Originally published on August 21, 2024.The feeling of déjà vu takes on a whole new meaning in the 1993 film “Groundhog Day” when Phil Connors, a narcissistic broadcast journalist, finds himself reliving February 2 — Groundhog Day — over and over. After countlessly repeating the same day and initially taking advantage of his prior knowledge of how events will play out, Connors gradually learns to think more about others than himself. It is only after learning from his poor behavior and changing it for the better that Connors is finally able to exit the time loop and find true love.The banking industry is experiencing a bit of déjà vu itself regarding the increasing amount of risk building within commercial real estate (CRE) portfolios, with signs pointing to a possible asset correction reminiscent of the 2008 subprime mortgage crisis. Rising Risk
CRE has yet to rebound from the COVID-19 pandemic. Since hybrid work has become the new norm, many businesses have permanently reduced their real estate footprints — a shift that resulted in a large number of ongoing commercial vacancies. Many building owners are struggling to maintain mortgage payments absent the rental income they previously counted on, and things are poised to get worse.Since CRE loans are typically renewed at new interest rates roughly every five years, a wave of CRE loans is set to mature over the next few years within an interest rate environment that is substantially higher than the rates that existed when these loans were initially underwritten. Added to that is the reality that the underlying value of many CRE holdings has also diminished in recent years, meaning numerous building owners will need to provide additional equity in order to secure new loans.According to the Mortgage Bankers Association (MBA), the value of outstanding CRE loans totals roughly $4.7T, approximately $2T of which is expected to mature by the end of 2026. Office space comprises a large portion of loans nearing maturity, but multifamily housing also accounts for a major percentage — an area where building owners face their own set of challenges in certain parts of the country. With cities such as San Francisco and New York City implementing regulations that limit rent hikes on certain types of apartment buildings just prior to the pandemic — regulation put in place amidst record-low interest rates — many of these owners have been struggling to make loan payments for the past few years.Given the factors above, financial institutions, which hold roughly 38% of all outstanding CRE loans, have tightened CRE lending standards over the past year at the highest rate outside of a recession. In the fourth quarter of 2023, 67% of financial institutions increased lending standards for non-residential loans and 65% did so for multifamily loans.Heightened Scrutiny and SkepticismA handful of Wall Street financial institutions have even begun preemptively unloading some of their CRE loans, such as Goldman Sachs, Deutsche Bank, and CIBC, all of which have sold off CRE loans to reduce risk within their lending portfolios. They are not alone, as many community and regional financial institutions have also unloaded real estate holdings of their own to reduce their risks.Following last year’s bank failures, regulators have heightened their scrutiny of financial institutions’ CRE holdings and increased skepticism abounds. Though non-performing CRE loans doubled in 2023 to 0.81%, up from 0.4% in 2022, it is believed the numbers may actually be higher. Analysts suspect that many financial institutions have been granting short-term maturity extensions for some of the CRE loans in their portfolios to give borrowers more time. As a result of this practice, analysts at PGIM Real Estate say CRE maturities in 2024 rose 35% above previous estimates, while analysts from Autonomous Research estimate roughly 40% of the CRE loans maturing in 2024 should have matured in 2023.Precautionary MeasuresAmidst signs of rising risks within CRE lending portfolios, some financial institutions are stepping up their efforts to get in front of this trend by running stress tests on their portfolios to identify troubled loans before they default, particularly among owners of office buildings and multifamily homes.By using computer algorithms to simulate specific scenarios and analyze how the loans within their CRE portfolios will fare, financial institutions can determine the extent of risk they face, particularly within specific subsets facing challenges such as aforementioned office buildings and multifamily homes.Stress testing can do more for your institution than just identify loans that may default. Routine stress tests on your portfolio can also help you:
CRE has yet to rebound from the COVID-19 pandemic. Since hybrid work has become the new norm, many businesses have permanently reduced their real estate footprints — a shift that resulted in a large number of ongoing commercial vacancies. Many building owners are struggling to maintain mortgage payments absent the rental income they previously counted on, and things are poised to get worse.Since CRE loans are typically renewed at new interest rates roughly every five years, a wave of CRE loans is set to mature over the next few years within an interest rate environment that is substantially higher than the rates that existed when these loans were initially underwritten. Added to that is the reality that the underlying value of many CRE holdings has also diminished in recent years, meaning numerous building owners will need to provide additional equity in order to secure new loans.According to the Mortgage Bankers Association (MBA), the value of outstanding CRE loans totals roughly $4.7T, approximately $2T of which is expected to mature by the end of 2026. Office space comprises a large portion of loans nearing maturity, but multifamily housing also accounts for a major percentage — an area where building owners face their own set of challenges in certain parts of the country. With cities such as San Francisco and New York City implementing regulations that limit rent hikes on certain types of apartment buildings just prior to the pandemic — regulation put in place amidst record-low interest rates — many of these owners have been struggling to make loan payments for the past few years.Given the factors above, financial institutions, which hold roughly 38% of all outstanding CRE loans, have tightened CRE lending standards over the past year at the highest rate outside of a recession. In the fourth quarter of 2023, 67% of financial institutions increased lending standards for non-residential loans and 65% did so for multifamily loans.Heightened Scrutiny and SkepticismA handful of Wall Street financial institutions have even begun preemptively unloading some of their CRE loans, such as Goldman Sachs, Deutsche Bank, and CIBC, all of which have sold off CRE loans to reduce risk within their lending portfolios. They are not alone, as many community and regional financial institutions have also unloaded real estate holdings of their own to reduce their risks.Following last year’s bank failures, regulators have heightened their scrutiny of financial institutions’ CRE holdings and increased skepticism abounds. Though non-performing CRE loans doubled in 2023 to 0.81%, up from 0.4% in 2022, it is believed the numbers may actually be higher. Analysts suspect that many financial institutions have been granting short-term maturity extensions for some of the CRE loans in their portfolios to give borrowers more time. As a result of this practice, analysts at PGIM Real Estate say CRE maturities in 2024 rose 35% above previous estimates, while analysts from Autonomous Research estimate roughly 40% of the CRE loans maturing in 2024 should have matured in 2023.Precautionary MeasuresAmidst signs of rising risks within CRE lending portfolios, some financial institutions are stepping up their efforts to get in front of this trend by running stress tests on their portfolios to identify troubled loans before they default, particularly among owners of office buildings and multifamily homes.By using computer algorithms to simulate specific scenarios and analyze how the loans within their CRE portfolios will fare, financial institutions can determine the extent of risk they face, particularly within specific subsets facing challenges such as aforementioned office buildings and multifamily homes.Stress testing can do more for your institution than just identify loans that may default. Routine stress tests on your portfolio can also help you:
- Quickly assess impact under multiple scenarios
- Calculate potential losses within a variety of economic environments
- Perform those calculations within the parameters of current reserves and forward earnings
- Provide strategies for how to move forward with problematic loans in your CRE portfolio and beyond
Once your team has a better idea of what risks could be hiding within your CRE loan portfolio, the strategies for addressing that risk can be incorporated into your risk management processes, which may or may not include unloading or other methods to avoid any potential loan defaults.Identifying the extent of CRE risks in advance allows financial institutions to better prepare themselves and to determine if they should be following the lead of larger players in the industry by offloading specific portions of their lending portfolios. As regulators become increasingly concerned about the impact that rising CRE defaults could have on the greater economy, it is likely only a matter of time before they heighten stress testing requirements anyway. PCBB is here to help your organization with stress testing and has a wide range of offerings and extensive expertise available.
