Banks’ CRE Default Rates Fall But Balances Still Being Drawn Down

Construction Lending Still the Albatross

The overall decline in the CRE default rate corresponds with a 14-bps drop in the default rate for commercial mortgages (excluding multifamily), which fell from 4.06 percent in the second quarter to 3.92 percent. Matching the broader improvements in apartment fundamentals and values, the default rate for multifamily loans fell sharply, by 43 bps, from 3.34 percent to 2.91 percent.

Construction loan default rates fell by 47 bps, besting the decline for both commercial and multifamily loans, but remain exceptionally high at 14.57 percent. Larger banks, owing in part to the higher quality and geographic location of their loans’ underlying properties, registered the most observable improvements. Across a range of banks, institutions with legacy balance sheets weighted toward cardinal markets like New York City reported more rapid declines in default rates.

Balance Sheets Weighted to Smaller Markets and Non-Core Assets Struggle

While the largest banks may also hold the largest absolute volume of non-performing multifamily and commercial loans, relatively smaller regional and community banks face some of the most significant challenges in managing distress. The portfolios of these institutions are more heavily weighted to the secondary and tertiary markets, where pricing has been slower to recover. Refinancing in these markets remains difficult, even for properties with stable cash flow, because of an absence of lenders seeking to expand their commercial real estate balance sheets. As a result, REO held by banks with less than $1 billion in net loans and lease is on par with the largest institutions.

Where individual institutions have worked to dispose of REO, the assets coming to market are generally of higher quality than the overall REO pool. The former are overweighted with properties that are projected to command the highest recovery rates and that will result in the lowest internalized losses. As a result, the residual pool of REO is declining in quality and portends larger losses on banks’ future liquidations.

Credit Availability Remains an Issue, Even if Not in Manhattan

In the most active markets, improving investment trends and more stable fundamentals have allowed a larger share of banks to re-engage in making new multifamily and commercial real estate loans. Nonetheless, the third-quarter findings underscore that some segments of the market remain credit constrained. Banks increased their net exposure to the multifamily sector by $1 billion in the third quarter. That increase was offset, however, by a net decline of $4.1 billion in banks’ commercial mortgage balances. Overall, banks are still reducing their exposure to commercial real estate.

Banks have reduced their exposure to multifamily and commercial real estate by $35 billion this cycle, a 2.7 percent decline following several years of rapid expansion. The slow shift in concentrations is observable across banks of all size tiers. Only New York and a handful of other cardinal markets have consistently bucked this trend. Not surprisingly, national construction loan balances have declined most precipitously. At $254.6 billion, construction loans held by banks are now 40.3 percent of their Q407 peak, reflecting tight lending standards as well as weak loan demand outside of the apartment sector.

New York and Other Cardinal Markets Less Dependent on Bank Financing

Absent significant external shocks, the analysis of the most recent bank-level data suggests modest lending improvements over the coming quarters, led by continued competition for apartment financing opportunities. But larger markets like New York City will continue to capture a disproportionate share of this improvement, supported by the self-reinforcing liquidity that results from a diversity of investors and lenders and that has undercut credit quality in the most active markets. As part of this dynamic, lenders that are active in New York show more rapid improvements in default rates and, in spite of competition from other sources of credit, growth in their balance sheets. The credit outlook remains reserved for smaller, less liquid markets as long as underlying employment and absorption trends remain weak, especially in light of the buffeting of CMBS activity as spreads have whipsawed.

dsc@chandan.com

Sam Chandan, PhD., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School.