Regional banks have had a roller coaster of a year so far. This past March, the banking sector was sent into shock with the failures of Silicon Valley Bank, Silvergate Bank and Signature Bank. Then came the news that First Republic Bank was being bailed out with $30 billion from a group of banks.
If that wasn’t enough of a hit, Switzerland’s Credit Suisse also required a massive bailout, further roiling markets. Regional bank stocks went down by an average of 30%, rallying slightly as North Carolina’s First Citizens Bank agreed to purchase Silicon Valley Bank – at a $16.5 billion discount.
The failures and bailouts sent the banking industry reeling as some businesses moved their money to larger banks, such as Bank of America and JPMorgan Chase. While this trend appears to be over, it remains a tenuous time for many banks. As analysts begin to unravel why the banks failed, some have discussed how the regional banks that defaulted or needed bailouts suffered from unique circumstances that are unlikely to translate to the regional bank sector as a whole.
“Regional banks are often more willing to lend to borrowers in their local markets since they have a better understanding of the local economy and property market conditions.”
The current bank crisis has aggravated an already difficult lending environment. The 10-year Treasury rate sat at 3.56% on March 29, 2023, up about 140 basis points from one year earlier. The Federal Reserve reported that the Secured Overnight Financing Rate (SOFR), which is the rate used to price short-term loans backed by Treasurys, increased from near zero in March 2022 to 4.81% as of March 2023.
Despite the difficulties facing some regional banks, the fact remains that this sector continues to play a crucial role in commercial real estate transactions and has long been a strong partner for many developers. Even prior to the recent bank failures, major financiers of commercial real estate (including JPMorgan Chase, Bank of America and Wells Fargo) had slowed their lending activities and tightened underwriting standards. This has forced real estate investors and developers to seek alternative sources of financing, including regional banks.
The reasons why major players are retreating from commercial mortgage lending and tightening standards for the loans they make can be broken down into interconnected problems. They include the deterioration of collateral values, less risk tolerance, the illiquidity of secondary markets and the increased reserve requirements on credit-downgraded assets.
The volume of commercial mortgage-backed securities (CMBS), which are a type of security backed by commercial and multifamily mortgages, has been declining recently. In the first few weeks of this year, CMBS sales dropped by about 85% year over year, according to a Bloomberg analysis. This has caused banks to keep more loans on their balance sheets. In turn, higher interest rates make takeout financing more difficult to acquire and cause loans to stay on a bank’s books. If these are loans backed by office assets, there is a high likelihood that they will be subject to higher reserve requirements.
All of these factors add up to a liquidity crunch and a lack of capital for new originations. Even as overall default rates remain low and balance sheets appear healthy, the largest real estate lenders are experiencing a liquidity crunch. Some lenders have had to tell longtime clients with attractive debt requests to seek financing elsewhere. But every market inefficiency represents an opportunity, and this is one that is being seized upon by regional lenders.
Regional banks are often more willing to lend to borrowers in their local markets since they have a better understanding of the local economy and property market conditions. As a result, business loan applicants report higher approval rates with smaller banks than with larger financial institutions. Smaller lenders also tend to have more flexible underwriting standards, allowing them to approve loans that may not meet the stricter requirements of larger banks.
Despite the recent troubles in the banking sector, this may still turn out to be a time of opportunity for the strongest regional banks to gain market share while onboarding experienced real estate investors and operators. They also can build lending and depository relationships with groups that previously would have defaulted to borrowing from the large national banks.
In an inflationary environment with rising interest rates, flexibility is crucial. Construction projects face higher labor costs combined with the higher cost of money, forcing developers to only push forward on projects with outsized returns.
The inflation-adjusted value of commercial construction starts is expected to drop by 3% in 2023, according to Dodge Data & Analytics. But a lack of new product should buoy demand for existing assets in low-vacancy markets. Purchasing undermanaged properties in tight markets with the ability to drive rents up can offset these market headwinds.
Commercial mortgage brokers need to realize that overall capitalization rate expansion could offer an opportunity for experienced investors to pick up infill assets for a bargain. Local developers and their regional lending partners understand the micro- and macroeconomic trends of each submarket, providing the knowledge to make smart asset-level decisions. Mortgage brokers will need to do their due diligence and discern which regional banks are not facing financial stress. Finding the right partner will be crucial during the difficult times ahead.
Many of the major sources of commercial real estate financing have been working through an extremely difficult environment. The CMBS market, for instance, is currently under severe pressure.
Borrowers have been unable to lock in rates on deals until shortly before closing. Spread ambiguity is also making it nearly impossible to determine how much equity to deploy, or whether a deal makes sense until closing. On the whole, conduit deals are pricing wide of the market in exchange for larger downpayments, and these rates are being sealed behind prepayment lockouts and defeasance.
Life insurance companies are pricing institutional-quality deals in the high 6% to high 8% range on a fixed-rate basis but with longer terms. Of course, borrowers are hoping for rates to go down within the next 12 to 24 months and are therefore leaning toward short-term financing. It appears that demand for the short-term life company bucket of three to five years will be high and this capital will be depleted quickly.
For floating-rate options, a major concern is the cost of interest rate protection, which increased sharply in the first two months of 2023 under hawkish Federal Reserve policy. Traders must price in the possibility of interest rates staying higher for longer. This has an outsized effect on longer-term interest rate hedges, and life insurance companies often require full-term hedges to be in place at closing. A 36-month interest rate hedge with a 4.5% strike, for example, will cost a borrower about $371,000 on a $25 million loan, or 49 basis points per year.
This brings us back to the banks. Borrowers are hoping for rates to come down in the intermediate period and are prioritizing flexible prepayments. Banks often allow borrowers to place interest rate protection 12 months at a time. With the larger banks increasingly sitting on the sidelines, regional banks are stepping in and providing this flexibility in exchange for the most valuable commodity in an illiquid market: deposits.
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In the next two years, the hope is that interest rates will have stabilized and the shocks currently being experienced will have applied some discipline to the commercial mortgage market. Stricter lending standards across the board should serve as the foundation for a healthier industry overall.
It is expected that a standard acquisition loan with a bank will size to 55% of cost and a debt yield above 10%. Debt-service coverage is now the primary constraining metric. If the SOFR eventually stabilizes between 3% to 3.5%, loans originated during this period will be particularly low risk. Mortgage brokers will need to identify the best assets in recession-resistant markets that are owned by operators with healthy portfolios.
Right now, it’s the regional banks that are using their willingness to lend, their local market knowledge and their quality customer service to acquire new clients and build their depository base. These lenders are hoping that brokers and borrowers will remember who stepped up and dug in when the chips were down. ●