Banks Face New Challenges as $1.5 Trillion of CRE Loans Come Due

The collapse of Silicon Valley Bank in the Spring sparked debate about whether SVP was an isolated incident in an otherwise sound banking system or was this failure an indication of swiftly deteriorating balance sheets across the industry. Then Signature Bank was seized.

Then the First Republic was rescued. Suddenly, three of the four biggest bank failures in history happened seemingly overnight, and the safety and soundness of the entire system was under scrutiny.

The Federal Reserve bailed the system out (yet again) by acting as lender of last resort and opening the cash window to banks in trouble. Interestingly, these bank failures weren’t caused by the usual suspect – bad loans – but from bad asset management. Each bank failed because its investment portfolios held low yielding bonds with long maturities, and those bond values plunged as the Fed relentlessly pushed interest rates up. The building losses eroded regulatory capital levels and caused doubt that deposits were safe. While the system withstood the estimated $425 billion of withdrawals in the first quarter, liquidity has tightened as have lending protocols.

The Federal Reserve increased interest rates ten consecutive times since March 2022, hiking the prime rate to 8.25%, its highest level in 16 years. The impact from these rate hikes will certainly cause a drag on activity throughout the economy, but the commercial real estate industry is anticipating a particularly difficult period which may lead to an avalanche of loan defaults.

$1.5 trillion of CRE loans are coming due in the next three years according to data provider Trepp. CRE loans represent about 33% of all loans on the books of banks with assets between $1 billion and $10 billion according to Fitch, and higher interest rates will put many loans at risk of default.

While CRE mortgage delinquencies currently sit at a benign 0.76%, interest rates have more than doubled since January 2022 and refinancings will be tough to navigate for certain sectors of the market. To be clear, this is not a replay of the 2008 financial crisis as banks are much healthier today and CRE borrowers are generally much stronger financially than the sub-prime borrowers that lead real estate into the depths 15 years ago.  Still, we expect foundational cracks to surface in bank CRE loan portfolios, especially with those over exposed to office and retail sectors.

A wildcard for CRE borrowers refinancing properties will likely be sharply lower reappraised values set by banks. Office and retail sectors are in tough shape and borrowers will likely face steep mark-downs in property values. Meanwhile, losses in bank portfolios have tightened both liquidity levels and loan criteria which, among other factors, will require a higher percentage of cash equity to be in place to secure a refinancing. So, the challenges are real, and we expect some borrowers and lenders to struggle as the CRE market recalibrates with imaginative repurposing plans to rehabilitate underperforming properties.