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Transcript

Tim Sablik: My guest today is Anne Davlin, a senior quantitative analyst in the Supervision, Regulation and Credit department at the Richmond Fed. She is part of the Bank's Risk and Surveillance team that monitors banking conditions in the Richmond Fed's Fifth District. Anne, thank you for joining me.

Anne Davlin: Thanks so much for having me, Tim.

Sablik: Today, we're going to be discussing trends in commercial real estate, or CRE, and what these trends mean for banks.

Longtime listeners may remember that we discussed this topic on the show last year. In that episode, which we'll include a link to in the show notes, we focused on national trends in CRE. Our focus in this episode is the Richmond Fed's Fifth District, which includes most of West Virginia, Maryland, D.C., Virginia, and North and South Carolina. Our earlier episode also focused on office real estate, but CRE encompasses a wide range of property types.

Anne, could you start by defining CRE and explaining the role that banks play in CRE lending?

Davlin: Sure, Tim. Commercial real estate, or CRE as I'll refer to it in most of this discussion, refers to any income-producing real estate that is used for business purposes, for example office buildings, retail, hotels, and apartments.

Banks provide financing in the form of mostly collateralized real estate loans. These loans can have different forms, such as permanent loans that are first mortgages on commercial property; small business loans or SBA loans, which are guaranteed by the Small Business Administration; and bridge loans, which can provide a short-term loan on a commercial property lasting six months to three years and are typical while awaiting longer term financing. Lenders consider the nature of the collateral, the property being purchased, the creditworthiness of the borrower, and the financial ratios when evaluating commercial real estate loans.

CRE loans tend to be more expensive than residential loans and typically have shorter terms that range from five years, or even less, to 20 years. The amortization period is often longer than the loan term, which means the lender will pay a smaller amount over the term of the loan with a balloon payment composed of the entire remaining balance at the loan's maturity.

Sablik: Thanks for that overview. That, I think, will come into play as we discuss some of the challenges we're seeing in this area.

What are some of the risks around CRE lending that we've seen emerge since the pandemic? Since, as you mentioned, this covers a lot of different categories, let's start with multifamily.

Davlin: Sure, Tim. Multifamily is one of the sectors that saw the largest decline in asset value since the pandemic. According to a report from Fannie Mae, the multifamily sector experienced significant shifts — including COVID-related shocks — followed by an unprecedented recovery and historic rent hikes. CoStar reported a 6.1 percent decline in the aggregate value of multifamily since 2019.

In the wake of the pandemic and the shift to remote work, people began moving further away from some cities and traditional job centers. Without a commute to work, many millennial renters found that they could now afford to buy a home further out. As a result, many renters became homebuyers. Home prices and rental prices diverged around the time the pandemic hit the U.S., with home values rising and rents declining, putting downward pressure on multifamily property values.

At the same time, lower-income households more likely to rent were also more likely to have experienced job loss in hard-hit industries like retail and food services. Many of these individuals facing financial pressure turned to alternatives like moving in with roommates or back in with their families, further adding to the decline in rental demand.

As the market recovered in the year following the pandemic, multifamily vacancy rates declined, particularly in suburban areas followed then by the urban markets. Surplus kept rents at bay for a while, but rents increased moving into 2021. As the residential market faced supply issues, rental vacancies declined and rents increased once again.

Recently, a record number of multifamily properties are being completed — just as the population of renters is increasing due to higher housing costs — boosting the demand for apartments. However, the number of properties under construction is declining, meaning the supply could soon be slowing. On the demand side, as the economy recovers and interest rates decline, we expect to see an increase in homeownership, which would then again put a downward pressure on rental demand.

Sablik: How about the office sector?

Davlin: According to CoStar, office lost 23.3 percent of its aggregate value since 2019.

Following the pandemic and the widespread adoption of work-from-home arrangements, there was a dramatic decrease in the use of office properties. Office availability rates, which includes the vacancy rate plus occupied space being marketed for lease and space listed for sublease, increased in 77 out of the largest 100 cities since 2019. Cities with the greatest increase in available space tended to be large coastal cities, followed by some in the Southwest and the Sunbelt.

Today, office visits are half of what they were pre-pandemic as measured by Placer.ai, a company who measures foot traffic through mobile phone data. Most employers have established return-to-office policies requiring between two to three days in the office, but few are actively enforcing the policies. It's expected that current levels will hold for the foreseeable future. This trend is clearly affecting tenants' decisions to renew leases as they come due, with many seeking to downsize their space.

While demand has dropped drastically as remote work scenarios and flexible work arrangements have become the preference, prices haven't declined as much. This is due to the fact that leases are usually long term in the office space, so the leases must expire before the rents can be readjusted.

One main concern in most of the commercial real estate sectors, particularly multifamily and office, is for maturing mortgages. Since many of these have balloon payments due at the end at maturity, we're facing a "maturity wall" in the next few years. If owners are forced to take lower rents due to oversupply of properties, the value of the property could fall, leaving borrowers with an outstanding loan balance greater than the value of their property. Borrowers may struggle to repay or refinance these loans now that we're at higher interest rates than they likely took the original loan, leaving the banks with nonperforming loans and potential losses.

Sablik: That's a great segue into talking about the implications for the banking sector. What does CRE exposure look like for banks in the Fifth District?

Davlin: The Fifth District [banking sector] has historically held higher concentrations in commercial real estate. This is largely driven by the metropolitan areas within our footprint. We have Washington, D.C. and the surrounding metropolitan areas, Baltimore, Charlotte, Norfolk, Raleigh, Richmond, just to name a few. The Fifth District is tied for the third highest in the nation in terms of commercial real estate as a percent of total loans. On average, our banks hold 45 percent of their total loan portfolio in commercial real estate. We're tied with the New York district and only led by San Francisco and Atlanta.

The Fifth District banks have the largest concentration of loans in the nonowner-occupied, nonfarm, nonresidential category. This includes office, retail, hotel, and industrials. This concentration has grown considerably since the Great Financial Crisis, while construction, land and development loans have significantly declined in our district.

Sablik: So, banks in the Fifth District have pretty high CRE exposure relative to the rest of the Federal Reserve System. What do CRE market conditions look like in the Fifth District?

Davlin: Taking a look at the Fifth District CRE market conditions, cap rates and vacancy rates — two very important determinants of the health of CRE — have trended negatively for office over the last several years. (As background, a cap rate can be viewed as the demand for a property's net operating income and is correlated with interest rates. The lower the cap rate, the higher the value of the property.) Cap rates on office properties in the [Fifth] District have increased since early 2022, indicating declining property values in the Fifth District markets. Office vacancy rates have been increasing since the start of the pandemic, but levels look to be plateauing in recent periods.

It's interesting that cap rates and vacancy rates are above those of the Great Financial Crisis levels in certain markets. For instance, vacancy rates in Charlotte have increased more rapidly than other Fifth District markets and are now higher than the Great Financial Crisis levels. In fact, Charlotte is one of 17 markets nationally with a vacancy rate over 20 percent. This trend is largely being driven by oversupply.

Turning to multifamily trends, while the Fifth District markets are seeing negative trends in most indicators of multifamily property health, these trends have generally not had the same effect on our banks' credit quality compared to other Districts such as New York, where there are more rent stabilized properties. Similar to office, cap rates have increased rapidly since the beginning of 2022, increasing most steeply in Norfolk, Greensboro, Richmond, Charlotte and Greenville MSAs. Vacancy rates have also increased, but levels are below those seen during the Great Financial Crisis in most cases.

Rent growth has been slowing in recent periods after steady increases from the first quarter of 2021 until the third quarter of 2022. According to CBRE, multifamily vacancy and rent growth are at an inflection point, with expectations of returning to long-term averages by the middle to end of 2026.

Sablik: What are bank examiners at the Richmond Fed doing to ensure that banks are taking appropriate steps to prepare for CRE risks?

Davlin: Examiners and surveillance staff are closely monitoring CRE concentrations — that is, balances in commercial real estate as a percent of capital and allowance — at District banks as well as monitoring CRE market trends. We are identifying banks with higher concentrations, particularly in office and multifamily, in markets that have shown particular stress. We are focused on ensuring that banks are actively recognizing loss through accurate loan grading, movement to nonaccrual status, and allowance for credit loss provisioning.

Timely and accurate risk ratings are key to managing risk in the CRE portfolio. Banks are risk-rating their loans and should be appropriately allowing for potential losses given the risk of the loans.

In addition to all the supervisory events, our surveillance and outreach staff has provided numerous forums, market updates, and supervisory guidance updates for bankers related to commercial real estate. I'll leave a plug here, Tim, for our Supervision News Flash article. The Risk and Surveillance team recently published a Supervision News Flash article related to navigating allowance for commercial real estate losses. Banks with total assets over $1 billion are now required to complete the Call Report Schedule RI-C, which provides the disaggregation of allowance for credit losses or ACL. This disaggregated reporting allows for greater insight into whether CRE allowance for credit loss is responsive to changes in CRE lending conditions and facilitates peer comparison of allowance coverage.

Sablik: We'll definitely include a link to that News Flash article for anyone interested in more information.

We've been talking a lot of "doom and gloom" around CRE, but are there any bright spots in this market, any areas that seem to be improving?

Davlin: We're definitely seeing some improvement. CBRE forecasts a 5 percent increase in annual investment activity this year, with further acceleration next year. Despite slowing job growth, they expect the economy will avoid a recession. A soft landing will buoy occupier confidence, resulting in resilient demand for space across all commercial property types.

Sablik: Is there anything in particular that you and your team will be watching over the next few months as you try to forecast whether CRE risks to banks are growing or subsiding?

Davlin: We'll be keeping an eye on the trends in cap rates, vacancy rates, commercial mortgage-backed security delinquency rates, and loans with looming maturity dates, as well as moves in interest rates and other economic measures like interest rates, inflation and employment. These are things we frequently watch, and we're going to continue to do so.

Sablik: Anne, thank you so much for joining me today to discuss this topic.

Davlin: Thanks for having me, Tim.