As with any investment, understanding the risks involved is crucial for making informed decisions. In the world of finance, one area that has garnered attention recently is the health of commercial real estate debt. Here, we explore the risks and potential outcomes associated with this asset class given the backdrop that the recent interest rate and banking pressure has created in the economy.
First, it's important to note that CRE debt is not a systemic risk for banks. Banks outside of the top 100 based on total assets have financed 15-20% of all CRE mortgages, diversified across 4,600 institutions nationwide, significantly mitigating risks. Moreover, debt service coverage ratios indicate loan term default risk is low and underwritten loan values are low, especially after considering the rise in property values over the past 10 years. In fact, CRE mortgages as a group are underleveraged. This is not residential subprime 2.0.
However, the greatest risk lies in the office sector, where owners may need to inject 30-40% more equity into their properties to maintain healthy loan-to-value (LTV) ratios upon refinancing. The outlook for property values is also uncertain. Cap rates are likely to adjust from higher interest rates, tighter lending conditions and slowing fundamentals. We anticipate some decline in real-estate markets over the next 12 months, correcting further after the run up in property values post pandemic. However, the majority of this correction will be felt by government sponsored entities, life insurance companies, and private real estate investors.
The banks' CRE exposure is relatively small, with the 25 largest banks by total assets holding 13% of all CRE mortgages, and the their exposure as a percentage of total assets is small at ~4%. Regional and community banks hold 31.5% of all CRE mortgages, and their exposure is much higher at 20% of total assets. Nevertheless, we believe the diversity of the 4,600 banks outside the largest 100 is underappreciated and helps mitigate risk. They finance smaller properties in smaller markets rather than larger core properties owned by institutional investors.
Office properties receive the most attention, but they represent just 17% of income-producing property loans vs. 44% for multifamily. In addition, 16% of loans mature in 2023, more than a quarter of which are office.
We anticipate increases in delinquencies and distressed sales, but the risk of loss to CRE lenders may be smaller than many believe. Lending standards are more conservative than before the Global Financial Crisis, with loan-to-values of 50-60% and debt service coverage ratios of >2.0x. CRE property prices would need to fall 40-50% before the loans would realize losses.
In conclusion, the risks associated with CRE debt are real, but they are not insurmountable. The market is relatively diversified and underleveraged, and banks' exposure is relatively small. Nevertheless, the most significant risks may be in loans originated in the past several years at peak valuations, especially if they were short term or variable rate. Overall, we believe the CRE market is resilient and can weather this current scenario especially in the light of a Fed that will most likely begin to cut rates over the next 12 months, which makes restructuring the CRE debt that matures in 2024 and beyond much less of a risk. Essentially we find this CRE debt issue a nature part of the economy and just another opportunity for certain investors to take advantage of declining values.
Real Estate is one part of a well diversified portfolio, so we urge our clients to remain calm and optimistic while reading negative headlines that you may see in the coming months regarding this issue.
Debt Service Coverage - Net Operating Income from a property divided by debt service which is the funds required to pay down debt. (NOI/DS)
Loan-to-value ratio - Mortgage amount / appraised property value
Source: Hill, Rich. "Commercial Real Estate Debt Market: Separating Fact from Fiction" Cohen & Steers. https://www.cohenandsteers.com/insights/the-commercial-real-estate-debt-market-separating-fact-from-fiction/ Accessed March 2023.
The views stated in this commentary are not necessarily the opinion of First Allied Securities, Inc. and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change without notice. Information is based on sources believed to be reliable; however, their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results.
All investing involves risk, including the possible loss of principal. There is no assurance that any investment strategy will be successful.
A diversified portfolio does not assure a profit or protect against loss in a declining market.