Fact or Fiction? CRE Debt Overestimated

Fact or Fiction? CRE Debt Overestimated | The Kitti Sisters - 1

143: Fact or Fiction? CRE Debt Overestimated


Is commercial real estate (CRE) headed for failure?

The answer depends on who you ask.

➡️ Take for example, our friends over at Moody’s Analytics (more on them later).

In case you’ve missed the drama, recently, there’s been extensive media coverage about the possible failure of commercial real estate due to factors such as high interest rates, inadequate loan arrangements, and reduced rental income 

We find ourselves wondering – is this accurate or just another example of sensationalism by the media to increase click-through rates? 🤔🤔

We’re going to look at an article from Moody’s Analytics that talks about all things CRE  – and break down our own thoughts on this meaty topic.

Who’s Moody?

You might be wondering – who is Moody’s Analytics?

No, they aren’t moody people who work in analytics; Moody’s Analytics is a company that does economic research, credit risk evaluation, and provides financial modeling tools. ✨

They help businesses and investors make smart decisions by providing support for things like strategic planning, investment analysis, and risk management.

So when the people over at Moody’s have something to say, we tend to listen.

Not all CRE is Created Equal

Before we dive deeper, let’s clear something up.

Commercial real estate actually includes both office spaces 🏢 and multifamily properties, but they’re pretty different beasts 🏨.

Office CRE is mostly made up of buildings designed for businesses, like corporate centers and office buildings (think WeWork 💭). 

👉 Office CRE guys make money by leasing out office spaces, and their demand can change a lot based on the economy and overall business trends.

But it’s really important that you know that it’s not the same thing as multifamily apartments!

Now, let’s talk about multifamily CRE, which includes residential properties like apartment buildings that are meant for multiple families or individual renters.

Instead of leasing office spaces, these properties make money from the rent paid by tenants. 😍😍

They’re usually more stable because obviously, people need a place to live no matter what’s going on in the economy. Plus, they’re not as affected by changes in technology or remote work trends like office CRE might be.

Lender’s Exposure to CRE Loans

Other buzz that you’ve probably heard in the news recently is a discussion on the commercial real estate (CRE) market’s reliance on bank lending, especially small to mid-size banks. Some people have been saying that regional banks make up around 65-80% of all CRE lending, which has caused some concerns about potential liquidity issues and debt availability for new borrowers.

But it turns out that the CRE lending landscape is more diverse than initially thought.

While banks are the largest lenders in the US, accounting for 38.6% of CRE lending, regional banks hold only 13.8% of that total.

🔈 In fact, the top 25 largest banks hold 12.1%, community banks hold 9.6%, and the remaining 3.2% is spread among very small local banks.

So, it’s not all on the shoulders of regional banks, as the media might have portrayed it.

Did you also know that the reported dependence of the commercial real estate (CRE) market on regional bank lending has been somewhat exaggerated? One reason for this is the changes that were made to the Federal Reserve’s stress testing limits back in 2018. 💡

These changes now only apply to banks with assets over $250 billion, which means that smaller banks with less than $250 billion in assets, including thousands of small banks, represent only 29.9% of CRE debt.

That’s quite a bit lower than the previously reported figure of 65-80%.

It’s possible that the higher percentages were meant to describe the share of bank-held CRE debt under $250 billion.

However, this doesn’t paint an accurate picture of the overall lending sources available for CRE borrowers. So, it’s important to take these things into account when considering the actual reliance of the CRE market on regional bank lending.

Another thing to think about is that banks have a potential concern aside from depositor runs and liquidity issues.

One of them is the stress that troubled commercial real estate loans could put on their balance sheets.

This stress 😓😓 could potentially create a negative feedback loop where declining CRE values would strain bank balance sheets, resulting in reduced CRE lending and further price drops. 

But we do have some good news! Although troubled commercial real estate loans could potentially create a negative feedback loop, it’s not the most likely outcome at the moment. This is because compared to pre-Global Financial Crisis (GFC) levels, CRE loan leverage and asset pricing have been relatively conservative. That’s a good sign!

Plus, borrowers of CRE loans have options to refinance with non-bank lenders. And even if there is a major CRE downturn, banks’ overall exposure to CRE is actually pretty low, especially among the largest banks.

Some small- to mid-sized banks do have concentrated CRE exposures, which is why it’s important to keep a close eye on these individual banks as the CRE credit cycle progresses. But overall, things are looking good and the situation is under control.

Are Banks Facing a Liquidity Crush?

We bet you didn’t know that certain financial strength indicators for the overall banking system are actually better today than they were during the pre-Global Financial Crisis (GFC) period of 2008-2010.

That’s definitely a positive sign. 💛

Keep in mind 👀 that while it’s not likely that we’ll see a widespread liquidity crisis in the banking industry, lenders may still be cautious and tighten their underwriting standards for new commercial real estate loans.

They want to protect themselves against potential downside risks, which makes sense.

So, we might see some changes in the underwriting process for new CRE loans. 

But this actually means good news for multifamily investors! With lenders being more cautious about commercial real estate (CRE) loans, they’re only approving loans for top-tier properties.

The reason why that’s a good thing is that it means that these properties have undergone even greater scrutiny from both the general partner and the lender.

Of course, no investment is ever completely risk-free, but this extra level of scrutiny can definitely give us more confidence in the investment.

So, if you’re a multifamily apartment investor, you can take some comfort in knowing that the properties you’re investing in have been thoroughly vetted and are less likely to encounter issues down the line. 

Who has the Highest CRE Debt on their Balance Sheet?

Did you know that when it comes to commercial real estate, community banks have the highest average direct exposure?

It’s true!

In fact, a significant share of regional and small banks also have a good amount of exposure to CRE.

Surprisingly 😘 😘 though, the 25 largest banks have a very low share of direct exposure to CRE. It’s interesting to see how the different sizes of banks vary in their involvement with commercial real estate.

When it comes to these large banks, only about 4.3% of their total assets are invested in CRE. However, if you include indirect exposures such as non-income generating owner-occupied CRE and unfunded construction loan commitments, the total exposure increases to 6.8%.

In contrast 🧐, the insurance industry has a higher exposure to CRE loans, around 8.3%, with some large life insurers even at or above 20%.

Different industries and sectors have varying levels of involvement with CRE.

But when it comes to direct CRE exposure, community banks definitely take the lead, with over 24% of their total assets invested in CRE.

This is significant, considering there are 829 community banks with assets ranging from $1 billion to $10 billion, which helps to limit systemic risk.

Larger regional banks (with $10 billion to $160 billion in assets) also have significant exposure, but it’s lower at 16.5%. Different sizes and types of banks approach investing in CRE in different ways, which is useful knowledge for you to put in your pocket.

Multifamily Value is Supported by True Income

Another thing that we learned from our friends at Moody’s Analytics is that the values of commercial real estate have actually been on the rise from 2013-2018.

What’s interesting 😎😎 about this is that the increase in value has been supported by actual revenue growth, unlike the pre-GFC era when values were often based on proforma rent growth expectations or equity market price-to-earnings ratios that were not closely tied to asset revenue. 

Nowadays, CRE is often considered a favored investment sector as an inflation hedge backed by real, scarce, income-generating assets. What does that mean?

Well, it means that investors see CRE as a safe investment that can help protect against inflation because it’s backed by actual revenue growth from these valuable assets.

Speaking of growth, there is consistent tangible rent growth by core CRE property types from 2013-2022. The rent growth has been particularly strong for multifamily and industrial assets, which is supporting higher values upon loan refinancing in 2023 and 2024.

And even though office and retail properties are currently facing some existential credit concerns, they have experienced positive rent growth as well. It’s great to see that despite the challenges faced by these property types, there is still some growth happening.

However, there are some poorly 😔 performing assets that have seen flat or negative property income growth.

This could cause some challenges for borrowers of these properties, especially if their loans mature in the next few years. It’s important to keep an eye on these poorly performing assets and make sure they’re being managed properly to minimize any potential risks.

➡️ According to Moody’s Analytics, the robust increase in commercial real estate values from 2013-2018 to 2023 was not primarily due to cap rate compression. Cap rate compression occurs when the cap rate (or capitalization rate) decreases, which means that the value of the property increases.

However, it seems like this wasn’t the main driver of the increase in CRE values during this time period.

In equity markets, price multiples can become super high relative to CRE pricing.

This means that investors might be paying more for a share in a company than they would for a piece of CRE.

But even though CRE is typically a highly financed asset class, investors have been playing it safe and underwriting conservatively with unlevered yields (aka cap rates) over the past decade. Essentially, they’re taking a more cautious approach when it comes to investing in CRE.

But don’t worry, this doesn’t mean that investing in CRE isn’t exciting or lucrative!‼️

There’s still plenty of opportunity for growth and returns 😊😊, and taking a more conservative approach can actually provide a more stable investment environment. It’s amazing to see how the CRE market is constantly evolving and how investors are adapting to the current economic climate.

Implication for Lenders

Let’s talk about the commercial real estate (CRE) sector and its lenders. There’s good news and some challenges ahead, but don’t worry, it’s not all doom and gloom!

On the positive side, on average there are multiple credit positives that suggest that any downcycle for the CRE sector and its lenders will be manageable.

Plus, both the sector and its lenders are in better shape now than before the GFC. 

With that said, it doesn’t mean we won’t see some tough times in the next year or so.

With significant loan maturities approaching, many borrowers may struggle to refinance and may ultimately default on their loans.

This is especially true for maturing office loans, where we’re already seeing some trouble. In fact, we expect around 40% of those borrowers to need additional equity capital to successfully refinance in the next two years. 🤓🤓

Of course, the challenges ahead will vary widely depending on the asset types, quality, and locations. But it’s important to remember that challenges also mean opportunities for those who are well-prepared and adaptable.

So, let’s keep an eye on the CRE sector and see how it evolves in the years to come!

The Big Picture

So hopefully you realize that the commercial real estate (CRE) market isn’t as scary as some people make it out to be!

Despite some concerns about its potential impact on banks and the broader economy, there are actually many factors that contribute to the stability of the market.

For one, conservative underwriting practices mean that lenders are less likely to take on risky loans.

And healthy cap rate spreads – the difference between a property’s net operating income and its cost – help to ensure that properties are generating enough revenue to cover their expenses.  😇😇

Another factor that helps to mitigate risks is the diverse lending landscape.

Unlike during the pre-GFC era, where banks were the primary source of CRE financing, now there are many different types of lenders, from community banks to insurance companies.

This means that if one type of lender runs into trouble, it is less likely to have a ripple effect across the entire market.

Of course, there are still some challenges and risks ahead, particularly with loan maturities coming up in the next year or two.

But even then, the number of challenges will vary widely depending on the type of asset, its location, and the quality of the loan. 🙏🏻

So, in the end, it’s important to keep things in perspective and not get too caught up in the sensational headlines. The CRE market is far from perfect, but it’s also more resilient than some might think! 🤟❤️



The Kitti Freedom Club


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We're Palmy ➕ Nancy Kitti 〰️ The Kitti Sisters

A sister duo team obsessed with all things financial freedom, passive income, and apartment investing + apartment syndication, who turned a $2,000 bank account into a nine-figure empire.  Now, we're sharing with you the behind-the-scenes secrets of our wealth building strategy.

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