment. The first one being, yes, eventually it will definitely lead to more loan volume. Now it’s one of the interesting things about the pandemic and the stimulus packages. I think maybe ag was, I’m gonna say, a little overstimulated by government direct payments. Which did a couple things, hopefully ag producers were able to pay down their debt load or debt carry which would make it easier for you to give them money going forward and make the credits have less risk. However because they got government subsidies and then commodity prices also went up at the same time as kind of like a double whammy where they were liquid with cash and really have been able to absorb to this point a lot of the increases in expenses. So kind of think of it this way, a lot of them prepaid some of their expenses for this year last year because they had some direct government payments and commodity prices were good. So the real impact hasn’t really hit a lot of the ag producers, but it is coming for sure.

Thomas Curley 2:50

Awesome! And then I know we’ve got a lot going on globally, which I think more than other industries affects the ag space, you know, any comments on the war in Ukraine or any other of the economic issues and how that might play into some of the banks and credit unions out there in the ag space?

Rob Newberry 3:09

Yeah I mean there’s a couple things going on specifically with the war in Ukraine is we get a lot of our fertilizer from Ukraine or were, so that price even for the non ag producer if you were just a homeowner going to buy fertilizer’s doubled or tripled in price just for a bag of it right? And so significant increase in fertilizer and then we have the oil issue right? And so Russia being a big oil supplier as we cut those ties the cost of fuel has exploded as well. So, two of the main inputs for ag have had the highest inflation and so kind of get this double whammy of, you know, fertilizer going, up gas prices going up, and with the also with the increase in interest rates. Thomas I’m not sure you’re probably aware that we had a significant increase just the other day. First time since the mid 90s I think that interest rates were hiked by 75 basis points.

The other main input a lot of times on ag is interest expense, so 3 of the biggest expenses have all significantly went up and so we have those things kind of going on in the ag landscape. Commodity prices are up so one benefit that we will see is because Ukraine’s not producing grain right now, the demand for a grain will go up. So commodity prices still should stay up. I think I read an article yesterday that they anticipate commodity prices at least through next year kind of being 5% higher, so pretty steady or higher which is good. But I guess the biggest concern I kind of have with that Thomas is with the high input costs. You know we were able to take advantage of that in 2021 and 2020. The flipside is and we’ll have high input costs and then when the commodity prices drop, we’ll be caught on the backside of that and that’s when a lot of folks will get in trouble. So if you remember back in 2019 and that’s the last time interest rates were this high, farm income was not very good right? I mean that was some of the ag stuff was getting pretty tight, not a lot of profitability and then COVID hit and things significantly changed. Now we’re kind of back to where we were March 3^rd, 2020 is when prime was 4.75 so exactly where we were before COVID from an interest rate perspective.

Thomas Curley 5:36

So what you’re saying is we should go and dust off some of those old white papers and blogs from 2019

Rob Newberry 5:42

Yeah absolutely, you know, and it’s interesting because, I think maybe you’ll ask me a question about how the 80s and ag crisis ties into now and, you know, one of the things that, a new term, it’s not a new term, it was back in the 80s to it’s called stagflation. Which basically means where we’re having inflation but our GDP is actually declining. So typically when you have inflation that means our economy’s booming in, you know, where it’s more expensive to do things because we have to pay more money for people to work and everything’s going great. We’re kind of in a unique situation that we have inflation and after the pandemic and you know now we’re raising interest rates to also shutter GDP that we have stagflation which is we have not enough supply but the demand isn’t really growing. And so that supply chain issue still, we’re still dealing with COVID issues, and we have you know microchip issues and we have all these other things still going on it’s interesting. Stagflation was also in the 80s ag crisis, it’s kind of, was one of the leading causes that created that issue back in the 80s so.

Thomas Curley 6:51

Yeah, no, we’ll definitely talk a little bit more because I wanted to get your thoughts on, you’ve written a white paper for us recently and I wanted to get some of your thoughts on that. Before we jump off the state of the ag landscape, always like to ask as I’m reading other ,you know, articles across the industry they’ll sometimes call out specific regions or maybe dairy farmers or ,you know, corn specifically. Are there any sectors that you think present a unique opportunity or maybe areas or vice versa? Maybe something to look out for from just some of the data that you’ve been seeing.

Rob Newberry 7:24

Yeah, you know, the only thing I saw that and it really didn’t concern me I mean steer so like livestock pricing looked like it was going to be level or down a little and with the high input cost of corn right? So when commodity prices of corn is high, it’s more expensive to feed your cattle. So if if the cost that the producers are getting for cattle is actually going to decline a little and their input costs are going to go up, there might be a little concern in the cattle lot. You know, cattle, cattle feeder, lot, ranch issue. The only other issue Thomas is with high input costs just commodity prices in general. If we take a dip in any of them just with a high input cost, it could lead to some significant issues rather quickly right? Just because everybody will be flipped upside down pretty quick.

Thomas Curley 8:18

Gotcha. And I guess that probably leads into the next question I had. We alluded to at the top end about, you know, will some of this stuff lead to increase demand given some of the stimulus that they’ve had and been able rely on the past couple of years. Do you see that being a something that’s gonna happen real soon or something that might still, like you said, is still being delayed a little bit? It might take some time to catch up.

Rob Newberry 8:42

Yeah I would anticipate that the volume will start picking up next year. So the next ag cycle. We’re kind of, you know, we’re, I’m in the Midwest here Thomas, you’re aware of that but you know we got all our crops in so we’re through that phase of the lending cycle. Once they get those crops in, depending on commodity prices I think next cycle you’ll see a lot bigger demand for loan volume because of the high input costs. Folks won’t want to prepay their expenses like they did previously coming into 2022 and I think you’ll see ag demand significantly increase going forward. So I think most folks have probably burned through the stimulus and their liquidity getting to where they’re at now in that we should see an increase in volume in 2023 as we start the ag cycle again.

Thomas Curley 9:37

Great and I think that that’ll be some good news. Obviously there’s always some nuance to that as I know obviously we don’t love inflation and some of the other things that come with it. But I think some good news for financial institutions out there.

Switching gears a little bit and we’ve already talked a quick second about the 1980s farm crisis. You wrote a white paper that had a little bit information in there and I wanted to get your thoughts on how you see the current environment similar to the 1980s. What should lenders be keeping an eye on based on your experience?

Rob Newberry 10:10

Yeah, a couple things. One is there’s always folks that chase hot deals. When commodity prices are high land values go up, so we’ve seen a significant and increase in land values. So then people that want to buy the land have to buy it at the highest level. That with high interest rates make that a lot riskier because if the ag land is elevated and then comes back to more normal pricing folks will feel like they are underwater right in their current purchase. So it just makes that debt load a lot heavier for them to carry as you go forward. And so Thomas that’s one of the big concerns and that’s what happened in the 80s was, a couple things. One is commodity prices drop but farmers had a lot of inventory. Well in order to survive they had to sell their inventory and that was what was backing up a lot of the loans. So then all of a sudden there were a lot of loans that were basically unsecured because they had sold the inventory underneath the bank without the bank being aware of that. The only good news is usually in inflationary time real estate’s a good thing to hold because the values go up. Now, the bad thing is if it’s a bubble and prices come back down, you maybe paid too much and if you’re paying ,you know, the current interest rates that have went up significantly in the last two months you can get caught on the backside of that. And that’s kind of what happened in the 80s.

Thomas Curley 11:36

Gotcha. One thing I’ve heard you talk about is risk scoring models. Are there some strategies that you think folks start to implement to mitigate the potential of some of those things from happening in their ag portfolio?

Rob Newberry 11:49

Yeah there’s a few things. And so unfortunately inflation hits the ag industry in a couple ways. If it’s a family farm you have it hitting you kind of double. You have your living expenses, a lot of times when we talk about credit analysis for ag we do what we call a global analysis, which means we’re gonna look at the farm income and the personal income and use that combination to qualify the borrower. Well if you have high input costs and inflation, so your living costs also go up and you’re using the same source of revenue to cover that it’ll squeeze that credit and, you know, the other big thing we have going on right now Thomas is we have CECL going on. So we have third and fourth quarter this year where all folks will be trying to implement CECL. Depending on the methodology they pick if they pick like a default loss given default method, right, and they do like what I would call loan grade migration, understanding that changing in that credit grade based on some of these things that we’re talking about will also have an impact on the amount they’d have to reserve for CECL. So, you know, that probability of default method is one of the methods I’m sure several institutions are probably using in that and so that’ll be something to be aware of on that front as well. The other thing is understanding cash flow right? We know that as interest rates go up that’s one of the major expenses, making sure that the borrower can cover both interest and expense on that front will be critical. And just watching, I think what happened in the 80s Thomas to go back just a second is a lot of times we didn’t have the due diligence. We knew they had inventory but we really didn’t check to see if it was still there. I think keeping our eyes on the ball a little more this time and so if we do get things a little tighter making sure if we do have inventory as collateral, we know that it’s there and we actually look at it. So if it’s a tractor, is it a pedal tractor is it a real tractor right? Understanding what is really the collateral behind some of those notes.

Thomas Curley 13:58

And you mentioned, you know, land is always a good asset to have typically during inflation periods. But obviously if there’s some sort of bubble, there could be something wrong with that. Anything that they should be doing on the pricing side or anything of that nature to be ready for any potential risk on something like that happening?

Rob Newberry 14:19

Yeah there’s a couple things they can do on pricing. Glad you ask that question Thomas. Really two things come to mind. Typically in a raising rate environment, we do a couple things right? We kind of were afraid of interest rate risk as bankers, so we typically want to go short and when you do short-term loans you’re working in the narrow part of the net interest margin band. So, you know, usually you don’t charge as much for a 1 year commitment as you do a 15 year mortgage because you have that interest rate risk. Well if you’re always working in the narrow band and your cost of funds goes up, you just have a less opportunity to make money as a financial institution. So one of the things you can do from a pricing perspective specifically if you’re competing with, you know, Farm Credit and some of the other government-backed agencies is you might want to consider going a little longer in your product. Offering products that give the customer a little protection as well from a fixed rate perspective. So I’ve seen a lot of ag clients that do like a 1 year fixed line of credit basically or a loan, but you know the spread’s very narrow on that instead of doing a 7 year, you know, 25 balloon or something. And so trying to understand maybe your product mix and creating features that the customer will pay up for that protection that they get from a credit risk perspective can be huge as you go forward in a raising rate environment because I don’t think rates are done moving up Thomas. We talked about, you know, the name of the podcast, ”Ahead of the Curve.” The curve’s still going up right? So there’s probably still a couple more interest rate hikes out there. And trying to understand how to price those will be critical to maintain your profitability as a financial institution.

Thomas Curley 16:13

Gotcha and I think you’ve already alluded to this a little bit but I know one thing that Abrigo from a software perspective is really trying to help people make smarter loans and be able to catch things if something starts to go bad. Are there any tips or tricks that you would maybe want to let the audience know about how to identify those problem loans before they get to that point, especially with an ag lens there?

Rob Newberry 16:40

Yeah there’s a couple of things you can do and I know a lot of ag folks might not be aware of thi,s but there are specific business codes even related to ag. So there’s not one ag, you can get as specific as corn farming, you know, honeybee farmers. You can get very specific in those NAICS codes. So one is understand your concentration risk and do stress testing. And so whether it’s, you know, we’re in a raising rate environment, what happens if their debt service coverage changes by 25%, can they still make those payments? Is the first thing. The second thing I would say is proactively manage your portfolio. So knowing that, you know, as financial institutions we’re typically a little leery of interest rate risk. We probably have a bunch of folks maybe resetting here in the near future. So if you had a operating line or you had a three-year balloon or five-year balloon, you might look to see if they’re a good credit can you take advantage and maybe you refi them a little early to take advantage of the interest rate cycle. If you look at this, at the interest rates today it only cost fifteen more basis points from a two year treasury to a ten year treasury. So very flat from two to basically thirty years is almost the same interest rate, so it doesn’t really cost you more money to go longer. It’s more convincing your board and forgetting all that stuff we said that was really bad about interest rate risk and actually booking some longer term fixed product on your books. Which one, is it improves your pricing, two, it reduces the credit risk a little because you’ve locked them into a rate, so if rates go up in general but your farmers are locked in at 5% versus moving it at up to 7% there’s that more ability for them to make profit because you’ve already got them locked in.

Thomas Curley 18:35

Awesome. Well so the intention was to hit on some of the the top concerns for ag bankers for sure throughout this podcast and so we’ve hit on the market just generally, globally. we’ve hit a little bit on the inflation, the rising rates, and some of the credit risk. One things that always pops up when I look at surveys and other resources that ag banks are worried about are competition right? And we mentioned Farm Credit, but what are some ways you’ve seen clients stand out in the ag space as it’s getting more and more competitive as we go each year.

Rob Newberry 19:10

Yeah I mean there’s a couple reasons for seeing that right, Thomas? One is there hasn’t been a lot of loan demand so you’re fighting over table scraps right, currently. So it gets pretty competitive in that space. A couple ways that some institutions can separate, I’ve seen them separate themselves, is one is try to avoid what I call commodity pricing on your loan products. Don’t offer the exact same product that all the banks around you are offering because then you’re going to get rate shopped and that that hurts everybody, right, because you’re only as good as the lowest person in your community or vicinity and you’re kind of at their mercy. But if you can create products with either features that people are willing to pay up for, one is even if it’s the same price if you have a different feature you might attract customers that you wouldn’t normally get and be able to close a higher rate because you have other features. Specifically knowing that we’re in a raising rate environment, once again giving them some long-term protection is probably a huge win. But even if it’s maybe a little lower rate but charging a origination point or letting them buy down the rate a little, you know, simple things like that Thomas that can separate yourself from, you know, everybody selling table salt would be a huge win I think for customers. The other one is just be proactive with your customers right? Understand we’ve just went through the pandemic, so a lot of them probably had some stimulus money but kind of understanding where they’re at and being proactive as you manage their portfolio so you don’t lose good customers that you have. So there’s attracting new customers to get growth and there’s maintaining the ones you have, so trying not to lose the ones you have.

Thomas Curley 20:55

Awesome! One question I had and I was wondering if, you know, I midwestern banks we’ve got a lot of producers and farmers out there that they like going into the branch but I was curious on if you’ve seen a huge shift towards technology, really digital application type tools at some of these ag banks and if that’s another way to start to differentiate too?

Rob Newberry 21:17

Yeah, you know it’s interesting Thomas because the pandemic I think’s taught us all whether you’re an ag farmer or you know us Thomas that we can work remote and be more efficient and especially with rising input costs and all those things. We’ve had this request multiple times of being able to have ag customers submit their financials electronically, being able to input them themselves and do all kinds of fun cool things, or being able to sign online. So, you know, if you can be in the field and not at a bank, you’re probably more efficient. So technology is definitely playing a role. not only there but you know think of all the automated machinery equipment that’s controlled by GPS right? You don’t even have to really drive your combine anymore it drives itself and so technology is becoming a bigger and bigger role in ag and I think some of the farmers that are a little longer in the tooth are starting to understand that piece. And we also have kind of a new generation of farmers coming in that are used to that type of technology, and if you don’t have it will be disappointed and probably bank somewhere else. So you have this kind of niche of some older folks finally getting to understand the importance of technology and newcomers expecting it and if you don’t have it, they’ll find someone that does. A couple ways technology is impacting them.

Thomas Curley 22:41

Yeah I think the beauty of what you were just talking about is that by having the technology doesn’t mean you have to use it for every single customer or producer that you’ve got. You can, you have the opportunity if that’s what they want to do but they can still come into the branch if needed. So it’s just a nice to have those options when you need it I think.

Rob Newberry 22:58

Ya Thomas if you look at it the opposite way, it could be a deal killer if you don’t have it right? But it’s not a, you know, that doesn’t necessarily mean they’ll use it. But if you don’t have it and you have once again as farms turn over to the next generation, that generation’s grown up using their phone to do everything right? And so if you don’t have that ability you’re going to lose out just because you don’t have that ability. Not that they will use it every time because they might come in the institution or you might need the technology to go out and see them instead of having them come in the branch. Can you go out there with technology and iPad or something else and digital signature and do some other things that are pretty cool versus them having to come in and sign a paper.

Thomas Curley 23:41

Good things to keep in mind for sure. So, I want to go ahead and start wrapping up our time here. If listeners take, you know, anything away from the conversation I was curious if you had maybe two or three main points that you’d want them to think about after the call keeping in mind we’ve got you know financial institutions across the United States with ag portfolios listening in.

Rob Newberry 24:06

Yeah, a couple things. One is, you know, don’t panic, the loan volume will come back. And so I think to your point earlier Thomas about the credit risk, making sure that your model is updated and that you understand that, you know, with high input costs the risk is commodity prices falling and the profitability of those customers going forward in inflationary times right? So that would be one. One is also, I would say do the due diligence whether it’s when you’re doing the credit and looking at the collateral or whether it’s managing your loan portfolio and trying to catch things before they go south on you right? Trying to fix things as you go. And then I guess the third one is, it’s okay to say no, so don’t fight over the table scraps that might not be worth fighting over. So we talked about, you know, there’s not a lot of loan demand right now. However, that doesn’t mean you should go try to chase every deal and either make no money on it because you’ve offered such a low rate or you pick up customers that you normally wouldn’t have done based on your credit policy just because you’re not having any loan demand. So, if it’s a bad loan, it’s a bad loan so, you know, just because there’s not any good loans out there don’t pick up the bad loans. If that makes sense Thomas.

Thomas Curley 25:30

I think that will do it for our episode today. For those that are new listeners or those that haven’t subscribed yet, you can find this podcast and future episodes on abrigo.com or you can find it on your favorite podcast app or platform. You can search Ahead of the Curve: A Banker’s Podcast or simply Abrigo. Thanks so much for listening and we’ll be back again with our next episode soon. And Rob, just want to thank you as always for joining us and talking a little bit of ag.

Rob Newberry 26:01

Thanks Thomas for having me and look forward to talking to you and everyone again soon.

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Thomas Curley 0:00

This is Ahead of the Curve: A Banker’s Podcast

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Thomas Curley 0:13

All right, welcome to this episode of Ahead of the Curve: A Banker’s Podcast. I’m your host Thomas Curley and I’m here with Matt Anderson, Managing Director at Trepp. Matt’s a recognized leader in the banking industry and works closely with financial institutions, regulators, clients, and prospects to identify emerging market needs in order to grow Trepp’s financial institution analytic and forecasting tools.

We also have repeat guest Rob Newberry on today to join Matt. Rob is a Senior Advisor on Abrigo’s Advisory Services team and is a current faculty member at the Graduate School of Banking at the University of Wisconsin-Madison. And over the last ten years he’s been super focused on working with financial institution leaders and regulators to develop a suite of credit administration tools for financial institutions. So, we are excited to have both of them on today to talk about commercial real estate lending. So, thank you both so much for jumping in.

Matt Anderson 1:12

Thanks for having me.

Rob Newberry 1:13

Yeah, glad to be here Thomas.

Thomas Curley 1:15

So, let’s jump right in then, Matt I figure we would start with you. We have lots of financial institutions listening to this podcast and I’m sure top of mind for them is the state of the market. CRE lending I know is a pillar for many bank and credit union portfolios across the country, so I wanted to ask you, you know, how would you maybe describe the current CRE landscape as a whole from a global view but also maybe a little bit domestic as well?

Matt Anderson 1:43

Thanks Thomas. So yeah, we’re in a really strong position at the moment. The momentum for the last couple quarters has been quite strong. Interest rates are still low. They have been really low, but they’re on the rise so the concern I think for everybody in the market right now is maybe we’re at a transition point right now from a very low rate but strong growth environment to now a high rate and uncertain growth environment. So, it’s been great so far, but definitely some clouds on the horizon. High inflation and higher interest rates being, you know, among the top concerns and then clouding that outlook of course is the situation in Ukraine with war there and in the disruption in food markets globally and oil markets globally. Oil and food are both key components of inflation, so we’re in a very strange spot right now. It would be an awkward position even without war in Ukraine but that just complicates things even further and, you know, on the rising rate front it’s pretty much guaranteed that the Fed is going to raise rates at their next meeting.

Now the talk is of course around 50 basis points but that would still put the Fed funds rate, you know, .75 which is you know, not really that high in the scheme of things. So, it’s a big jump big single period jump but it’s not a big absolute jump from you know where rates have been in the past. Having said that, the market is already pricing in future increases according to how we unwind, you know, future expectations from the yield curve. Looks like the market is expecting about a 300-basis point increase over the next two years and, you know, the long-term rates have now gone over 3% so that the 10-year rate is right around 3%. That’s going to increase borrowing costs across the board.

Thomas Curley 4:15

Anything you’d add to that Rob?

Rob Newberry 4:18

Yeah, Matt I had one question. Do you think that the increase in rates and inflation has a positive or negative impact on the credit risk of existing commercial real estate? Right? So, if it costs more to build a new commercial real estate building how will that impact the market as we kind of look forward the next few years.

Matt Anderson 4:37

Yeah, that’s a great question. So, for floating rate borrowers, of course, higher interest rates are going to mean higher costs sort of in the near term when those rates readjust, reset they’ll be resetting to higher rates. So, their payments will be going up and as a result, you know, the debt service coverage ratio that’ll go down and that’s a that’s a key metric for you know credit risk. It’s one that we look at in our default and loss modeling. So that’ll for floating rate borrowers, and that’s about roughly half of the commercial real estate market is you know on fixed on floating rate debt you know, so for that segment of the market, the risks will go up pretty immediately. How high they’ll go up is the other you know part of that question. There’s probably a lot of capacity still among those borrowers to handle rate increases. I’m not sure if 300 basis points though would be that easy to you know to handle, you know, that’ll remain to be seen.

There’s another component of the interest rate or rising interest rates and that’s the impact on cap rates. So, when long-term rates go up, real estate underwriting so evaluations tends to be keyed to long-term rates so as those go up your cap rate expectations will go up as well and that’ll have a negative impact on prices. In the short run, there are kind of a couple potential negative impacts on credit risk. So, one just the debt service coverage ratio for floating rate borrowers and then for everybody the negative impact on valuations from higher cap rates. Interestingly though we recently put out a study where we took a look at the long-term impacts of higher inflation and higher interest rates. And perhaps not too surprisingly the longtime folks in the commercial real estate industry, commercial real estate does tend to have a positive correlation with inflation. So higher inflation leads to higher income higher rental income and in the long run that leads to higher valuations. So short term definitely, you know, a lot of risk but longer term for folks that can last the next couple of years and beyond, longer term those negative impacts will smooth out as a result of higher income.

Rob Newberry 7:47

Great okay.
Thomas Curley 7:49

And I know you mentioned a study Matt that y’all released and I know I try to do my best to keep up with all the blogs and data releases that Trepp has on a pretty consistent basis. Are there any, you know, reports or data releases recently that stuck out to you as far as certain verticals or sectors that performing better or worse in the commercial real estate area?

Matt Anderson 8:11

Um, yeah, excellent question. So, from a share you know performance numbers standpoint, sector wise of course lodging is still you know problematic from, you know, the covid impacts and there’s still some lasting impacts there. Although that’s been you know, tapering off, it’s not gone all the way. So, lodging took a big hit and it’s been coming back but still viewed as high risk. Retail has recovered a lot of ground, retail was also hit with higher delinquency and default rates, higher risk ratings for all the, you know, sort of usual reasons. At the other end of the spectrum, industrial was the darling of the pandemic and still is ah. Volume in the industrial space is probably two or three times what it was pre pandemic in terms of loan volume. It’s still, it’s sort of a not exactly a niche market but it’s a smaller segment dollar wise within the commercial real estate landscape just because, you know, tends to have lower per square foot valuations. So even a large warehouse you know isn’t necessarily going to be as expensive as a you know, mid-sized office building for example. But industrial was, you know, is still reaping the benefits and tailwinds from the pandemic. And then multifamily which, you know, there was a lot of handwringing about multifamily early on in the pandemic but really whatever forbearance that lenders had to extend for the first, you know, several months of the pandemic by the end of 2020 that was really tapering off and now there are only like a few loans here and there that I know of that that our clients have told us that still are getting still under some sort of forbearance. So multifamily is bounced back in a big way and of course rental increases are up strongly and in multifamily so the big question mark right now is the office sector. Office had, excuse me, office had done well through the pandemic partly as a result of long-term leases that are in place that even though office occupancy or physical occupancy had gone way down all the space was still, you know, leased out and the tenants were paying on those leases. But you know, occupancy still hasn’t bounced back in a huge way at least in the in most of the major urban locations. So, I’d say urban office is the big question mark right now. We’ve seen delinquency rates go up a little bit there, so it’s not for the bank loans that we survey the office delinquency rate is about 1.5%, that’s up from pre pandemic level of about 0.5%. So, it’s noticeably up from where it was, having said that you know in the in the great financial crisis those were you know much higher delinquency rates. Commercial real estate overall was at about a 10% peak delinquency or default rate. So, you know, office is nowhere near that at the moment but risk ratings are higher. Lenders, our bank clients in the major markets are keeping a close eye on their office loans. And then from a data point standpoint we did put together some data recently on the office market and we tallied an estimate of about 320 billion of office loans that are coming due in the next couple years. So, this in 2022 and 2023, that’s across the entire landscape. About half of that is bank lending and about half of that is non-bank lending, but still, that’s a big number. There’s currently, there’s plenty of liquidity and there has been plenty of liquidity to handle that but that’s a pretty big number at a time when everybody’s got lots more questions than answers about the future of office.

Rob Newberry 13:02

So, Matt would you see the potential for folks to try to change the business use of their space? So maybe moving it from office space to warehouse on the bottom floor to help with the vacancy rate.

Matt Anderson 13:22

Ah, yeah, that would that’s an excellent point. We have seen things like that happen in the past where if you go back to previous cycles like in the great financial crisis or even before that back to the early 90s you had cases where, you know, entire markets were really depressed and as a result, the building owners had to get creative and find different uses for those spaces. So, we have seen cases where, for example, office would be converted into residential of some sort or hotels for like multi-story office. You could do that sort of thing. So yeah, it would all depend on the location and physical parameters of the building itself. But I think you’re right, I think owners and lenders if they become owners of real estate, they’ll have to you know, get creative about some of those uses.

Thomas Curley 14:32

Shifting gears a bit. You know we’ve been walking through a little bit on the current landscape, but for some listeners I know some more practical tips and tricks when it comes to navigating these volatile times will be super helpful. So, Rob I wanted to start with you and see if maybe from your experience working with institutions if you’ve maybe seen a few common pitfalls amongst those that have you know a lot of CRE in their portfolio and what you would recommend staying clear of or preparing for in that circumstance.

Rob Newberry 15:02

Yeah. I think one of the things that people or financial institutions today have, I don’t want to say it’s a common pitfall but there’s a lot of liquidity in the bank market right now. So, they compete pretty heavily against each other for the few commercial real estate loans that are out there and so they might be underpricing the risk that they’re taking on. And so, if you have a commercial real estate I think it’s important to understand your pricing model and make sure that you are pricing in the risk that you’re taking and just not trying to fill your balance sheet full of loans because commercial real estate is the only one you can find out there. Does that make sense Thomas? So that’s one of the common pitfalls. The other one is just understanding, I think as Matt mentioned, there’s a lot of uncertainty in the market so making sure that you’re doing the appropriate stress testing at the transaction level when you’re underwriting the credit initially and then ongoing as we get some of these questions answered on, you know, how the market will perform. And some of these other things that there’s just a lot of unknowns on will people move back to office space, will they still work from home and we talked about do they change the main use of those spaces? So, there’s just a lot of unanswered questions yet that I think you have to be aware of in that you should be building stress test models around your commercial real estate portfolio to make sure that you’re not blindsided in two years if all of a sudden things start to go a little south on you.

Thomas Curley 16:39

And I know we’ve done a couple other presentations in the past too, I know another best practice that we’ve talked about, you know, is some of the specialization and getting more in the weeds and I think to the point that Matt was making earlier that I think there are certain sectors or segments that are a little bit more uncertain than others. Is that something that you would recommend for institutions to maybe focus on a certain area or smaller dollar amounts or something around something like that?

Rob Newberry 17:08

Yeah I would, you know, it’s like having a good stock portfolio Thomas. I think a good rule of thumb is to have some good diversification. Now there are some vectors that are performing or segments better than others, however, in the big scheme of things if you have a well-balanced portfolio, you’ll be better off. So, you don’t want to load up all on lodging obviously, but if you had a good mix of lodging and warehousing and industrial light manufacturing your overall portfolio will probably perform a little better than putting all your eggs in one basket. So once again, understanding that concentration risk is pretty important and if you have an opportunity to mitigate some of that concentration risk in the next few years as you’re kind of boarding new opportunities or things are refinancing take advantage of that to get a nice balanced CRE portfolio versus you know, sometimes just based on where the financial institution is you get some unintended concentrations and be aware of those as you’re booking your loans and moving forward for sure.

Matt Anderson 18:17

Yeah, and I’d add to that. Diversification is of some sort anyhow is definitely your friend because you never know, even the best performing sector right now could be next year’s you know worst performing sector. That happened. So, we’ve definitely seen it with some of our clients that went heavily into, you know, what seemed like really safe sectors and over the long term they really are only to be blindsided by some short-term hiccups in in particular markets or particular product types. So yeah, that can definitely happen. One comment I was going to make about potential pitfall for the kind of flip side of going for diversification, just be a bit careful about out of footprint lending. That tends to be something that the regulators tend to focus on quite a lot for good reason. If you’re lending outside of your geographic footprint, not that you can’t do it, but you just want to make sure that you’re dotting every I and crossing every t when you when you do that.

Rob Newberry 19:31

Yeah, and I could talk a minute about we call them participation loans in the community banking space and they probably have a little kind of a dirty word if I mentioned those back in 2009/10/11 because a lot of community financial institutions thought they bought a lot of their problems to mass point through probably trying to diversify but getting things outside their footprint. And there’s some simple common best practices on making sure you’re doing site reviews and doing the same due diligence you would a loan in your own territory. So, make sure you’re not treating it as an investment but actually as a loan and do the same due diligence. But there’s probably also a little extra making sure because it’s outside of your area, potentially outside of your area of expertise and lending in general but also out of your local market. So, you might not even know what’s going on in that geographic area so doing some site visits and doing your checking is critical if you do decide to do participation loans. And Matt I do see that as probably an opportunity because there’s a lot of liquidity and not a lot of loans in certain areas. And so one of the ways to solve that problem is to do participation loans and making sure you understand what you’re getting into will be a key for that.

Thomas Curley 20:51

On a slightly different note, but I know one best practice that we’ve talked about in the past is around just management reporting. Matt are there any specific types of dashboards or risk assessments that you would maybe recommend for an institution that has a focus on CRE to make sure they’re understanding their portfolio as well as I need to?

Matt Anderson 21:13

Yeah, I think getting a good hand, I mean a lot of it’s pretty straightforward conceptually but then in practice ends up being more challenging. So, believe it or not just being able to summarize your portfolio and have a handle on, you know, where your portfolio is both geographically and property type wise. Maybe by vintage things like that being able to produce metrics on your portfolio at those different levels is meaningful and useful for management and your board to keep an eye on. Anytime you talk to your regulator you want to be able to impress them that you really know what’s going on both in your portfolio and then in your markets. So, once you have a good handle on what’s going on in your portfolio, then being able to expand that and look to your markets and have an idea of how your portfolio and its performance fits within the broader market. I think those are those are all useful things. And we’re getting a lot of questions from folks these days that are essentially trying to do that, so measure just the content of the portfolio, the performance of the portfolio, and then the risks, the forward-looking risks in the portfolio. If you can do that at all those different levels, I think you’re in good shape. Having said that, a lot of the big challenge that we come across these days seems to be around information and information systems. So, lot of banks believe it or not still really don’t have information systems that are up to snuff. There’s a lot of data that’s still in hard copy files somewhere, paper files or if not a paper file then a Pdf file. And really, you need to get it out into an accessible electronic format where you can do something with it.

Rob Newberry 23:35

Yeah Thomas, and I would probably add to what Matt’s talking about, you know, unfortunately a lot of community financial institutions still probably have segments a little higher probably at the call code level versus broken down even into the simple commercial segment or vectors that you might want to look at. So, adding some simple things like NAIS code and property address really make a big difference when you’re trying to segment your portfolio not only just for informational purposes and dashboard, but also as you look for CECL and other opportunities.

Thomas Curley 24:13

Well one last topic I wanted to hit on because I know it’s always of interest to our listeners is a regulatory perspective. And so I know we’ve already spent some time discussing the markets and best practices, but for financial institutions with high CRE concentrations or a good chunk of their portfolio, you know, what is expected of them right now? Anything different from the usual, Matt?

Matt Anderson 24:35

Well really some of what we just alluded to a minute ago about, you know, having a good handle on your portfolio where it is and how it’s performing. That’s certainly part of that, you know, information push that you’re going to get or request you’ll get from your regulator. And then yes as far as stress testing goes, being able to do reasonably rigorous stress testing on your portfolio. That’s going to be a pretty key thing. If you can go down to the loan level and stress at that level then that’s great, otherwise, we’ve seen institutions that will aggregate like loans together and then you know handle their stress testing at that level. That works too. So, you could bundle your you know Houston industrial properties together and take a look at how they’re performing or your, you know, Miami multifamily properties and look at things that way. That works but definitely if you can run your portfolio through the scenarios that the regulators provide for the large banks that tends to be a not exactly a requirement but it’s a bit of an expectation at the regulator level for when they go and do an exam for banks with concentrations.

Thomas Curley 26:14

Makes sense. One other topic I know we discussed a little bit before our call today around regulatory expectations, Matt I think you’re the one that brought it up but just saying you were hearing more about climate or environmental risk from the regulatory perspective. You think that ties in a little bit to our CRE conversation today?

Matt Anderson 26:32

Yeah, absolutely. So, we’ve started to hear from some of our bank clients that the regulators are asking them pointed questions along the lines of stress testing now instead of just outright expected loss figures under different scenarios. They’re asking more open-ended questions about environmental or climate risk and so they’re asking the banks basically to come back to them and take their portfolio and, you know, define to the regulator where the environmental risks or climate risks in their portfolio are. And then step two of course will be, okay so you know what are you doing to mitigate those risks? It’s good and bad that the regulators are asking at this point pretty open-ended questions. So, the good part of that is that if you can define or craft your own response as long as you’re basically you know covering the content of the question, which is just to say something about your environmental exposure or your exposure to climate risk, then it’s really up to you to figure that out and report it back to the regulator. The downside of that is, of course, then you have to figure it out. But folks out there have started to, you know, make an effort at doing that sort of thing and I’ve seen some creative responses already to, you know, trying to assess the risk in the first place and then say something about what it what it looks like going forward. Just one thing to add on the stress testing front, so there is a sort of intersection between climate risk and stress testing. Some of our clients have been asking for climate risk scenarios for doing the stress testing. So, the idea being, okay there’s a, you know, climate impact of x or y for these different markets, then how does that translate into stress testing type impacts. And so that’s something that we’ve also been exploring recently with some of our clients.

Rob Newberry 29:11

Yeah Thomas, and I would add that I love the concept that Matt just talked about on the on the back end on the portfolio. But I also love pulling it forward into the initial risk assessment when you’re underwriting the deal upfront, so understanding upfront how you would classify the environmental risk is one of the major items underlying the total risk along with cash flow, LTV value, and you know understanding that environmental risk will be key I think as we continue to go in the future on commercial real estate and some of the issues we might have with climate issues.

Thomas Curley 29:48

Yep, good points and all things to keep an eye out for. Looking at time here I wanted to go ahead and start wrapping up our conversation. Matt I’ll start with you and then Rob feel free to jump in but if our listeners take anything away from our conversation today, maybe, what would be your one or two items you want to leave them with?

Matt Anderson 30:11

Yeah, I suppose just reflecting on the last few minutes of what we’ve talked about, you know, we are really at an interesting point or problematic point for the markets overall. So, conditions are really good at the moment or have been good. Loan performance overall is quite good, but I am concerned about the impact of higher interest rates, higher inflation, to really how we’ll you know deal with that will be, that’ll help define the markets over the next, you know, twelve to twenty-four months and even beyond. At the same time, you know, that does kind of plug into our discussion around information systems, dashboards, and stress testing so to the extent that you can model those higher interest rates and the impacts they’re going to have, that’s an important feature of what I think real estate lenders out there right now should be doing on their portfolio. And I liked Rob’s point about making new loans, any new loans that you’re making you want to factor in higher interest rates for sure as a feature of the future landscape and make sure that they can handle those higher rates moving forward.

Rob Newberry 31:40

Yeah Thomas, the only thing I was going to add to that was don’t be afraid to do commercial loans right now, commercial real estate loans. So even though there’s uncertainty, here’s still opportunity. You probably make more net interest margin spread on a CRE loan than you would on an investment right now. So don’t be afraid to do it just because there’s uncertainty in the market.

Thomas Curley 32:00

For those that are new listeners or maybe haven’t subscribed yet, you can find this podcast in future episodes on abrigo.com or you can find it on your favorite podcast app or platform, just search Ahead of the Curve: A Banker’s Podcast or simply search Abrigo. It’s a little bit shorter. Thanks so much for listening and we’ll be back again with you soon with our next episode and I just want to thank both Matt and Rob so much for their time and insights today. We sure do appreciate it.

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