Owing to the recent bank failures and slowing down of commercial real estate (CRE) deals, a lot of investors have speculated about the vicious influence cycle between the banking sectors and CRE.
When experts need to examine the real cross-exposure of both sectors and the structural differences in today’s real estate industry and that 15 years ago, the conclusions are not too sensational but instead more nuanced.
However, both banking and CRE face several challenges in this rapidly rising environment.
In 2022, rising interest rates that were set to combat historic inflation foreshadowed a CRE slowdown in 2023. This manifested a declining trading volume and lowered asset values in 2022. From the past economic cycles, we knew that these would lead to a rise in the defaults in commercial real estate loans.
This is especially true for maturing loans that are backed by struggling assets. Simultaneously, this meant that as deposits shrank, the strain on banking sectors increased.
This is why a lot of banks were pushed towards insolvency in 2023 Q1 and forced investors to reevaluate the situation of the CRE industry.
But, the exposure of each sector to one another is limited and the risks faced by both sectors came with mitigants that were not present during the Global Financial Crisis (GFC). Now, CRE loans have less leverage, while asset pricing has more cushioning and borrowers have a wide range of varied debt sources.
This means that the current CRE market is in a relatively better state especially since it is facing a condition similar to 2008’s bank liquidity crunch. On the other hand, banks are also better capitalized and have several credit facilities in hand.
So, they can better backstop temporary liquidity issues and stem contagion.
To help you better understand the situation of today’s CRE loans and banks, we have divided our report into two parts – CRE exposure to banks, and the other way round.
We will also discuss the effect of enabling technologies on the industry to ensure you have a better understanding of the different factors in play.
The Exposure of CRE to Banks
This year, a lot of articles on CRE’s effects on the banking sector have come up especially because a lot of investors are concerned. But, the major focus has been on their effect on small and mid-sized banks and what it means for them in all.
Some articles suggest that if there is any scope for liquidity trouble that local banks might face, the majority of the debt that is available to new CRE borrowers would disappear.
This would cause massive loan defaults and cause a lot of problems. But, due to the diversity of the CRE lending business, local banks account for quite a small share of it.
If small and mid-sized banks stopped lending, it would mean a strain on the CRE market. However, the CRE market in the US is quite diverse, and large banks, non-bank lending companies, and private bridge lenders can easily step in to fill the gap.
Moreover, as Fed hikes continue disrupting bond spreads, Commercial Mortgage-Backed Security volume will sputter while ensuring it will remain a debt source for a few borrowers.
Although there are numerous issues in today’s banking sectors on the heels of the Fed interest rate hikes, there were no insolvency announcements in March. This means that there is a small breathing room for small and mid-sized banks.
Another important point to keep in mind is that there are some structural features in place that support these banks in all liquidity crises that have risen after the GFC.
Out of the numerous programs that are in place, the most notable one that didn’t exist before the GFC is the Fed’s new Bank Term Funding Program (BTFP) facility. It is a direct reflection of the desire of banks to increase liquidity buffers and keep on participating in lending activities.
Another notable factor that is in play is the desire of banks to smooth out potential issues that depositors might have over the financial year.
So, as noted, several CRE lenders will continue their CRE lending activities but might be under the pressure of high interest rates and tighter lending policies.
This can give rise to several financial gaps, increase maturity default rates, and lead to a cyclical correction in multiple weak CRE assets.
The Exposure of Banks to CRE
Other than the existing concerns that banks need to tackle, another additional one is the trouble CRE loans might face on bank balance sheets.
This street can cause a negative feedback loop where CRE causes a decline in the strain on bank balance sheets which can lead to banks pulling back further on CRE lending. This can also cause further price declines and other magnanimous effects.
However, this is not likely to happen at this stage since CRE loan leverage and asset pricing have been a bit more conservative compared to the situation prior to the GFC.
Moreover, as per our previous reports, CRE loan borrowers always have refinancing outs with non-bank lending companies. This means that most banks will continue lending throughout even in cases of major downturns for CRE.
Investors Look To Speed Up During Slowdown
Now that we have discussed the effect of CRE and banking sectors on each other, let us analyze a critical commercial real estate investor behavior – they’re speeding up investment in CRE deals during an economic slowdown.
Today, investors are putting in huge effort to prepare for the imminent rebound, while also ensuring that they work through the current industry challenges.
Some lending firms are evaluating riskier assets and deciding to shift their investment from these to higher-quality properties. Simultaneously, to reduce risk further in the complete investment process, investors are now looking for more stability signals among their partners and tenants.
This means that they have set higher degrees of diligence in place, which equates to lower market risks in the long term.
Moreover, in the current volatile environment, the rising interest rates and the increasing capital costs have caused significant growth in the risk of new CRE deals.
Due to these high interest rates, investors who have cash available, are allocating more equity and reducing their reliance on expensive debt.
In the case of current investments, some investors are looking for ways to eliminate leverage and put more equity into their CRE deals to decrease the associated long-term risk.
Some Investors Capitalize On Pockets of Opportunity
In this section, we will discuss another important investor behavior that you must understand to better navigate today’s CRE investment space.
Throughout these difficult times, investors have been looking for lucrative property deals and investment opportunities like multifamily to easily pivot into them.
On the other hand, time-tested investment sectors like offices and workspaces continue to endure headwinds.
Several other asset classes have continued to outperform and these include – self-storage, data centers, digital infrastructure, life sciences/labs, and single-tenant-net-leased (STNL) properties.
But, at the same time, there are also opportunistic investors who are looking at the distressed asset category to seek exposure to attractive CRE deals at better deal terms.
Enabling Technologies
Similar to other industries around us, a technological revolution is disrupting the real estate industry. Not only is it affecting the residential mortgage area, but it is also magnanimously affecting the CRE industry.
According to a report, venture capitalists have invested about USD 44.4 billion into financial technology (popularly known as fintech) and related startups in 2020.
This is a huge growth compared to the mere investment of USD 1.1 billion in 2009 and attests to the fact that leading technologies are disrupting the CRE industry.
This means that the lending business will never be the same and in addition, the Wall Street grabbing for better single-family housing opportunities is disrupting the industry.
Simultaneously, demand for multifamily properties is at an all-time high, and along with it, the loans that investors need to buy them. This has caused a rise in development opportunities which seem to have no end in sight.
Advanced technologies can change the entire structure of the CRE industry and the way the assets and deals are managed.
Some changes in the CRE industry that are underway include:-
- Due to increased data collection and huge databases, tech platforms allow investors to better survey properties
- With augmented reality, investors can offer potential visitors a property walkthrough from any location and bring in more customers
- Due to cloud-based applications, all data is stored in the cloud which means better creation and maintenance of real estate contracts and customer data that all parties involved can access at their convenience
- Virtual tours allow customers to streamline the visit process and decide whether they want to consider the property for further consideration or not
- Custom customer management systems can also allow property owners to better manage customer data and contact them as needed
- Better sending of follow-up emails and customized reminders via artificial intelligence for a better impression on potential buyers
Conclusion
As the world around us shifts, so does the real estate industry; but as an investor, you must always be on top of these changes. After all, the CRE industry is volatile, but also profitable and can bring in great investment opportunities from time to time.
We hope the above article helped you understand the scenario of today’s CRE industry to ensure you can easily strike better deals.
Need expert help to ensure that you can make profits in the CRE industry without much hassle? Get in touch with private capital investors to discuss your concerns and know more about how you can grow further in today’s dynamic CRE market!
