Recent stress in the banking sector is not a systemic commercial real estate debt problem, and the risk of loss to lenders likely will be smaller than many believe, says Rich Hill, a senior real estate strategist at Cohen & Steers.
Bank closures and aggressive moves by financial regulators to prevent contagion in the banking system have raised questions about the health of the US commercial real estate (CRE) debt market. Our analysis suggests the magnitude of the problem and its implications have not been closely examined and are misunderstood.
The CRE mortgage market for income-producing properties is roughly $4.5 trillion, based on Mortgage Bankers Association data analysis. There are also $467 billion of construction loans, and the FDIC classifies $627 billion of owner-occupied property loans as commercial mortgages.
While the total amount of CRE mortgage debt on bank balance sheets has grown over the past several decades, the percentage relative to total bank loans has generally remained in the 10% to 14% range. Furthermore, this is spread across 4,700 banks, which helps to mitigate risk—a fact that we believe is underappreciated.
There is a commonly held belief that regional and community banks own the majority of outstanding commercial mortgages on their balance sheets. While regional and community banks own more than 70% of the loans held on bank balance sheets (as a result of Top 25 banks decreasing exposure), they own only 31.5% of all outstanding commercial mortgages.
These smaller banks have an average CRE exposure of almost 20% of total assets. And only 3% of total bank assets are office loans. It is true that a handful of smaller banks have greater than 50% exposure to CRE, with some standing at more than 70%. However they typically finance smaller properties in smaller markets rather than larger core properties owned by institutional investors.
How much will property prices decline?
We expect a pullback in the availability and cost of credit coupled with higher return expectations will impact valuations. A strong relationship exists between loan growth and CRE property prices, as measured by the NCREIF ODCE index (a measure of private real estate returns), and there is an even tighter relationship between lending standards (based on the Federal Reserve’s Senior Loan Officer Opinion Survey) and the NCREIF ODCE index.
We believe there could be a 20–25% decline in CRE property prices. This was already in process prior to recent events in the banking system, as the NCREIF ODCE index fell nearly 5% in 4Q22, the first decline since 2009. Given the lead/lag relationship of public and private real estate and the fact that REITs were down 25% in 2022, the decline in private returns does not come as a shock.
What is the risk of loss?
While 20–25% declines may sound like a lot, the risk of loss to lenders may be smaller than many people expect. This is because 50–60% loan-to-value (LTV) ratios help mitigate the risk of declining property valuations, especially since the properties themselves are still generating cash flow. Said differently, if a property’s valuation declines by 40% and the LTV is 50%, then the loan still has a 10% cushion from loss.
“While the total amount of CRE mortgage debt on bank balance sheets has grown over the past several decades, the percentage relative to total bank loans has generally remained in the 10% to 14% range. Furthermore, this is spread across 4,700 banks, which helps to mitigate risk—a fact that we believe is underappreciated.”
In fact, the entirety of the commercial mortgage market may be underleveraged, given lower cap rates, but also underappreciated annual net operating income growth that averaged 4.5% during the past decade. The combination of these two factors has led to significant increases in property valuations over the past 5–10 years, which has pushed down LTVs in many instances. However, loans that were originated over the past several years at peak valuations with shorter maturities likely represent the greatest risk, as their LTVs will be difficult to maintain.
There has also been discussion of REITs being under pressure as a result of this environment, however, we think the market may be overestimating these risks. First, REIT balance sheets are on strong footing with current loan-to-values of 34.8%, while almost 86% of US listed REIT debt is fixed for an average of the next six years. Second, while office represents 20.2% of the NCREIF ODCE index, it was only 3.6% of US listed REIT market cap at the end of December 2022. Consider that listed REITs have also outperformed the NCREIF ODCE index by almost 14% over the prior two quarters, reinforcing our view that REITs are a leading indicator and may offer an opportunity for investors.
Equity problem
Ultimately, we view this as primarily an equity problem for some property types, but not a debt problem. Borrowers will be required to inject new equity into their properties to maintain consistent LTVs as property valuations decline. We do anticipate increases in delinquencies and distressed sales as borrowers grapple with refinancing challenges, including whether they have sufficient capital to refinance the loans and the opportunity cost. However, this is much different than the subprime crisis during the GFC, where LTVs on homes were around 90% and property values fell 40% while unemployment was high.
*Rich Hill is head of real estate strategy & research at Cohen & Steers.
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