What Are the Real Risks in Today’s Banking Uproar?

Article originally posted on ICSC on March 24, 2023

With the interest rate ticking up to a 15-year high, many Marketplaces Industry watchers fear a looming wave of commercial property mortgage maturations. If borrowers default or fail to make payments as their loans mature, that could trigger more bank failures. But others say management teams at the banks serving the Marketplaces Industry have healthy loans and the capital and acumen to weather any impending storms.

Midsize and regional banks like the recently failed Signature Bank and First Republic Bank provide the bulk of commercial real estate loans. According to Trepp, smaller banks hold around $2.3 trillion in commercial real estate debt. Of that, $270 billion is set to expire this year, meaning borrowers will need to pay off those loans or refinance them. That’s the highest amount of debt ever set to expire in one year. And the risk is concentrated in the vaults of smaller banks. Most of these loans are held by banks that have less than $250 billion in total assets, Trepp reported.

Marketplaces Industry players already are noticing the impact of the recent bank failures. One  lawyer who represents banks told The New York Times that after the high-profile demises of Silicon Valley Bank, Signature and First Republic, lenders would hesitate to write loans for any new-construction projects other than “trophy deals.” Klein Enterprises president Daniel Klein told the publication he’d been talking to several banks recently about a construction loan for a new project. One pulled out suddenly after the collapses of Silicon Valley Bank and Signature. “Banks in general are being more conservative than they were six or nine months ago,” he said.

Climbing interest rates have raised fears that many borrowers with floating-rate loans will default. And a wave of defaults would fan fears over the financial health of the U.S. banking system, according to analysts who spoke to The Wall Street Journal.

The value of real estate loans and securities held by banks is almost $1 trillion lower than the book value on their balance sheets, according to Tomasz Piskorski, the Edward S. Gordon professor of real estate at Columbia Business School. That gap in value puts 186 banks at risk of failure if half their uninsured depositors decide to pull their money, as the investors at Silicon Valley Bank and Signature did, he and colleagues wrote in a white paper quoted in WSJ. At the median U.S. bank, commercial real estate loans account for 38% of loan holdings, according to Keefe Bruyette & Woods.

Small and regional banks are also responsible for many of the commercial mortgage-backed securities sold. And that market is showing signs of weakness. Trepp reported earlier this month that the CMBS delinquency rate increased 0.18 percentage points in February to 3.12%, the second-largest increase since June 2020.

Even so, CMBS delinquency rates remain lower than a year ago and much lower than during the Global Financial Crisis. “This is not a rerun of the Global Financial Crisis,” DLC Management founder and CEO Adam Ifshin said in an episode of his company’s Retail Retold podcast. “Banks have a ton of capital. The assets side of their books is cleaner than ever.”

Loan-to-value ratios today range from 55% to 60% versus the Global Financial Crisis’ 70% to 80%. Debt service coverage ratios remain healthy: from 2 to 2.5 on average, according to a report from Cushman & Wakefield chief economist Kevin Thorpe, head of economic analysis and forecasting for global research Rebecca Rockey and head of investor insights Abby Corbett. In other words, if a typical commercial property owner’s rate is fixed, it has more than double the net operating income needed to pay its monthly mortgage.

And the issues facing those banks that are under pressure are not linked to performance of their credit or outstanding loan portfolios, the report said. Instead, these banks’ woes relate to the rising-rate environment and the resulting impact on bond and securities values.

“We have a fairly limited situation due to confluence of deposit concentration and lack of mark-to-market in a handful of banks’ securities books,” Ifshin said. “The overwhelming majority of assets are high quality. This is the fault of management of a handful of banks that set up a classic mismatch. They borrowed short and lent long.”

Meanwhile, most regional banks have diversified deposit bases because they came up through communities and are not susceptible to the types of bank runs experienced by Silicon Valley Bank and Signature. Small regional lenders like Berkshire Bank in Boston have a lot of smaller accounts and spread liability risk across a huge number of customers, and they’re not as vulnerable because more than half of their deposits are insured by the FDIC, Ifshin said. “This is not going to get much farther,” he said. “There’s a lot of liquidity in the system still. Most bank management teams will not make the same mistakes that these teams made.”

Some government assistance is already in play in case the contagion does spread. The Federal Reserve indicated it would accept bonds and other assets at face value as collateral from banks. However, when borrowers default, the bank must reduce the value of the debt on its books, and rising interest rates are spurring more defaults. Additionally, more small and regional banks could be at risk for going under if they must sell commercial property loans to raise capital to meet regulatory requirements.

Loans backed by office properties are considered the riskiest because the values of many of those properties declined during the pandemic, as tenants downsized related to work-from-home. The national office vacancy rate rose 20 basis points in the final quarter of 2022 to 18.7%. It’s now higher than the prior pandemic high of 18.5% in the second quarter of 2022. Rents grew a meager 0.1% at office properties in 2022, according to Moody’s.

Retail, meanwhile, is relatively healthier, though still vulnerable. Shopping center occupancy was 91.3% at the end of 2022, up from 90.2% in 2021, according to NCREIF.