The most likely outcome: Lenders will muddle through using their Great Recession playbook. Most will likely pay down commercial loans or work to extend them.

RICHMOND, Va. – Like the sobriety test in Steve Martin’s 1983 film “The Man with Two Brains,” where Martin declares “your drunk tests are hard” after the police demanded he walk a straight line – on his hands – and then one hand, and then tap dance while juggling and singing the Catalina Magdalena Hoopensteiner Wallendiner song, commercial real estate loans are getting harder and harder to obtain.

What was made difficult by rising interest rates and stalling rents is now made increasingly so because of fear of commercial real estate lending at banks. Headlines have overblown the facts on the ground where there are some issues at some properties that could lead to some losses. The implied disaster we keep reading about – problem commercial real estate loans will bring the banking sector down – is possible, just not probable.

According to Trepp, a commercial real estate data analytics firm, the past month brought an uptick in CMBS (commercial mortgage-backed securities) loans that are specially serviced. Loans that are transferred to special servicing are transferred because there is a default or a potential default looming. CMBS loans represent about 13% of the entire commercial and multifamily loans outstanding and are seen as a proxy for what might come. Most of the stories so far of problem loans have been with CMBS and other non-bank sources.

In the next several years as old, low rate, loans mature and are refinanced in a much higher rate environment, greater delinquencies are likely. Higher interest rates have weighed on values and made debt service coverage ratios harder to meet, which has effectively reduced leverage across all property types.

Delinquencies are likely to be much larger in the CMBS universe than with other lending sectors, but banks are the largest lender for commercial and multifamily loans. According to data from the Mortgage Bankers Association, banks held approximately 38.6% of all commercial and multifamily mortgages outstanding at the end of 2022. Probably a little more concerning is that they provided approximately 56.4% of all new loans originated in 2022.

The key takeaway is to keep the industry functional, capital needs to keep flowing from banks.

According to Moody’s Analytics, community banks with $1 billion to $10 billion in total assets have the largest percentage of exposure to CRE (when compared to other bank sizes) with approximately 24.3% of their assets in loans secured by commercial and multifamily real estate. Within that sub-group, there are sure to be some lenders that will struggle and others that will have very few issues. The wild card is how the regulators respond.

The most likely outcome is lenders will muddle through using the playbook they adopted in the GFC. For guarantors that can “right size” or pay down loans, banks will come knocking and for borrowers that are not as financially strong, banks will likely work to extend loans.

If banking regulators force banks to recognize troubled loans, that will be the worst outcome for all. If regulators let banks muddle through, there is little risk of significant dislocation.

Regardless, credit will be tight for new loans in the coming year. And money is not cheap.

According to the latest John B. Levy Commercial Mortgage Survey, 5- and 10-year loans price in the 5.50% to 5.75% for lower leverage deals. Shorter term, floating rate transactions are pricing higher and are in the 6.75% to 7.50% range from banks and even higher for non-banks.

CRE lenders need to keep the spigots flowing or the industry is going to face a sobriety test it can’t pass.

© Copyright 2023, Richmond Times-Dispatch, Richmond, VA

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Author: kerrys