Navigating Through the CRE Market’s Shifting Tides

The commercial real estate (CRE) market has witnessed drastic changes in the past few years since the COVID-19 pandemic. Various property types have experienced different levels of demand and resilience.

Rental and vacancy rates across different property types have fluctuated, mirroring the market’s response to evolving economic conditions. A CRE market analysis by CU Times revealed that credit unions’ increased exposure in commercial real estate loans constitute legitimate concerns about heightened credit risks.

In response to these concerns, the NCUA has expanded its monitoring efforts, risk assessments and scenario analysis. Simultaneously, the Mortgage Bankers Association has revised its forecasts due to high interest rates and uncertainty about property value. This recalibration has led to a decline in loan originations, significantly impacting the CRE market.

What If? The Role of Risk Management

In a volatile interest rate environment, effectively managing risk hinges on identifying the risks at play. Typically, lenders are primarily concerned with interest rate and credit risks in such scenarios, but it is important not to overlook secondary concerns like operational and strategic risks.

Lenders must proactively anticipate fluctuations in interest rates and their impact on portfolio profitability. Strategies to align portfolio yields with market conditions include offering variable rate loans, instituting rate floors during the underwriting process, reducing rate reset timelines and employing swaps as a hedge against the rising interest rate risk.

Utilizing stress tests to evaluate leverage at higher margins allows you to meticulously scrutinize both the financial health of the borrowers and their repayment capacity. Additionally, it’s prudent to conduct comprehensive loan reviews for the existing portfolio and implement a thorough analysis of potential risks. This underscores the need for internal processes and expertise, particularly for Annual Term Loan Reviews.

Bank regulators in the U.S. are urging financial institutions to work prudently with borrowers facing stress in the commercial real estate market. As a significant amount of commercial real estate debt matures this year, there is increased risk in distressed commercial property assets. Short-term loan accommodations and accounting changes can help navigate this challenging terrain.

Improvise, Adapt, ­Overcome: Evolving ­Lending Practices in CRE

Economic expectations, most notably the “higher for longer” interest rate environment, will have a great impact on the future CRE lending landscape. Understanding changes in lending criteria is critical for preventing unfavorable outcomes.

The credit union industry at large is grappling with liquidity constraints. In highly competitive lending environments, members may be lured by attractive offers and terms to alternative banking relationships. For credit unions facing this challenge, they should focus on strengthening existing member relationships.

On the other hand, members may come to realize they have limited alternatives and will need to lean into their existing relationships with lenders for their financial needs. For those credit unions with the capacity to lend, they are at a distinct financial advantage in the relatively uncompetitive landscape. While these credit unions should still prioritize their existing members, it is important to recognize that this market presents an opportunity to obtain new depository relationships.

As interest rates continue their climb, it becomes imperative to balance out the portfolio with higher yielding debt. Bear in mind as the rates go back down that it’s crucial to have operational procedures in place to minimize portfolio attrition.

Lastly, consider diversifying the CRE portfolio across different geographic regions by leveraging participations desks and CUSOs. This enables credit unions to expand this strategy in a broader market and tap into seasoned credit expertise.

In the face of these challenges and opportunities, financial institutions play a pivotal role in supporting CRE borrowers and investors. As the market experiences stress, financial institutions should proactively work with borrowers to identify viable solutions. Short-term loan accommodations and accounting changes can help mitigate risks associated with maturing commercial real estate debt and distressed commercial property assets.

The Need for Market Adaptability

In this dynamic environment, adaptability is paramount to success in the constantly shifting CRE market. Financial institutions, investors and borrowers must be agile, well-informed and adaptable to thrive.

Distinguishing between viable and risky lending scenarios is the essence of intelligent decision-making. Variables like cap rates, which indicate a property’s potential return on investment, and cash flow analysis, which assesses a property’s ability to generate income, will help determine the feasibility of lending.

CRE in general can be affected by a multitude of economic factors, however some asset classes such as medical office, industrial and self-storage, to name a few, are all asset classes that tend to perform well in recessions from a macroeconomic perspective. Despite this optimistic view, lenders should always make sure to conduct a scenario analysis and stress the debt at an appropriate margin to ensure they aren’t taking on too much leverage risk.

The Role of Technology in Modern Lending

Data-driven underwriting is particularly impactful for financial institutions. It allows lenders to assess the creditworthiness of borrowers more accurately, reducing the risk of default. Additionally, it enables lenders to tailor loan terms and conditions to individual borrowers based on their specific financial needs.

It’s good to understand where the breaking point is. When this analysis is generalized to an entire portfolio, it provides lenders with a benchmark as to what level of interest rate refinance risk the portfolio can withstand, and it also provides time to formulate a risk management strategy before it’s too late.

In my role, overseeing debts and participations at a CUSO, for new originations I focus on assets that have performance history and where borrowers have or are putting significant “skin in the game” or equity. Diversified markets with low vacancy are a major credit factor as well. These are the markets with stable valuations, thus leverage risk is limited.

Experienced borrowers and borrowers that have in-depth knowledge of their market dynamics are also a plus. As simple as this sounds, curb appeal and condition of collateral are critical as nicer properties tend to get leased up or sold first in any economic environment. In an industry where cash flow has the biggest impact on value, this is the collateral one should target for their portfolio. Conducting thorough due diligence on borrowers’ affiliated repayment capacity or global debt service ensures they have some ability to repay the debt obligation in the event there are hiccups with the property’s cash flow.

Maturing low-rate debt in a high interest rate environment will certainly spur tough conversations between borrowers and lenders. It is better to understand what risk level your portfolio is at and start reaching out to borrowers sooner than later to negotiate new terms or re-margin the collateral, so as not to catch anyone off guard.

As the CRE market continues to evolve, it is imperative to remain adaptable and educated. It is essential to differentiate between viable and risky lending scenarios, leveraging data and technology to make informed decisions. The ability to improvise, adapt and overcome challenges is the key to success in the CRE sector. As we progress, remember that the CRE market offers challenges and opportunities. Stay informed, stay malleable and seize those opportunities to thrive in this ever-changing environment.

Shivan Perera SVP AVANA Companies Peoria, Ariz.