The unwillingness of some U.S. banks to fully assess their loan exposure to commercial real estate is increasing the risk of financial fragility in the economy, according to the New York Federal Reserve Bank.
A bank analysis titled, “Extend-and-Pretend in the U.S. CRE Market,” describes a situation over the past several years where banks fueled loan maturity extensions, giving rise to a wave of debt coming due soon that it states likely won't be paid.
How it plays out “depends on whether banks will be able to deal with rising defaults in an orderly fashion or whether widespread defaults will lead to sudden and extensive losses,” the report stated.
Many banks began extending loan maturities starting in the first quarter of 2022 when the Federal Reserve hiked borrowing rates to help curtail historically high inflation, according to the report. Higher interest rates led to an erosion in property and real estate security values that were already weakened from the pandemic.
The New York Fed found this so-called extend-and-pretend strategy was most evident by banks experiencing drops in value of their commercial real estate portfolios. The impact was partially responsible for the collapse of three major regional banks in the spring of 2023 including Silicon Valley Bank.
As a result, many banks "extended" the maturity dates of their distressed commercial real estate mortgages coming due and "pretended" that such a credit provision was not a risk to avoid further depleting their capital, the New York Fed said.
The strategy, however, crowded out banks' origination of new commercial real estate loans as well as loans to their business customers, the report said. This led to a 4.8% to 5.3% drop in commercial real estate loan originations since the first quarter of 2022.
Understated problem
The conclusions are “scary enough,” Rebel Cole, professor of finance in the College of Business at Florida Atlantic University, told CoStar News in an email. Cole, who teaches graduate-level classes in corporate finance and financial institutions, added the New York Fed report understates the problem.
The report classified loans as distressed if the net operating income of the underlying property is lower than the net operating income when the debt was issued, according to Cole. “There are millions of loans that do not meet this standard but should be regarded as distressed because the underlying value of the collateral property has dropped significantly,” he said.
Nationally, values for top-tier properties — investment-grade commercial real estate — are down about 20%, according to the benchmark NCREIF National Property Index.
“This has inflated mortgage loan-to-value ratios significantly,” increasing the probability of default, Cole said. “So even a property whose NOI has not changed is much riskier, especially if it faces a refinancing during the coming year.”
The problem puts hundreds of banks and billions of dollars in assets at near-term risk, he said.
Extent of risk
Using federally available data released quarterly, Florida Atlantic University calculates each bank’s total commercial real estate exposure as a percentage of its total equity. Bank regulators view any ratio over 300% as excess exposure to commercial real estate, which puts the bank at greater risk of failure, according to the university’s analysis led by Cole.
Among the 4,594 banks of any size, including smaller banks, 1,849 had total commercial real estate exposures greater than 300% as of June 30; 1,096 had exposures greater than 400%; 536 had exposures greater than 500%; and 293 had exposures greater than 600%.
“My educated guess is that we will see about a quarter of the 156 banks with more than $10 billion in assets disappear within the coming 12 months, either forced to merge or closed" by the Federal Deposit Insurance Corp. because of excess commercial real estate mortgage exposures, Cole said. “Among the 4,400 smaller banks, I expect to see between 500 and 1,000 disappear for the same reason.”
State banking regulators have already closed two banks this year, appointing the FDIC as receiver, according to FDIC data. The largest, Philadelphia-based Republic First Bank with $6 billion in assets, was shut down in April.
This month the FDIC took over The First National Bank of Lindsay in Lindsay, Oklahoma, with assets of $107.8 million.
While there is a substantial number of banks with heavy exposure to commercial real estate, the FDIC has far fewer on its list of problem banks. As of June 30, the FDIC counted 66 with total assets of $83.4 billion. The number of banks has grown in the high-interest environment from 44 at the end of 2021, but the asset value was down from $170.1 billion, according to FDIC data.
'Maturity wall'
The New York Fed report concluded that extend-and-pretend behavior has led to an ever-expanding "maturity wall," of commercial real estate loans, which it argued represents a meaningful financial stability risk.
The volume of coming commercial real estate maturities is substantial, according to data from S&P Global Market Intelligence's analysis of nationwide property records. Rate hikes and changes in post-pandemic behavior has put added pressure on office property borrowers needing to refinance loans coming due.
Origination data shows that the maturity wall will grow to nearly $1 trillion in 2025 and peak in 2027 at $1.26 trillion, S&P estimates.
“Should borrowers fail to seek the necessary refinancing and default on their loans, banks would not only face losses on their loans but valuations in the [commercial real estate] market could come under significant pressure,” S&P said in a report last month.
The extend and pretend strategy is not necessarily bad, according to S&P. Extensions could provide borrowers some cover in the short term as well as give lenders time to work out troubled credit and selectively prune their commercial real estate portfolios through strategic sales in the secondary market.
“But some borrowers could need rates to move notably lower for refinancing to be viable,” S&P said. “Any borrower seeking refinancing at current rates would face a rate shock.”
The Fed’s lowering of interest rates by a half-percentage point at its September meeting could be the beginning of some relief to borrowers, S&P added.