The lifeblood of the commercial real estate industry is under threat as regional banks reel from the recent marquee failures of two of their own.
Roughly 80% of U.S. commercial real estate lending is provided by banks that have assets of less than $250B, Goldman Sachs economists wrote in a recent report. Increasingly those loans — worth a combined $2.3T, according to Trepp — are being looked at as another source of stress for small and regional banks.
With Silicon Valley Bank and Signature Bank being taken over by regulators and First Republic Bank needing emergency cash infusions to stay solvent, fear of broader contagion is likely to curtail regional banks’ lending activity, which could leave a huge swath of CRE investors struggling to find the money.
“I think a lot of people have been in denial about the value of their real estate because we haven’t seen trades,” said Brett Forman, principal at Forman Capital, a South Florida-based CRE debt and equity lender. “I think it’s going to have a profound effect on regional banks.”
Small and midsized banks are the financial backbone of the type of commercial real estate investing idealized by the industry when it is defending itself against regulation or higher taxes: families purchasing a strip mall or apartment building in the hopes of creating generational wealth.
“We provide the bulk of lending to small businesses,” said Archie Brown, the CEO of Cincinnati-based First Financial Bank.
At the end of last year, amid the most aggressive interest rate hike campaign in the Federal Reserve’s history, regional banks continued to make commercial real estate loans, stepping into some bigger deals that money center banks had retreated from.
Federal regulators have moved swiftly to try to shore up confidence in these institutions. The Fed, the Federal Deposit Insurance Corp. and the U.S. Treasury Department all promised depositors at SVB and Signature that their money was guaranteed, backstopping potential customer losses.
The Fed also created a Bank Term Funding Program, allowing banks to borrow additional funds to cover deposits on one-year loans at par — banks took out $300B through that program in a week.
Treasury Secretary Janet Yellen also said Tuesday the U.S. government was ready to step in to prevent further small bank failures.
Many of the lending experts Bisnow spoke with said these federal government moves have stabilized the system, but they acknowledged that they fear a continued deterioration of confidence.
“The main concern I have is the contagion question,” Brown said. “The main thing is to make sure that the Fed is instilling confidence in the deposit base. As long as we do that, I think everything else will manage itself.”
Regulators said late last week that deposits at regional banks had stabilized as some confidence returned to the sector, Reuters reported. But in the aftermath of SVB’s failure, Bank of America alone saw an increase of more than $15B in deposits, and JPMorgan Chase, Wells Fargo and Citigroup also experienced heavy cash inflows as small bank customers fled to “too big to fail” banks, Bloomberg reported.
San Francisco-based First Republic lost roughly half of its deposits in recent weeks, The New York Times reported, a $70B run that required both the federal government and a group of 11 large banks to cycle cash back into First Republic to prevent another collapse.
“The effect on regional banks could be devastating if depositors decide to move their funds to stronger players like J.P. Morgan, Bank of America or Wells Fargo who are seemingly immune at present to liquidity issues,” David Keiran, the chief financial officer for Boston-based real estate services firm Senné, wrote in an email.
“Depositors moving from smaller and regional banks to money center banks to secure their deposits will also reduce liquidity which will also further reduce available funds from these small and regional banks for lending to customers.”
First Republic lost half of its deposits, $70B, in a matter of weeks as its customers fled for the safety of larger institutions.
The leakage of deposits faced by regional banks today began long before this month. The total deposits in all commercial banks has dropped by more than $530B over the last year, according to Federal Reserve of St. Louis data.
“If banks do end up struggling, the first thing we see here on the front lines is a reduction in their real estate exposure,” Brad Kraus, senior director at the CRE financial consulting firm Ascension, wrote in an email. “If things get worse, they simply start quoting rates which guarantee profitability, thus effectively pricing themselves out of the market.”
With more lenders out of the market, less liquidity means commercial real estate values, already being called into question because of higher interest rates, will continue to be pushed downward.
“Those looking to sell anytime soon, especially those owners that are facing loan maturities, will have to offer their deals at higher cap rates to attract buyers,” Keiran wrote. “So I would expect to see a major value adjustment in the CRE sector, especially if we are in a recession.”
Beyond lower deposits, banking officials and regulators have also expressed concern in recent months about the concentration of commercial real estate loans on banks’ books, especially on office buildings, where tenants are shrinking their footprints in response to permanent hybrid work schedules and layoffs.
In August, the FDIC said it would apply more stress testing to banks with high percentages of commercial real estate loans.
In an effort to free up their balance sheets of CRE debt, some regional banks may turn to the securitized market, said Lisa Pendergast, the executive director of the Commercial Real Estate Finance Council.
Regional banks could potentially sell their existing mortgages to investment banks, which in turn would bundle them and sell to investors in the CMBS market, she said. That would allow regional banks to free up financial capacity to make new loans at today’s higher rates.
“In an interesting sort of development you may find the CMBS has the ability to provide the liquidity,” she said, adding that the CMBS market’s transparency, especially after the Global Financial Crisis, could help bolster confidence in debt backed by commercial real estate. “I think [CMBS] investors will be highly selective, but it does give us another avenue of liquidity if the balance sheet lenders dry up.”
Banks are also grappling with $270B in commercial mortgages scheduled to mature this year, the highest number on record, according to Trepp data reported by The Wall Street Journal. Many borrowers will have a tougher time paying those off with interest rates far higher now than most were at the time of their initial underwriting.
“The CRE sector is already being stressed by higher interest rates and lower valuations, and because of these bank failures, we should expect to see underwriting tighten for mortgage loans and credit facilities,” Keiran wrote. “In the end, I think you are going to see smaller and regional banks be a lot more cautious when it comes to making new loans right now.”
Core Family Office Chief Financial Officer Avneet Kaur said in an interview that she thinks many regional banks will likely be out of the lending picture for the next year — but it could be longer if regulators fail to stem the panic.
“I feel like the banking industry just keeps losing trust every time they do this,” she said. “I’m hoping this doesn’t continue because of a domino effect.”