Distressed CRE Alone Will Not Bring Down the Banking System

Many have been predicting doom and gloom for the commercial real estate industry, but John Chang is not jumping on the bandwagon. While he acknowledges that the rising cost of capital has caused values to decline, and put the brakes on CRE property sales, he believes that hyper focusing on CRE loans as the potential source of bank failures is misguided.

Chang, who serves as senior vice president and national director of research services at Marcus & Millichap, told LoopNet that his firm has been focused on keeping it “fact-based and grounded,” while assessing the current cycle, and he shared numerous perspectives that provide a sobering view of current and future CRE conditions.

In this article covering his insights, he makes the case for why CRE loans alone will not bring down the banking system; discusses what his CRE clients are most concerned about; and explains the conflation of the First Republic Bank failure with real estate.

In a related article, he discusses why he believes the CRE industry is not in a recession, why there is not a capital crunch and how the transaction market could reignite later this year.

As part of his campaign to move beyond surface-level headlines and provide context about quickly changing economic and financial conditions, Chang has been releasing short videos tackling issues like loan distress, the labor market and supply and demand conditions in CRE.

In one of those videos, entitled “Could CRE Loans Default en Masse?” Chang set out to dispel media stories reporting that about 70% of commercial real estate loans were held by small and regional U.S. banks. By compiling data from the Federal Reserve, Trepp, the Mortgage Bankers Association, MSCI and other sources, he illustrated that U.S.-based small and regional banks (essentially all U.S. banks apart from the largest 25) hold just 20% to 25% of the total commercial real estate debt. The rest is held by national and international banks, government agencies, private equity funds, investor driven debt capital funds and issuers of Commercial Mortgage Backed Securities.

Another oft repeated notion he dispelled is that most commercial real estate loans will default en masse and drive banks under. He acknowledged that some commercial real estate borrowers will absolutely get into trouble, but the vast majority won't for two reasons.

First, he said commercial real estate underwriting has generally been conservative, with loan-to-value ratios hovering around 65%. In the video, he cited a hypothetical $10 million property financed with $6.5 million of debt and $3.5 million of equity. This means that generally, borrowers would default if the property value fell by 35% or more. But, he said, most properties, with the exception of some office buildings, don't face that level of value decline.

Second, Chang illustrated that debt coming due today was most likely placed between three and 10 years ago and on average, commercial real estate revenues have gone up by 25.7% over the last five years. The numbers vary considerably across property types, with office being the weakest at just under 2.1% growth. But most properties, except for office, are probably worth more today than they were when the loans were originated.

One caveat, he told LoopNet, is that there are borrowers who placed debt on their properties in 2021 or early 2022 with either a floating rate or a short-term maturity. “Those are the ones with a higher risk profile because they haven't had time to season yet. They don't have that value appreciation. The market got softer rather than stronger because of the rising interest rates, so they may be upside down.”

Chang added, “hopefully they locked in some sort of cap on their lending rates, so they have some safety margin there.”

Based on data compiled by Marcus & Millichap, local, regional and national U.S. banks hold roughly 37% of total CRE debt. This means roughly two-thirds of maturities will be spread across government agencies, insurance companies, private sources and issuers of CMBS. And, Chang said "the vast majority of the CRE debt coming due in 2023 is in well-performing assets. While there is a significant volume, this will not be the Great Financial Recession 2.0."

Some lenders could be in trouble, as it is not yet clear to the market which sources hold what types of property loans and how those maturities are concentrated. But the data indicate that the bulk of the potential distress does not lie with smaller banks and is instead dispersed among a variety of lenders, as well as across asset types.

“As a basis, everybody is concerned about the higher cost of debt capital; that's the number one thing,” Chang said, adding that the rise in rates “took great deals and made it so they don't pencil anymore. Anybody who took floating debt – especially if they didn't have a cap on it – really got hurt.” Owners looking to refinance a property will be facing a much higher cost of debt, “and that’s a major concern across the board.”

With multifamily, Chang said “you're looking at a wave of development, and depending on your market, that may or may not be impacting you.” The same is true for industrial assets where record levels of completions, concentrated in about 10 markets, representing roughly half of all the development, will make it challenging for owners to stabilize buildings. But outside of those markets, “if you're investing in local fulfillment in a city with smaller industrial spaces, it's not an issue.”

Senior housing is another area of concern, Chang said. “They're still trying to recover from COVID with challenges around health protocols … and restructuring them to be able to meet that need.” He added that with the labor shortage facing the healthcare sector, these forces “are combining to create huge challenges for senior housing.”

It’s difficult to explain why CRE is such a recurring topic in the discussion about the health of banks, Chang said. “It seems to be the psyche of what's going on. But two things come to mind: the media and First Republic.”

Concerning the media, Chang said that, in general, there are fewer reporters and less of them are doing their own research. “They're often just taking something that's written in an article, and they're replaying it over and over again without doing independent fact-checks, creating an echo chamber of unvalidated, sometimes inaccurate, information,” resulting in headlines like the ones Chang is working to dispel or clarify.

He cited news coverage of the First Republic Bank failure as an example. Chang said that the bank’s December 31, 2022 8K form reported that 82% of its loans were backed by real estate and they broke out as follows: single family 59.3%; multifamily 13.2%; commercial real estate 6.6%; and multifamily, commercial and single family construction loans combined to total 1.7%.

“While real estate was a big piece of their loan holdings,” Chang said, few outlets emphasized that the vast majority was in single-family residential loans in deep-pocketed residential markets like the Bay Area, Los Angeles and New York. Additionally, “their exposure to the weakest sector — office — was very, very small. It was a couple of percentage points of their portfolio.”

But distressed real estate loans were not why First Republic Bank got shut down by regulators, Chang emphasized. The bank failed because of the rising interest rate environment. Over a very short time frame, $100 billion was withdrawn by depositors against the backdrop of mostly long-term residential mortgages issued at lower rates. Chang said these withdrawals may have been “partially attributable to real estate from the standpoint of the media” publishing stories about “real estate being the next shoe to drop.”

Chang said the perception that banks with significant real estate debt — of any type — were headed for trouble contributed to uninsured depositors pulling their money out of First Republic.