Silicon Valley Bank and Signature Bank went under just days apart, and after momentary panic, regulators swooped in last month. Although the broad economic implications are still being assessed, it looks like the collateral damage could be particularly painful for commercial real estate.
Long before these bank failures, commercial real estate on the office space side was already struggling with rising vacancies and falling property values as workers resisted returning to their nine-to-fives. Those commercial real estate troubles could be exacerbated if in the aftermath of bank failures lenders decide to tighten lending standards for commercial real estate [CRE] loans.
Experts in the commercial real estate space didn't mince words when speaking with Fortune: Buckle up, they say, for more CRE defaults and delinquencies.
Rich Hill, the head of real estate strategy and research at global investment management company Cohen & Steers, told Fortune their estimate puts commercial real estate at a more than $20 trillion market in the U.S., with several “subsectors that roll up into this broad commercial real estate umbrella,” even though it’s typically thought of as a single asset class. Relative to the size of this market, Hill said, the CRE mortgage market underlying it is around $4.5 trillion, according to the Mortgage Bankers Association. On average, Hill said, that means the commercial real estate market has approximately a 25% loan to value ratio.
But how much do banks hold of that $4.5 trillion? The Mortgage Bankers Association has it at less than 40% (which is the largest share). As for the Federal Deposit Insurance Corporation, which has a different estimate of $5.6 trillion, it’s estimated that banks hold more than half. As for small and midsize banks? The estimates vary as well. Earlier this month, Goldman Sachs analysts said lenders with less than $250 billion in assets account for roughly 80% of commercial real estate lending. Hill told Fortune that he “can’t get to that number…the large banks, the large lenders [like] Wells Fargo, JPMorgan, Citibank, by definition, they’re just going to have more absolute commercial real estate loans and smaller banks.”
Still, Hill said that smaller banks (the 51 to 100 largest banks by total assets) have around 33% exposure to commercial real estate. But that’s not to say some banks don’t have greater exposure; he’s seen a couple “where their exposure was north of 70%.”
Kevin Fagan, head of commercial real estate economic analysis at Moody’s Analytics, told Fortune that larger banks account for more commercial real estate loans than smaller banks, with roughly two-thirds held by large banks, per the Mortgage Bankers Association. Fagan called it a “relatively small piece of the pie, although not inconsequential.”
Hill echoed that sentiment, saying, “that’s not to ignore the fact that smaller banks do have meaningful relative exposure to the commercial real estate market.”
Banks tightening lending standards
There’s a general consensus that the Silicon Valley Bank and Signature Bank failures will likely tighten credit, in the form of fewer loans and stricter lending standards. Stricter lending standards have already been in place, so this will likely exacerbate the already tight conditions, which will have an effect on property values.
After delivering another interest rate increase this week, at a news conference, Federal Reserve Chair Jerome Powell said that tighter credit could have the same effect on inflation as rate hikes—suggesting that the bank failures were effectively like an interest rate hike. So when asked if we’re going to see credit tighten from here, Hill said: “the short answer is absolutely.”
“We saw lending standards tightening and loan demand declining even before this,” Hill said, adding later, “I think it would be naive to suggest that lending standards aren’t going to tighten even more on the heels of this. That’s what happens when you head into softer economic conditions, never mind one where there’s friction in the banking system.”
"Challenging to get deals done"
A commercial real estate broker at BRD Realty, Max Fisher, told Fortune that it’s already become a more challenging market in terms of financing since the Fed started tightening, and the bank failures are likely to make it more challenging to get deals done, “almost freezing markets,” as he referred to it. “They’re underwriting, they’re tightening up,” Fisher said, adding later, “we’re going to see a major slowdown.”
Xander Snyder, senior commercial real estate economist at First American, told Fortune, “as far as the bank failures go, I can’t imagine how they would increase liquidity in the market…So I do think it’ll exacerbate the existing liquidity crunch that’s been slowly developing in the commercial real estate market.”
It’s confirmed by the Fed’s January senior loan officer survey on bank lending practices, which says “banks reported tighter standards and weaker demand for all commercial real estate (CRE) loan categories.”
Fagan told Fortune that there was an understanding within the commercial real estate sector that this “would be somewhat of a painful year for the industry,” even before the bank failures. That being said, commercial real estate property valuations are likely to decline, which isn’t necessarily a surprise to those within the sector, who’ve already suggested that valuations were going down, if they haven’t already fallen. But if we’re to see tighter lending conditions, commercial real estate valuations could fall even further, “maybe more than what people were previously anticipating,” Hill said.
“If you would have asked me six months ago, how much I thought property valuations were going to be down in 2023, I would have told you that they’re going to be down 10 to 20%,” Hill said. “Now, I think, it’s probably going to be a lot closer to that 20% scenario and maybe even a little bit higher than that once you take into account tighter lending conditions.”
Movement in the credit market can affect CRE property values
That doesn’t mean the entirety of commercial real estate is at risk, but that there’s risk with some property types, specifically refinancing risk. “Lenders are going to want to at a minimum keep their [loan-to-value ratios] constant,” Hill said. That means that borrowers looking to refinance may have to inject more equity back into the property, and the question Hill said, is do they have that money? It’s a real risk, he said, because to refinance the lender is going to require borrowers to keep the “LTV constant at a lower property valuation.”
And the office sector that might already be lacking the additional capital needed to refinance, plagued due to the widespread shift to remote work brought on by the pandemic, could be of particular risk, Hill pointed out.
If you have a $10 million asset and you put $5 million of debt on it, you have a 50% LTV loan, Hill said, giving a hypothetical scenario. But if the property valuation declines by 20%, your LTV goes up, and “in this environment a lender is not going to want to give you a higher LTV loan…they might even say ‘actually I want tighter lending conditions right now on some property types given everything that’s going on.’” So you’ll have to put more equity into the property, reducing the loan amount and getting that LTV back to 50%. With that “defaults will increase, distress will increase, delinquencies will increase, that’s all going to occur,” Hill said.
There’s not a wave of maturity coming through this year, Fagan said, but there’s a challenge for loans that are maturing, with some already being delinquent. Commercial real estate data provider Trepp estimates “$448 billion in maturing loans in 2023, of which $270 billion are from banks, and a total of $2.56 trillion maturing between 2023–2027, of which $1.4 trillion are from banks.” As a lender looking at a commercial real estate property, your primary goal is to not lose money. So as a lender, in the current market, you’re looking at the somewhat unstable prices in the, and “it’s hard for you to lend right now because you don't really know what the underlying value of the collateral is, that is the building,” Snyder said.
Jeff Feldman, senior vice president and debt broker at AANDAR Real Estate Capital, told Fortune “the whole industry is built on debt,” and any movement in the credit market can affect property values because of how tightly the two are connected. Still, not even a month has passed since the two banks went under, and just this week the Fed delivered another rate hike, so where the commercial real estate market doesn’t seem to be fully understood. Although it’s clear that the sector expects credit to tighten further from here and the impacts of that would be felt soon.
“Banks have stepped back, and I imagine banks are going to be even more cautious as a result of just everything that’s happened in the last couple of weeks and the increased scrutiny that’s going to come as a result of that,” Snyder told Fortune, adding later that “if there isn’t a lot of borrowing happening…it makes it a lot more difficult to buy a building.”
