One Lender's Portfolio May Indicate Why Widespread CRE Foreclosures Have Yet To Occur

As the first half of 2023 draws to a close, the wave of bank failures that many predicted — based largely on the potential for widespread business failures and property foreclosures — has yet to materialize. But with the expectation that the U.S. Federal Reserve will raise interest rates again this year, has the would-be storm passed or just been delayed?

Striking a positive chord, one regional bank executive indicates that there are reasons to be optimistic about the wherewithal of both property and business loans.

With a portfolio that includes both commercial real estate and business loans, Brad Fouss has insight into the financial wherewithal of both landlords and tenants. As a market president with OceanFirst Bank in the Philadelphia region, Fouss covers all major CRE real estate asset classes.

The heaviest concentration of loans in his portfolio is in the multifamily sector and the second largest is in retail. Other property types include industrial projects, student housing and medical office buildings. On the business side, his clients include manufacturing companies, service companies and large retailers, among others.

While talking with LoopNet, Fouss was careful to establish that his perspective is based on his own loan portfolio, and that the characteristics and conditions of his portfolio may not be universal. However, given that the U.S. banking sector has, so far, continued to operate with minimal disruption, the conditions he is seeing may be more widespread than he thinks.

As such, they may provide insight into why many landlords, as well as tenants, have been able to weather the interest rate pummeling of the last year.

One dynamic contributing to the stability of Fouss’ portfolio is that after the worst of the pandemic, his bank began lending again, in earnest. Between late 2020 and most of 2022, rates were close to zero, so they were very advantageous for borrowers. “We had some very strong years of refinancing multifamily projects, retail projects and some warehouse,” Fouss said.

Because rates were so low, OceanFirst advised many of its clients, at that time, to lock in for longer terms. “You could [execute] a 10-year fixed rate [loan] in the three [percent range], which was unheard of historically,” Fouss said. So, they worked with many of their borrowers to secure fixed rate financing for five, seven and 10 years.

Since so many borrowers are locked into longer terms, Fouss said there's not going to be a need for widespread refinancing for a number of years. “We do not see a lot of stuff coming due over the next year or two,” he said.

Of note is that this two-year period is critical, because this is when market conditions are projected to be at their worst, as business owners delay making space commitments given the threat of a recession, and property owners work hard to reconcile rising finance, operating and marketing costs against flat or falling rents. This confluence of circumstances could likely lead to lower property valuations, coupled with high interest rates, creating a challenging environment for refinancing.

“Construction's a little bit different,” Fouss said. “We still have some construction projects that were started a year or a year-and-a-half ago and those loans will be coming due for the permanent loan sometime in the next 12 to 18 months.” But the difference between where developers thought rates would be and where they are now — even though they modeled rate sensitivity scenarios — turned out to be bigger than anticipated.

“So, we're working early with a lot of our borrowers to look at where rates are now and what they might need to do when loans become permanent.” In some cases, they may need to pay down, Fouss said. In others, they were hoping to cash out or extract equity from the project upon completion of construction.

“But what we're seeing now is that most of our borrowers are probably not going to have to put money into the project, [and] they're not going to be able to cash out like they thought they would.”

“The other thing we're doing … with some of [our borrowers] relates to the forward rate environment — one year out — which is actually better than it is today because the market is anticipating a slowdown in the economy. So, if I did a fixed rate today at 6.5%, the forward-looking rate a year out, if you do an interest rate swap, might be 30 to 40 basis points lower,” Fouss said.

In some cases, his lending team is having early conversations with borrowers to say, “maybe we should be looking to fix your rate one year out, because if it works for you, you might be saving 30 or 40 basis points,” as opposed to settling on a fixed rate today, Fouss said. “A lot of it is getting ahead of what's happening with our borrowers and having early conversations with them.”

Those borrowers that are securing terms today are locking in for two to four years, and they are negotiating with the bank to establish more attractive refinance terms — relating to prepayment penalties, for example — so they can refinance in the future if rates come down, Fouss added. “That is one trend we're seeing and we're supportive of that for borrowers.”

“My group handles business loans as well,” Fouss said. The start of the pandemic in 2020 was a scary time for business owners because the world shut down and they didn't know if they would survive. As financial support measures were put in place, “there was a political conversation about whether there was too much PPP [Paycheck Protection Program money] and stimulus in the market, but it did help businesses get through [the pandemic] and stabilize.”

Providing context about current business activity, Fouss said “before the pandemic, 2019 was what I call the ‘base year.’ Most businesses had very solid years that year,” so most businesses generated good profits. “2020 is a year no one ever wants to talk about again,” Fouss said, but coming out of it, most businesses, in 2021 and 2022, outperformed 2019 with better revenue and better profitability.

“Things have slowed down a little bit this year, and that's what the government has wanted with rates going up. But what we've seen is, unlike during the Great Recession, these businesses did all the right things,” Fouss said.

He added that over the last couple of years, when businesses were having good years, they paid down debt and held cash on their balance sheets. So, for the most part, if they're looking at higher interest rates, it’s probably impacting more of their short-term borrowing or lines of credit.

“We're having a lot of conversations now, as many businesses are ending their second quarter, and forecasting the second half of the year,” Fouss said. While most business activity has slowed compared to 2022, “they are still up from the base year of 2019. In addition, they appear to be able to manage the increased interest rates.”