Ahead of the curve: A banker’s podcast episode 5 – CRE lending
Commercial real estate lending: Best practices, trends, and regulations
For financial institutions across the country, commercial real estate (CRE) remains an area of high emphasis within the loan portfolio as they pursue growth. However, with rising interest rates and inflation as well as the ongoing impact of the pandemic on office space, it’s important to keep an eye on the market and the inherent risks this type of lending presents.
In this episode, Matt Anderson from Trepp and Rob Newberry from Abrigo discuss how CRE is being impacted by the current economic conditions and give some tips on what to keep in mind when lending in this space.
In this podcast, we discuss:
- The state of the CRE lending landscape
- Best practices related to management reporting and stress testing
- Current regulatory expectations, including climate and environmental
Check out the series!
Ahead of the curve: A banker’s podcast
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Thomas Curley 0:00
This is Ahead of the Curve: A Banker’s Podcast
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
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.