Banks — historically the primary lender to commercial real estate — are pulling back significantly on their lending activity within the sector.
It’s creating ripple effects that are already dampening a broad range of activities within commercial real estate, including new development and refinancing.
Compared to August 2022, loans on nonresidential properties declined 3.8% in September 2023, CoStar Group Inc. (Nasdaq: CSGP) recently found.
After reaching 18.2% annual loan growth in the first quarter of 2023, the pace of expansion in the past six months has declined rapidly, especially among smaller lenders.
That comes at a time when an estimated $1.9 trillion in commercial real estate loans will mature in the next four years — 47% of which are on bank balance sheets, according to CoStar.
Some 20% of that $885 billion on bank balance sheets maturing soon are tied to office properties, which’ve seen their values slashed in the wake of higher interest rates, sluggish new demand for office space and tenants downsizing or exiting office buildings entirely.
Several banks have stopped lending to office real estate while others are preparing for losses in commercial real estate.
Chad Littell, national director of capital market analytics at CoStar, said banks are most acutely concerned about their office loan portfolios, with some buildings seeing as much as a 30% value erosion since the pandemic.
“That’s a property type they don’t want to touch right now,” he said.
But, Littell continued, it’s likely banks will raise their scrutiny on other property types, too, including multifamily and industrial, which were red-hot real estate sectors throughout the Covid-19 pandemic.
That’s because, especially in multifamily, the underwriting for acquisitions in the past couple of years was based on double-digit rent growth — seen during the height of the pandemic — continuing into the future. But rent growth has slowed considerably this year.
RealPage Inc., which closely tracks the apartment market, found effective asking rents fell 0.3% in September from the month prior. Year-over-year rent growth that month was only 0.1%, compared to 9% in the prior one-year period. In the West and South regions of the country, rents have actually declined — 1.1% and 0.8%, respectively — on an annual basis.
Flatlining or rent declines are attributed in part to the record amount of new construction coming to market, especially in places like the Sun Belt. New apartment completions in the third quarter totaled more than 128,000 units, the highest level in more than three decades, according to RealPage.
“Banks are starting to say ‘We need to watch this, let’s be more cautious about the loans and the refinancing we’re doing,'” Littell said, of the multifamily sector.
How banks are reacting to CRE slowdown
While there have been some examples of banks selling off parts of their commercial real estate loan portfolios, there haven’t been a lot of those deals so far, he added. Most banks are still focused on how to manage the loans on their books right now, Littell said.
There also remains some dislocation with pricing, particularly within the office sector, as few buildings — especially ones facing rising vacancy and value deterioration — have sold since the pandemic.
Mike Santomassimo, chief financial officer at San Francisco-based Wells Fargo & Co. (NYSE: WFC), referenced a lack of office trades during the bank’s Oct. 13 third-quarter earnings call.
“There’s a few in certain cities, and they’re all a little bit different in their complexion,” he said. “So you still have somewhat limited information in price discovery in a lot of places. And so we’re doing … we do a lot of our own work to try to evaluate each of the underlying properties and what they could be worth in a bunch of different scenarios.”
He continued, saying it feels like the appraisal market is starting to catch up, with appraisals that are “more realistic and more updated.”
“So that’s certainly bringing in different data points as we look at it,” Santomassimo continued. “And, as we looked at the quarter, we sort of look at all those data points and the underlying loans and try to do our best to come up what we think the different range of loss could look like.”
Wells Fargo’s allowance for credit losses increased $333 million in the third quarter, primarily for commercial real estate office loans.
Another major commercial real estate lender, New York-based The Goldman Sachs Group Inc. (NYSE: GS), reported net losses of $212 million in equity investments in the third quarter. The bank attributed that largely to markdowns on investments in commercial real estate.
The bank also said it’s either marked or impaired down its commercial real estate exposure by about 50% this year.
Denis Coleman, CFO at Goldman, said during the bank’s Oct. 17 earnings call it started 2023 with about $15 billion of commercial real estate alternative investments, which have since been reduced by about $5 billion. He said the bank intends to continue to move down its exposures.
Since the fallout from the pandemic, many lenders have opted to give short-term extensions to their borrowers to give time for the economy and the office market to recover. But there’s skepticism about whether many office buildings facing distress will ever recover.
With banks pulling back from commercial real estate, borrowers are instead having to consider debt funds or preferred equity as stopgap measures at refinancing, Littell said. But higher interest rates mean higher borrowing costs, including for those short-term solutions.
To get the full picture of fallout for banks from commercial real estate, and vice versa, will take many quarters, if not years. Leases and debt on commercial properties are typically long-term deals, and — in the event more lenders move to foreclose on properties — those processes take a long time to work through.
Littell pointed to the global financial crisis, when commercial mortgage-backed securities delinquencies didn’t peak until 2012, years after the onset of that economic recession.
“The reality is, these are multi-year processes,” Littell said. “(We’re at) the beginning stages of this, but I don’t think any property type will be spared from a commercial real estate downturn.”