How banks, regulators are navigating office loan challenges

In the early 1990s a drawn-out real estate recession and recovery was the result of banks and regulators being heavy-handed when there was no liquidity in the market. The game plan in the Great Recession of 2008-2010 was squeeze those that can pay and leave the others alone. It was a somewhat laissez-faire approach by the banks that seemed to work and allowed weaker balance sheets to improve over time while regulators were patient.

This time, lenders and regulators alike seem to be using a similar playbook with the difference being that large banks largely avoided making big bets in real estate this cycle, learning from their experience in the Great Recession. Recent passing grades on stress tests and research from Moody’s indicates that large banks, or at least the vast majority, are solid.

What is helping regulators keep a lighter hand in this cycle is they don’t see systemic banking risk brought on by suffering in the real estate sector. Since no other industry is as reliant on capital, the acute pain of “higher for longer” rates is isolated to real estate.

The wildcard this time is the change in office attendance and significant drop in office space demand and occupancy. That has led to the most scrutiny of office loans which, of course, are not ready for the spotlight.

According to research from Trepp, banks have increased their net charge-offs, have increasing delinquencies on loans and their collateral loan-to-values are rising due to sinking occupancy. While Moody’s research seems a little more bullish, it still predicts that 70% office-backed bank loans will default at maturity.

As with many things in life, the solution for bank and borrower alike is time. Assuming regulators will be light-handed, the banks will keep extending maturities and time will help heal some gaping holes in loan portfolios brought on by underwater office loans.

In the meantime, liquidity for bank loans is a little tight leaving room for other lenders to increase their volumes. CMBS lenders see a bit of an opening in an unlikely place – multifamily loans.

The problem for many loans is the cash flow available for debt service does not allow for a new loan to be taken out at the same level of proceeds. This may be why CMBS lenders are seeing an uptick in multifamily loans, long dominated by agency (Fannie and Freddie) lenders. CMBS lenders can underwrite a DSCR that is based on interest only payments and therefore squeeze out more proceeds than agency lenders. Today, the rates are not terribly different either.

Commercial mortgage rates are now in the 6.00% to 6.50% range for most five- and 10-year loans. Floating rate loans are priced much higher and now are in the 8.00% range for assets that are not stabilized.

Lower leverage loans may price more aggressively, and office loans will likely price wider. It is no surprise that most bank lenders are being very cautious with their capital allocations, but if the past is any predicter of the future, this is a good time to put loans on the books.