Commercial property risks rise up bank investors’ worry list

Commercial property loans are joining deposit flight and bond portfolios as the biggest perceived risk for US banks as rattled investors fret about lenders’ strength following the collapses of Silicon Valley Bank and Signature Bank.

Strains in the $5.6tn market for commercial real estate loans have deepened in recent months as the Federal Reserve’s year-long series of interest rate rises leads to sharply higher borrowing costs and weakening property valuations. Analysts fear any further reduction in lending — say, from businesses more keen on hoarding deposits following two shock bank runs in a week — could make a perilous situation worse.

The threat of a credit crunch rippling across the global financial system has overtaken inflation this month as investors’ biggest worry, according to a monthly global survey of fund managers by Bank of America.

Thousands of small and medium-sized banks that make up the bulk of US lenders account for about 70 per cent of so-called CRE loans, according to JPMorgan analysts.

Most of the products are not repackaged for the asset-backed securitisation markets so remain on banks’ books. CRE loans make up 43 per cent of small banks’ total lending, against just 13 per cent for the biggest banks.

“The collapse of SVB is putting a magnifying glass on regional banks, and their commercial real estate loan books remain an area of major concern,” said JPMorgan securitisation analyst Chong Sin. “Credit availability to CRE borrowers was already challenged coming into this year,” he added, warning in a note to investors that a retreat from lending among smaller banks risked creating “a credit crunch in secondary and tertiary CRE markets”.

New York Community Bank’s purchase this week of $39bn of assets from collapsed rival Signature did not include any of its real estate business, in a move NYCB said was part of its efforts to diversify away from CRE lending.

However, bank analysts said they did not expect immediate blow-ups in the sector as the effects of higher interest rates are only felt slowly.

“I’d agree that credit is the next thing on the radar as we look over the rest of this year and next,” said Gary Tenner, senior research analyst at DA Davidson, which covers more than 100 US banks. “It depends where a bank has exposure, but I don’t think it starts quite yet from a credit loss perspective.” 

Asked for his views on CRE risks, Fed chair Jay Powell on Wednesday told a press conference that the central bank “was aware” of concentration in the sector but added he didn’t think the issue was comparable to the other strains banks had experienced.

Offices are seen as the area of biggest risk after tenants cut back on space to reflect the popularity of working from home following pandemic lockdowns. Vacancy rates have risen in each of the top 25 markets since 2019, according to rating agency Moody’s. In San Francisco, the worst-hit city, almost 19 per cent of space was unoccupied at the end of 2022, up from 5 per cent three years earlier.

High-profile defaults have highlighted the potential for stress. Canadian property giant Brookfield last month stopped making payments on $734mn of loans covering two prime Los Angeles office towers while one of New York’s biggest office landlords, RXR, said it was negotiating with lenders to “hand back the keys” to two buildings in an acknowledgment that they no longer made financial sense.

One New York developer expressed amazement at big rivals’ willingness to relinquish properties to lenders since in doing so, this person argued, they had given cover for others to follow suit.

“There’s going to be a lot of hard discussions in the next few years,” the developer said.

While banks have been generally more conservative in their lending since the excesses that caused the 2008 financial crisis, falling prices could create problems if banks’ once-modest loan-to-value ratios balloon, said Andrew Scandalios, co-head of JLL Capital Markets. Rising ratios can trigger higher regulatory capital requirements, further squeezing the space for fresh funding.

“The lending community needs to acknowledge the sharp and deep declines that have occurred in office valuations,” added Scandalios. “Virtually everyone is going to be impacted here.”

Banks have already begun raising the bar for new loans, with about two-thirds of lenders tightening terms for construction and land development deals by the end of last year, while more than half were also lifting standards for apartment buildings as well as other non-residential commercial properties, according to the Fed’s quarterly survey of senior loan officers.

“It has become more difficult to secure capital, particularly at the types of leverage that real estate investors have historically strived for,” said John Fraser, chair of global structured credit at Tikehau Capital. “That not only puts a damper on real estate development but can have an impact on refinancing.”

Compounding the risks for commercial operators as well as their financiers is a slow market for commercial mortgage-backed securities, which is squeezing the ability of banks to free up lending capital by shifting existing loans off their books, and also reducing the exits available to other sources of funding such as the private markets.

Issuance of the bonds, as with their residential mortgage cousins, is running at a fraction of the levels of recent years as volatility has widened the spread, or premium charged, over risk-free Treasuries. Those higher yields have pushed down the prices of existing bonds and made it hard for lenders to find loans that can yield what the market is asking.

About 17 per cent of office loans are held in CMBS, according to Goldman Sachs, making the market joint-top funder alongside regional and local banks.

Commercial real estate is a market that “relies quite heavily on bank lending — especially actually among the small and midsized banks” said Lotfi Karoui, chief credit strategist at Goldman Sachs. “The ability to substitute and look for other sources of capital is quite constrained.”