Takeaways
- Regional banks quadrupled their market share of commercial real estate loans during the age of easy money.
- Facing a tidal wave of maturing loans, lots of these smaller banks have retreated from the market.
- Alternative lenders and real estate debt investors saw this coming and are ready to deploy record levels of capital.
In Q1 2023, smaller banks originated 34.2% of all commercial real estate loans. It was an all-time high, according to a report recently published by MSCI, a leading capital markets research firm. But then something interesting happened. Near the end of Q1, several high-profile regional banks collapsed in very quick succession. Of course, I’m referring to Silicon Valley Bank, Signature Bank, and First Republic Bank.
Impact of the Banking Crisis
The failure of these three banks has collectively come to be known as the banking crisis of 2023. It was a turn of events that unsettled the financial markets, triggered a sharp decline in the stock prices of banks, especially regional banks, and generally induced fears of bank-driven financial contagion. As I’ve discussed in previous articles, the banking crisis very much got the attention of the bank regulatory agencies, serving as the catalyst for proposed changes to capital requirements for banks.
So, in the wake of the banking crisis, how many commercial real estate loans did smaller banks originate in Q2 2023? As I mentioned, they were very much on a roll, setting records in Q1. Even so, the only thing more impressive than their dominance in the market in Q1 was their retreat from the market in Q2. Their share of originations dropped to 25.1%. It was far and away the sharpest quarterly decline in market share for smaller banks since MSCI began tracking this data in the early 2010s.
Smaller Banks Make Their Move
To put all this in context, let’s go back to the beginning of this data set. Although the Great Recession ended in 2009, and the US economy was officially in recovery in the early 2010s, it was experiencing slow growth, to say the least. In 2012, regional banks were only originating about 8% of all commercial real estate loans. Leading up to the onset of COVID-19 in 2020, over a span of about eight years, they doubled it to about 17%. Then, in about half as much time, they had doubled it again to about 34% at the pinnacle in Q1 2023. Think about that for a moment. They went from a market share of 8% to 34% in just over a decade.
During this period of tremendous growth, which was fueled by historically low interest rates and easy credit, regional banks very much established themselves as the go-to lenders for commercial real estate borrowers. According to the Federal Reserve, about 40% of loans on commercial real estate are currently held by regional banks and their even smaller cousins, community banks. To make sure we’re on the same page, let’s quickly define these terms. The Federal Reserve classifies banks with between $10 billion and $100 billion in assets as regional banks. It classifies those with under $10 billion as community banks.
Bitten Off More than They Can Chew?
Okay, here’s the thing. Now that smaller banks have made these incredible inroads into the commercial real estate market, it seems that maybe, just maybe, they’ve bitten off more than they can chew, as my grandfather used to say. As all those loans start coming due, several hundred billion dollars over just the next couple of years, it’s highly likely that the smaller banks that originated them will have no appetite for refinancing them. They’ve become much more conservative for a number of reasons, such as the way they were vilified during the banking crisis, the growing consensus that interest rates will have to remain higher for longer, and more to the point, how that will impact both the economy and the commercial real estate market, and not least of all, the potential regulatory increases in capital reserve requirements for banks that were of course brought on by the banking crisis itself.
A Possible Doom-Loop Scenario
Just last month, KC Conway of Red Shoes Economics, an especially well-known economist within the commercial real estate industry, noted at a NAIOP conference how the exposure of community and regional banks to imminent loan maturities is even bigger than commonly reported. This was generally a reference to how loans that originated just a few years ago would no longer fit in these banks’ credit boxes given subsequent increases in interest rates and cyclical, dare I say secular, changes in real estate markets. Here’s how he put it: “These banks are in danger of setting off a doom-loop scenario where losses on the loans trigger banks to cut lending.”
Alternative Lenders Are Ready and Waiting
Now, put yourself in the shoes of the unfortunate borrower who needs to refinance their investment property as all of this is playing out. What would you do? Would you sell the property, perhaps at a loss, to pay off the loan? Would you bring in equity to pay down the debt, effectively resizing the loan to a level that meets current underwriting criteria? Would you choose to give back the keys to the bank? Clearly, none of these options are ideal.
It’s in this environment of otherwise inevitable dislocation and illiquidity that alternative lenders are about to deploy record levels of dry powder to finance commercial real estate. The numbers can differ wildly depending on the source, but it’s at least several hundreds of billions of dollars that’s ready and waiting to enter the capital stacks of legions upon legions of properties. Are these private credit funds and other alternative lenders saving the day or just taking advantage of opportunistic circumstances? Perhaps it’s a little bit of both.
Real Estate Debt Investments to Outperform
There’s no question, however, that the best of these investment firms and their investors are going to reap tremendous success over the next several years, while enabling a broad swath of borrowers to keep their investment properties. We’re about to enter a period of time when real estate debt investments are generally expected to outperform real estate equity investments. Will it stay like that forever? No, but that will be our reality as some $714 billion in bank loans on income-producing commercial real estate comes due soon. Taking another page out of my grandfather’s book, who was in fact a farmer, “make hay while the sun shines.”
