Commercial Real Estate: Key Trends and Risk Management in a New Era
by Jessica Olayvar, Senior Manager, Supervision, Regulation, and Credit, Federal Reserve Bank of Richmond, and Mina Oldham, Senior Supervision Analyst, Risk and Surveillance Team, Supervision, Regulation, and Credit, Federal Reserve Bank of Richmond*
While the banking industry is widely viewed as more resilient today than it was heading into the financial crisis of 2007–2009,1 the commercial real estate (CRE) landscape has changed significantly since the onset of the COVID-19 pandemic. This new landscape, one characterized by a higher interest rate environment and hybrid work, will influence CRE market conditions. Given that community and regional banks tend to have higher CRE concentrations than large firms (Figure 1), smaller banks should stay abreast of current trends, emerging risk factors, and opportunities to modernize CRE concentration risk management.2,3
Several recent industry forums conducted by the Federal Reserve System and individual Reserve Banks have touched on various aspects of CRE. This article aims to aggregate key takeaways from these various forums, as well as from our recent supervisory experiences, and to share noteworthy trends in the CRE market and relevant risk factors. Further, this article addresses the importance of proactively managing concentration risk in a highly dynamic credit environment and provides several best practices that illustrate how risk managers can think about Supervision and Regulation (SR) letter 07-1, “Interagency Guidance on Concentrations in Commercial Real Estate,”4 in today’s landscape.
Market Conditions and Trends
Let’s put all of this into perspective. As of December 31, 2022, 31 percent of the insured depository institutions reported a concentration in CRE loans.5 Most of these financial institutions were community and regional banks, making them a critical funding source for CRE credit.6 This figure is lower than it was during the financial crisis of 2007–2009, but it has been increasing over the past year (the November 2022 Supervision and Regulation Report stated that it was 28 percent on June 30, 2022). Throughout 2022, CRE performance metrics held up well, and lending activity remained robust. However, there were signs of credit deterioration, as CRE loans 30–89 days past due increased year over year for CRE-concentrated banks (Figure 2). That said, past due metrics are lagging indicators of a borrower’s financial hardship. Therefore, it is critical for banks to implement and maintain proactive risk management practices — discussed in more detail later in this article — that can alert bank management to deteriorating performance.
Most of the buzz in the CRE space coming out of the pandemic has been around the office sector, and for good reason. A recent study from business professors at Columbia University and New York University found that the value of U.S. office buildings could plunge 39 percent, or $454 billion, in the coming years.7 This may be caused by recent trends, such as tenants not renewing their leases as workers go fully remote or tenants renewing their leases for less space. In some extreme examples, companies are giving up space that they leased only months earlier — a clear sign of how quickly the market can turn in some places. The struggle to fill empty office space is a national trend. The national vacancy rate is at a record 19.1 percent — Chicago, Houston, and San Francisco are all above 20 percent — and the amount of office space leased in the United States in the third quarter of 2022 was nearly a third below the quarterly average for 2018 and 2019.
Despite record vacancies, banks have benefited thus far from office loans supported by lengthy leases that insulate them from sudden deterioration in their portfolios. Recently, some large banks have begun to sell their office loans to limit their exposure.8 The sizable amount of office debt maturing in the next one to three years could create maturity and refinance risks for banks, depending on the financial stability and health of their borrowers.9
In addition to recent actions taken by large firms, trends in the CRE bond market are another important indicator of market sentiment related to CRE and, specifically, to the office sector. For instance, the stock prices of large publicly traded landlords and developers are close to or below their pandemic lows, underperforming the broader stock market by a huge margin. Some bonds backed by office loans are also showing signs of stress. The Wall Street Journal published an article highlighting this trend and the pressure on real estate values, noting that this activity in the CRE bond market is the latest sign that the increasing interest rates are impacting the commercial property sector.10 Real estate funds typically base their valuations on appraisals, which can be slow to reflect evolving market conditions. This has kept fund valuations high, even as the real estate market has deteriorated, underscoring the challenges that many community banks face in determining the current market value of CRE properties.
In addition, the CRE outlook is being affected by greater reliance on remote work, which is subsequently impacting the use case for large office buildings. Many commercial office developers are viewing the shifts in how and where people work — and the accompanying trends in the office sector — as opportunities to consider alternate uses for office properties. Therefore, banks should consider the potential implications of this remote work trend on the demand for office space and, in turn, the asset quality of their office loans.
Key Risk Factors to Watch
A confluence of factors has led to several key risks impacting the CRE sector that are worth highlighting.
- Maturity/refinance risk: Many fixed-rate office loans will be maturing in the next couple of years. Borrowers that were locked into low interest rates may face payment challenges when their loans reprice at much higher rates — in some cases, double the original rate. Also, future refinance activity may require an additional equity contribution, potentially creating more financial strain for borrowers. Some banks have begun offering bridge financing to tide over certain borrowers until rates reverse course.
- Increasing risk to net operating income (NOI): Market participants are citing increasing costs for items such as utilities, property taxes, maintenance, insurance, and labor as a concern because of heightened inflation levels. Inflation could cause a building’s operating costs to rise faster than rental income, putting pressure on NOI.
- Declining asset value: CRE properties have recently experienced significant price changes relative to pre-pandemic times. An Ask the Fed session on CRE noted that valuations (industrial/office) are down from peak pricing by as much as 30 percent in some sectors.11 This causes a concern for the loan-to-value (LTV) ratio at origination and can easily put banks over their policy limits or risk appetite. Another factor impacting asset values is low and lagging capitalization (cap) rates. Industry participants are having a hard time determining cap rates in the current environment because of poor data, fewer transactions, rapid rate movements, and the uncertain interest rate path. If cap rates remain low and interest rates exceed them, it could lead to a negative leverage scenario for borrowers. However, investors expect to see increases in cap rates, which will negatively impact valuations, according to the CRE services and investment firm Coldwell Banker Richard Ellis (CBRE).12
Modernizing Concentration Risk Management
In early 2007, after observing the trend of increasing concentrations in CRE for several years, the federal banking agencies released SR letter 07-1, “Interagency Guidance on Concentrations in Commercial Real Estate.”13 While the guidance did not set limits on bank CRE concentration levels, it encouraged banks to enhance their risk management in order to manage and control CRE concentration risks.
Key Elements to a Robust CRE Risk Management Program
Many banks have since taken steps to align their CRE risk management framework with the key elements from the guidance:
- Board and management oversight
- Portfolio management
- Management information system (MIS)
- Market analysis
- Credit underwriting standards
- Portfolio stress testing and sensitivity analysis
- Credit risk review function
Over 15 years later, these foundational elements still form the basis of a robust CRE risk management program. An effective risk management program evolves with the changing risk profile of an institution. The following subsections expand on five of the seven elements noted in SR letter 07-1 and aim to highlight some best practices worth considering in this dynamic market environment that may modernize and strengthen a bank’s existing framework.
Management Information System
A robust MIS provides a bank’s board of directors and management with the tools needed to proactively monitor and manage CRE concentration risk. While many banks already have an MIS that stratifies the CRE portfolio by industry, property, and location, management may want to consider additional ways to segment the CRE loan portfolio. For example, management may consider reporting borrowers facing increased refinance risk due to interest rate fluctuations. This information would aid a bank in identifying potential refinance risk, could help ensure the accuracy of risk ratings, and would facilitate proactive discussions with potential problem borrowers.
Similarly, management may want to review transactions financed during the real estate valuation peak to identify properties that may currently be more sensitive to near-term valuation pressure or stabilization. Additionally, incorporating data points, such as cap rates, into existing MIS could provide useful information to the bank management and bank lenders.
Some banks have implemented an enhanced MIS by using centralized lease monitoring systems that track lease expirations. This type of data (especially relevant for office and retail spaces) provides information that allows lenders to take a proactive approach to monitoring for potential issues for a particular CRE loan.
As noted previously, market conditions, and the resulting credit risk, vary across geographies and property types. To the extent that data and information are available to an institution, bank management may consider further segmenting market analysis data to best identify trends and risk factors. In large markets, such as Washington, D.C., or Atlanta, a more granular breakdown by submarkets (e.g., central business district or suburban) may be relevant.
However, in more rural counties, where available data are limited, banks may consider engaging with their local appraisal firms, contractors, or other community development groups for trend data or anecdotes. Additionally, the Federal Reserve Bank of St. Louis maintains the Federal Reserve Economic Data (FRED), a public database with time series information at the county and national levels.14
The best market analysis is not done in a vacuum. If meaningful trends are identified, they might inform a bank’s lending strategy or be incorporated into stress testing and capital planning.
Credit Underwriting Standards
During periods of market duress, it becomes increasingly important for lenders to fully understand the financial condition of borrowers. Performing global cash flow analyses can ensure that banks know about commitments their borrowers may have to other financial institutions to minimize the risk of loss. Lenders should also consider whether low cap rates are inflating property valuations, and they should thoroughly review appraisals to understand assumptions and growth projections. An effective loan underwriting process considers stress/sensitivity analyses to better capture the potential changes in market conditions that could affect the ability of CRE properties to generate sufficient cash flow to cover debt service. For example, in addition to the usual criteria (debt service coverage ratio and LTV ratio), a stress test might include a breakeven analysis for a property’s net operating income by increasing operating expenses or decreasing rents.
A sound risk management process should identify and monitor exceptions to a bank’s lending policies, such as loans with longer interest-only periods on stabilized CRE properties, a greater reliance on guarantor support, nonrecourse loans, or other deviations from internal loan policies. In addition, a bank’s MIS should provide sufficient information for a bank’s board of directors and senior management to assess risks in CRE loan portfolios and identify the volume and trend of exceptions to loan policies.
Additionally, as property conversions (think office space to multifamily) continue to crop up in major markets, bankers could have proactive discussions with real estate investors, owners, and operators about alternative uses of real estate space. Identifying alternative plans for a property early could help banks get ahead of the curve and minimize the risk of loss.
Portfolio Stress Testing and Sensitivity Analysis
Since the onset of the pandemic, many banks have revamped their stress tests to focus more heavily on the CRE properties most negatively affected, such as hotels, office space, and retail. While this focus may still be relevant in some geographic areas, effective stress tests need to evolve to consider new types of post-pandemic scenarios. As discussed in the CRE-related Ask the Fed webinar mentioned earlier, 54 percent of the respondents noted that the top CRE concern for their bank was maturity/refinance risk, followed by negative leverage (18 percent) and the inability to accurately establish CRE values (14 percent). Adjusting current stress tests to capture the worst of these concerns could provide insightful information to inform capital planning. This process could also offer loan officers information about borrowers who are especially vulnerable to interest rate increases and, thus, proactively inform workout strategies for these borrowers.
Board and Management Oversight
As with any risk stripe, a bank’s board of directors is ultimately responsible for setting the risk appetite for the institution. For CRE concentration risk management, this means establishing policies, procedures, risk limits, and lending strategies. Further, directors and management need a relevant MIS that provides sufficient information to assess a bank’s CRE risk exposure. While all of the items mentioned earlier have the potential to strengthen a bank’s concentration risk management framework, the bank’s board of directors is responsible for establishing the risk profile of the institution. Further, an effective board approves policies, such as the strategic plan and capital plan, that align with the risk profile of the institution by considering concentration limits and sublimits, as well as underwriting standards.
Community banks continue to hold significant concentrations of CRE, while numerous market indicators and emerging trends point to a mixed performance that is dependent on property types and geography. As market players adapt to today’s evolving environment, bankers need to remain alert to changes in CRE market conditions and the risk profiles of their CRE loan portfolios. Adapting concentration risk management practices in this changing landscape will ensure that banks are ready to weather any potential storms on the horizon.
- 1 The November 2022 Financial Stability Report released by the Board of Governors highlighted several key actions taken by the Federal Reserve following the 2007–2009 financial crisis that have promoted the resilience of financial institutions. This report is available at www.federalreserve.gov/publications/files/financial-stability-report-20221104.pdf.
- 2 See Kyle Binder, Emily Greenwald, Sam Schulhofer-Wohl, and Alejandro H. Drexler, “Bank Exposure to Commercial Real Estate and the COVID-19 Pandemic,” Federal Reserve Bank of Chicago, 2021, available at www.chicagofed.org/publications/chicago-fed-letter/2021/463.
- 3 The November 2022 Supervision and Regulation Report released by the Board of Governors defines concentrations as follows: “A bank is considered concentrated if its construction and land development loans to tier 1 capital plus reserves is greater than or equal to 100 percent or if its total CRE loans (including owner-occupied loans) to tier 1 capital plus reserves is greater than or equal to 300 percent.” Note that this method of measurement is more conservative than what is outlined in Supervision and Regulation (SR) letter 07-1, “Interagency Guidance on Concentrations in Commercial Real Estate,” because it includes owner-occupied loans and does not consider the 50 percent growth rate during the prior 36 months. SR letter 07-1 is available at www.federalreserve.gov/boarddocs/srletters/2007/SR0701.htm, and the November 2022 Supervision and Regulation Report is available at www.federalreserve.gov/publications/files/202211-supervision-and-regulation-report.pdf.
- 4 See SR letter 07-1, available at www.federalreserve.gov/boarddocs/srletters/2007/SR0701.htm.
- 5 Using Call Report data, we found that, as of December 31, 2022, 31 percent of all financial institutions had construction and land development loans to tier 1 capital plus reserves greater than or equal to 100 percent and/or total CRE loans (including owner-occupied loans) to tier 1 capital plus reserves greater than 300 percent. As noted in footnote 3, this is a more conservative measure than the SR letter 07-1 measure because it includes owner-occupied loans and does not consider the 50 percent growth rate during the prior 36 months.
- 6 See the November 2022 Supervision and Regulation Report.
- 7 See Arpit Gupta, Vrinda Mittal, and Stijn Van Nieuwerburgh, “Work from Home and the Office Real Estate Apocalypse,” November 26, 2022, available at https://dx.doi.org/10.2139/ssrn.4124698.
- 8 See Natalie Wong and John Gittelsohn, “Wall Street Banks Are Exploring Sales of Office Loans in the U.S.,” American Banker, November 11, 2022, available at www.americanbanker.com/articles/wall-street-banks-are-exploring-sales-of-office-loans-in-the-u-s.
- 9 An Ask the Fed session presented by Brian Bailey on November 16, 2022, highlighted the significant volume of office loans at fixed and floating rates set to mature in the coming years. In 2023 alone, nearly $30.2 billion in floating rate and $32.3 billion in fixed rate office loans will mature. This Ask the Fed session is available at https://bsr.stlouisfed.org/askthefed/Home/ArchiveCall/329.
- 10 See Konrad Putzier and Peter Grant, “Investors Yank Money from Commercial-Property Funds, Pressuring Real-Estate Values,” Wall Street Journal, December 6, 2022, available at www.wsj.com/articles/investors-yank-money-from-commercial-property-funds-pressuring-real-estate-values-11670293325.
- 11 See the November 16, 2022, Ask the Fed session, which was presented by Brian Bailey and is available at https://bsr.stlouisfed.org/askthefed/Home/ArchiveCall/329.
- 12 See “U.S. Cap Rate Survey H1 2022,” CBRE, 2022, available at www.cbre.com/insights/reports/us-cap-rate-survey-h1-2022.
- 13 See SR letter 07-1, available at www.federalreserve.gov/boarddocs/srletters/2007/SR0701.htm.
- 14 The FRED database is available at https://fred.stlouisfed.org/.
* The authors thank Bryson Alexander, research analyst, Federal Reserve Bank of Richmond; Brian Bailey, commercial real estate subject matter expert and senior policy advisor, Federal Reserve Bank of Atlanta; and Kevin Brown, advanced examiner, Federal Reserve Bank of Richmond, for their contributions to this article.