Commercial real estate mortgages are unlikely to pose a systemic risk for the US banking sector due to the diversity of capital sources and more stringent underwriting that has emerged since the end of the global financial crisis, according to a new report from Cohen & Steers.
Richard Hill, senior vice-president and head of real estate strategy and research at the New York-based investment manager, last week published an extensive analysis on bank exposure to commercial real estate lending in order to get a better handle on actual versus perceived risks.
“We believe the commercial mortgage market is important to commercial real estate because commercial real estate is inherently a levered asset class. But it also occurred to me that there were a lot of numbers being reported, all of which were true, but did not connect the dots in a holistic manner,” Hill said.
Cohen & Steers sized the US commercial mortgage market at around $4.5 trillion of debt backed by income-producing properties and about $470 billion of construction loans. Within that, Cohen & Steers found banks hold about 45 percent of all mortgages and that banks outside of the 100 largest have provided financing for 15-20 percent of all commercial mortgages.
“When you think about commercial mortgage finance, there is actually a wide variety of lenders that provide capital to the commercial real estate market beyond banks,” Hill said. “What we wanted to do first and foremost was to unpack how much exposure the banks actually had to the commercial mortgage market.”
In addition to national and regional banks, Hill cited active lending sources which include Fannie Mae and Freddie Mac and the growing roster of alternative lenders. There is less concentration in commercial real estate among the largest lenders, he added.
“The top 25 banks in the US finance 30 percent of all loans held on bank balance sheets, which means there are a lot of banks outside of that top 25 that provide financing,” Hill said. “This is a level that spreads the risk across the US and in a much more diverse manner than I think the markets were anticipating.”
He continued: “The point is not to minimize the problem. The point is to understand it and understand there are real problems. But we don’t see those as systemic risks to the market as is perceived now.”
Potential for loss
The report underscored that the problems in the market today do not mean the market is poised for another residential subprime situation. “Debt service coverage ratios indicate loan default risk is low and underwritten loan values are low, especially after considering the rise in property values over the past 10 years. In fact, we believe commercial mortgages as a group are underleveraged,” Hill said.
The report also stated the risk of loss to commercial real estate lenders is likely less than is expected, with Hill estimating a 20-25 percent drop in values. Moreover, lending standards are much more conservative than they were prior to the global financial crisis.
“The worst CMBS loans ever originated were the 2008 vintage, originated at peak valuations right before the global financial crisis. Those loans saw losses of around 12 percent. If LTVs were then what they are today, the losses would largely be di minimus, with the exception of some idiosyncratic risks. The real risk here is borrowers having to inject more capital into their loans,” he said.
That said, not all borrowers will have to inject fresh capital into deals as maturities loom. Hill noted that property values are up roughly 44 percent since the beginning of 2022.
The risk associated with refinancing varies by sector, with Hill citing office, hotel and retail as potential sources of concern. These property types will need the largest amount of capital injections in order to refinance successfully.
“The risks in multifamily, industrial and healthcare or other property are more concentrated and are primarily related to properties that were financed with shorter-term debt over the past several years at peak valuations,” Hill said. “If you financed a multifamily property 10 years ago and the debt is coming due in 2023, you’re probably going to be able to do a cash-out refinances given how much values have risen. The same is likely true with the industrial and healthcare sectors.”