As mid-2023 approaches, the market is digesting a number of market developments, including the first prominent bank failures since the Global Financial Crisis (GFC). Recent headlines have highlighted the risk exposure that banks are facing in terms of lending on commercial real estate properties.
Banks are designed to lend money – it’s an essential part of their business.
Since the GFC there has been a slew of regulatory requirements thrust upon banks to avoid the systemic failures that the banking system experienced in 2008-2009. However, many of these requirements and oversights have been scaled back sharply in recent administrations. One of the biggest priorities for financial institutions today is to ensure they hold enough capital to offset any potential losses that they may suffer due to existing loans already on their books.
Looking at the current situation from an owner’s point of view on the equity side of the business, there have been substantial increases in the operating costs associated with managing commercial real estate assets today. Many of these expenses have increased due to inflation, but rising interest rates have also driven up the cost of debt service which many CRE operators must now pay. Compounding to this problem is additional pressure to top-line revenue that higher vacancies deliver which can create a real risk for many commercial real estate investors. In this scenario, investors can find themselves with an asset that does not provide the necessary cash flow, nor does it support their need to establish equity.
With this combination of market conditions and factors, many lenders are envisioning the distinct possibility that they will have to hold onto numerous loans that are in default or at risk of default – these loans are called sub-performing or non-performing loans (NPLs). Today’s uncertain market environment challenges lenders to take a closer look at their books and make prudent decisions on how they can meet regulatory requirements and minimize their risk exposure.
What are the top two strategies a bank with significant commercial real estate (CRE) holdings can take now?
1. Perform a detailed review of its loan portfolio:
When a bank proactively conducts a thorough concentration analysis, the results can be a valuable tool for identifying and flagging loans that may be at future risk of default. A bank can also consider leveraging a third-party provider for independent marks on the loans’ values, either via a Broker’s Opinion of Value or through a licensed appraiser.
2. Develop a liquidation plan today, ahead of any potential forced sale:
Develop a liquidation plan today, ahead of any potential forced sale: In this case, a bank works directly with a broker to help determine the best mix of performing and NPLs, as well as evaluate which loans may be candidates for sale. The goal of this analysis is to identify loans likely to yield higher returns and keep the bank’s balance sheet well-structured and in line with reserve requirements over the near term.
A recent analysis of the current volume of commercial real estate loan sale transactions compared to historical data from LightBox RCM®, the global marketplace for commercial real estate transactions, yielded an interesting development. Utilizing the post-GFC era (2009-2014) as a benchmark, loan sales activity in 2023 is already showing an early uptick. In the first four months of 2023 the RCM platform has tracked loan sale volume that is already four to five times the volume that would normally be brought to market at this point in a typical year.
So, what does this all mean? The latest data suggests that this year’s loan sales in the commercial real estate market could well surpass the historical average as more lenders respond to evolving market conditions. In the wake of recent bank failures, lenders are turning a critical eye to their own risk exposure and responding to the requirement of maintaining adequate capital reserves. This recent trend will create opportunities for not just for CRE brokers bringing loan sales to market, but also for the expertise of appraisers and environmental due diligence providers to support lender clients as they divest loans in an otherwise slow property transactions market.