Is the next crisis waiting to happen in the commercial real estate sector?
There are estimates that around USD 1.5 trillion of commercial real estate debt in the US is maturing over the next three years. Investors are worried, but we think it’s manageable.
Concerns about the commercial real estate (CRE) sector moved to the forefront following the fall of Silicon Valley Bank (SVB) and the mini banking crisis that ensued thereafter.
Why? Well, the work-from-home arrangements that led to high vacancies raised questions about the future of US office space. One of the scarier numbers being thrown around is the amount of CRE debt that needs to be refinanced over the immediate term, with the most common refrain citing USD 1.5 trillion maturing over the next three years.
Smaller US banks remain meaningful players in commercial real estate lending. Banks with less than USD 5 billion in assets still comprise about 30% of holdings, with another 21% held by banks with USD 5-25 billion in assets.
Are CRE concerns valid?
Despite the seemingly dire numbers, we believe the CRE concerns are overblown.
As our research partner, CreditSights, has reported, banks do not normally participate in fixed-rate lending for CRE, as around 81% of CRE loans under the coverage of CreditSights have variable interest rates. This lessens the risk of unexpected price adjustments when the loan matures.
Moreover, longer-term trends indicate that CRE loan exposures as a percentage of the banking system’s tangible equity are still at multi-decade lows, much lower than what we saw before the economic downturns in the late 1980s and mid-2000s, indicating that banks are not taking on too much risk in the CRE sector.
Ratios to take note of
The ratio of outstanding commercial mortgages to GDP can be a proxy for CRE demand. The historical behavior of this measure shows that during financial crises, the ratio considerably deviated from its long-term trend.
What is interesting is that there has not been a surge in debt levels that would lead to a significant deviation for more than 10 years. The brief spike in 2020 stemmed from the COVID-19 pandemic, but generally, there has not been a persistent trend of heightened borrowing.
When comparing bank lending for CRE to the Commercial Property Price Index, which reflects asset valuations, we observe that valuations have outpaced loan growth since the financial crisis. This suggests that there is a more careful and balanced approach to leverage and loan-to-value (LTV) ratios in the CRE market.
Better prospects this time around
Banks have substantially scaled back their lending for construction and development projects since the 2008 crisis. These loans have not significantly increased since then. Note that these development loans had high default rates compared to other types of CRE loans and were a major driver behind the losses that banks sustained during the financial crisis.
While construction lending has been relatively flat since 2017, stabilized CRE lending, or loans for CRE properties that are already operating and generating consistent income, has been gradually growing, slightly exceeding the growth of total bank lending.
The sector that attained significant expansion is multifamily properties, such as apartments. Note that multifamily lending is reinforced by strong demand, particularly because people need shelter and these multifamily properties are a necessity, combined with other factors such as affordability.
Banks’ exposure to office properties is relatively minor compared to their total loan portfolios. Banks also have strong reserve levels, and they hold senior positions in the capital structures of these properties, which diminishes possible risks.
It is important to note that larger national banks usually have a bigger share of lending in industrial and office assets, while smaller banks play a more prominent role in lending in the retail and hotel markets.
Hence, recent concerns about office assets should not be taken to reflect the overall health of the broader CRE market.
Moreover, banks only have a limited amount of non-agency Commercial Mortgage-backed Securities, or CMBS securities, which are higher-risk securities with no government backing, in their holdings. This further reduces their exposure to potential risks.
Although smaller US banks have significant exposure to CRE lending, they also tend to be more biased toward lower-risk owner-occupied CRE loans, making up 40-50% of holdings for banks with assets of less than USD 5 billion.
Recent concerns about the CRE sector seem exaggerated, as there has been a significant decrease in banks’ exposure to higher-risk construction and development loans, a relatively low level of leverage in the CRE market, and other changes in the banks’ overall CRE lending approach.
The total CRE market has been more stable compared to past periods of financial crises, indicating that banks are in a much better position now to handle potential risks.
Challenges and opportunities
While we believe the CRE risk is not systemic, challenges remain for the smallest banks amid tight lending conditions and high interest rates. Despite the disconnect with market pricing, the US Federal Reserve has explicitly stated it does not expect policy rate cuts this year to deal with recessionary risks, namely, the looming credit crunch, the debt ceiling standoff, and the climate hazard from El Niño.
Thus, in a risk-off environment, there are opportunities in the fixed-income market as we think the Fed has reached the peak of its tightening cycle. Capital gains can be realized when the real pivot, i.e., policy rate cut, takes place.
The perceived economic uncertainty warrants a preference for high-quality assets like government securities and investment grade (IG) credits over equities. A new easing cycle on the horizon, granted that inflationary pressures ease, could then present opportunities for the equities market.
For now, it is prudent to be conservative and switch to higher-yielding assets as inflation remains elevated, and wait until the US Fed and the Bangko Sentral ng Pilipinas see a compelling reason to cut interest rates.
ANNA ISABELLE “BEA” LEJANO is a Research & Business Analytics Officer at Metrobank, in charge of the bank’s research on the macroeconomy and the banking industry. She obtained her bachelor’s degree in Business Economics from the University of the Philippines School of Economics and is currently taking up her Master’s in Economics degree at the Ateneo de Manila University. She cannot function without coffee.
GERALDINE WAMBANGCO is a Financial Markets Analyst at the Institutional Investors Coverage Division, Financial Markets Sector, at Metrobank. She provides research and investment insights to high-net-worth clients. She is also a recent graduate of the bank’s Financial Markets Sector Training Program (FMSTP). She holds a Master’s in Industrial Economics (cum laude) from the University of Asia and the Pacific (UA&P). She takes a liking to history, astronomy, and Korean pop music.