The pace of growth in commercial real estate lending by banks has slowed down dramatically
The acquisition of First Republic Bank by JPMorgan Chase & Co. will result in the consolidation of two of the top 25 commercial real estate lenders in the United States. This could potentially complicate asset pricing due to increased competition for the debt portion of the capital stack.
Having a larger number of lenders vying for a borrower’s business usually results in better rates and terms. Conversely, having fewer lenders competing can lead to less favorable terms. While this merger is not a significant consolidation, removing First Republic Bank from the list of top 25 loan originators for 2022 could lead to a further reduction in the number of lenders.
The consolidation may also result in a rebalancing of the U.S. lender field. Since 2015, nonbank financial systems have become more popular as traditional bank lenders have faced regulatory scrutiny and uncertainty.
The state of construction lending
According to the latest data from the Federal Reserve, the pace of growth in commercial real estate lending by banks has slowed down. The recent failure of First Republic Bank has added to the uncertainty that is causing banks to reduce their commercial real estate loans.
Commercial Real Estate Owners Slow Refinancing as Interest Rates Rise
Over a period spanning from March 2022 to May 2023, the Federal Reserve increased interest rates 10 times consecutively. This has resulted in a rapid escalation of rates, the likes of which have not been seen in decades, and it is taking some time for investors to adapt. As a result, many commercial real estate owners are still making payments at rates lower than the current levels, leading to a decline in refinancing activity. Whether rates will continue to rise or if the Federal Reserve will change course in the latter half of the year remains to be seen, which creates a sense of uncertainty for investors.
The economic outlook is bleak for borrowers seeking to refinance loans, as rising interest rates, stricter underwriting standards, and reduced appetite from banks for certain commercial real estate (CRE) sectors like office and multifamily have made it more difficult to secure refinancing options. The CRE office sector is particularly struggling, with high vacancy rates that have persisted due to nationwide work from home routines put in place during the pandemic.
Moreover, the regional real estate dynamics are uneven, with some urban centers like San Francisco and Manhattan facing significant challenges. In San Francisco, a $300M office building on California Street is up for sale, but its value has plummeted by 80% over the last four years. MUFG, the Japanese bank that owns the building, is also the largest taxpayer in the city. Meanwhile, Blackstone is in danger of defaulting on a $270 million non-recourse loan backed by 11 apartment buildings in Manhattan, where rents are insufficient to cover debt service and maintenance costs.
Although the Boston Metro area benefits from demand diversity in the education, technology, and research industries, there are still signs of trouble in the overall Commercial Real Estate market. First-quarter CMBS performance metrics have not shown a spike in delinquencies or defaults, but transfers to special servicing have increased, indicating trouble. The New York office sector is also a cause for concern in the CMBS market, as it has the largest concentration of loans set to mature soon.
Moody’s has downgraded the Macro Profile of the US banking system, noting a trend of negative pressure on earnings, weaker capitalization, and default and delinquency risk posed by commercial real estate. Although non-bank lenders like CRE REITs are ready to step up in anticipation of traditional lenders pulling back their exposure to the sector, CRE mortgage originations have decreased by 40% since 2021, and banks like Wells Fargo have reported increased loan loss reserves due to their exposure to the CRE office sector. Despite having more than $15 billion in available liquidity, REITs provide only limited relief, given that $2 trillion in CRE loans will mature by 2027.
Read More About Commercial Real Estate Meltdown:
The Role of CMBS in Commercial Real Estate Lending
Commercial real estate lending relies heavily on mortgage-backed securities, which make up over 13% of the outstanding debt for commercial and multifamily mortgages. CMBS consist of various mortgages that finance commercial properties such as hotels, apartment buildings, and office spaces.
The process of creating CMBS involves pooling individual mortgage loans, securitizing them into rated securities, and dividing them into tranches based on their credit quality. The top-rated tranches, often rated AAA, have low credit risk and come with credit enhancements that protect investors from losses. Conversely, investors in the lower-rated tranches are exposed to more credit risk but can earn higher yields.
Another type of CMBS is formed by a single loan that is secured by a single property or multiple properties in a single-asset single-borrower (SASB) deal, with its risk distributed among rated tranches.
Optimistic Scenario: An immediate recession lasting two years, followed by stabilization and eventual recovery. In this scenario, the office sector would experience a 38% default rate based on market value, as well as a 5% reduction in office rents.
Stress Scenario: It predicts a more severe outcome for office properties. In this scenario, 68% of office loans would default, and there would be a 10% reduction in rent. These rent reductions would primarily occur in more stressed commercial business districts.
Source: Bloomberg, Real Capital Analytics, Trepp and AB
Newer CMBS is not necessarily better.
Investors should also take into account the timing of CMBS issuance when making investment decisions. Older CMBS vintages, particularly those issued from 2014 to 2018, have been positively impacted by property value growth and increased credit enhancements.
However, newer-vintage bonds have higher exposure to distressed office properties and are harder to refinance. Additionally, these bonds have seen little to no appreciation in underlying property values. Therefore, investors who are considering investing in more recent CMBS should focus on investing in the highest-quality tranches.