A wobbly CRE market requires maximizing relationships and minimizing risk

A version of this article first appeared in the BAI Executive Report: Navigating effective risk management. You’ll find more insight within on prepping for CRA enforcement, liquidity and credit risk, fraud considerations and more.

Commercial real estate (CRE) market contagion has been quieted into late 2024 and as the financial services industry looks ahead to 2025. But few bankers directly or indirectly impacted by CRE can exhale just yet.

Ongoing global conflicts in Ukraine and the Middle East, as well as the pending presidential election and congressional uncertainty, trail on the back of a long stretch of higher-for-longer interest rates. Landlords for offices, apartment complexes and other CRE are carrying $1.5 trillion of debt due by the end of next year, and about a quarter of that borrowing could be hard to refinance, according to real estate market tracker Jones Lang LaSalle Inc. These factors have combined for an impactful macroeconomic picture bound to keep CRE risk factors in play.

For now, the Federal Reserve in September began what most expect to be a string of interest-rate cuts, especially with major inflation indicators back within the central bank’s comfort zone. But there’s more to consider. “On the income side, drivers like rents and vacancies will likely be flat to stable for most property types, with the exception of office,” says a midyear CRE outlook from analysts at J.P. Morgan Chase. “On the pricing side, it’s going to be a landmark year when it comes to price discovery. We’re forecasting transaction activity, loan originations and CMBS [Commercial Mortgage-Backed Security] issuance to rise by 25% to 30%, relative to 2023 lows.”

Office performance numbers remain top of mind for most observers. The national office vacancy rate rose to 19.6% in Q4 2023, breaking the previous record of 19.3%. And while the very concept of the “office building” isn’t yet obsolete, it’s unclear how far demand will drop and how high vacancies will rise in this post-pandemic cycle, the analysts caution. Within the data lies a challenge to find the most desirable office properties in the most active locations.

Rounding out the CRE sector, the J.P. Morgan report finds that apartments and multifamily properties remain strong although with pockets of oversupply. Smaller, smarter retail, especially grocery-anchored neighborhood shopping centers in densely populated areas, are upside movers. In line with this trend, several major big-box retailers are opening smaller concept stores. E-commerce meanwhile underpins demand for industrial properties. The growing trend of “nearshoring,” essentially the opposite of offshoring production, along with the need to replace older, outdated industrial buildings could continue to drive construction and demand in the second half of 2024 and beyond, the analysts predict.

With this outlook and others casting a similar scenario, BAI talked with Mike Horrocks, senior vice president, corporate strategy and product marketing, with consultancy Baker Hill. He partners with financial institutions on getting products into the market, as well as M&A opportunities and has a long track record leading on new market opportunities in lending, risk management and analytics.

Prior to his advisory roles, Horrocks was a commercial banking relationship manager at Zions Bank.

Horrocks sees an opportunity for business bankers to take a healthy assessment of the impact of CRE exposure, including indirect market ripples. Doing so can limit undue risk but also spark resourceful support of local economies finding their footing in a new normal.

BAI: What do you mean when you suggest that CRE risk can be highly correlated?

Horrocks: In risk management, the concepts of diversification and correlation allow you to analyze distinct risk profiles and identify subtle issues. For example, an institution operating in the Elkhart region of Indiana might have several large commercial clients in the RV manufacturing space. They may have first, second and third-tier suppliers as borrowers. The institution may hold real estate loans, inventory loans and lines of credit for these companies. At a glance, the portfolio might look diverse since the commercial clients span multiple lines of business categories, but from a true cash-flow risk perspective, it’s highly correlated – and therefore risky. If demand for RVs slows down or collapses, as it did during the Great Recession, that financial distress for the area will manifest in banks’ balance sheets.

In today’s economy, CRE poses a similar challenge to lenders across the nation. The COVID-19 pandemic and the shift to remote work emptied out office buildings, subsequently hurting lease income and dragging down property valuations.  And the impact did not just stop at the building with the empty cubicles. The retail strip malls that housed the deli, the dry cleaner and other businesses that were counting on the traffic from “in the office” employees were also subsequently impacted.

BAI: What’s your current assessment of the CRE picture?

Horrocks: According to CoStar Risk Analytics’ Head of Capital Markets Joseph Biasi, high vacancy rates are likely to persist through 2026. Lenders will have to dig deep into their portfolios to get an accurate picture of open risk and to identify opportunities to salvage troubled relationships.

This isn’t to say that all CRE mortgages are in trouble. The industrial sector seems healthy and even some types of office buildings are bucking the national trend.

BAI: What role can bank and credit union relationship managers play well before CRE risk becomes a crisis?

Horrocks: The term “intimacy” might seem out of place in a discussion about real estate risk and the prospect of a lending crisis, but it helps make a point. Banks, lenders and relationship managers need to approach this situation with extra care, compassion and genuine concern for their clients.

If your team is willing to build an intimate knowledge of individual clients, you’ll set yourself up for two victories.

The first is demonstrating proactive concern for your clients. Nobody wants to default on a loan. Prior to the pandemic, the idea that the entire office real estate category would fail to recover from a recession seemed looney. A seemingly bullet-proof investment has now turned into a burgeoning risk for investors at multiple levels.

Higher-for-longer interest rates surely kept refinancing options limited. But refi isn’t the only arrow in your quiver. By making the first move and showing your clients that you care and want to find solutions, you’ll generate invaluable goodwill.

And second, you can leverage the network in your business lending portfolio for good. It’s been stated that every business was impacted by the pandemic in some way or another, so do not myopically focus only on the CRE concerns. Take the role of a connector and find other businesses that could benefit from a new location, expansion opportunities, or even that place to hang their first shingle outside of their garage. This can also create multi-level wins with a win for your real estate client with new tenants, a win for your business banking client and a win for you with an increased role or a trusted advisor.

BAI: What are some common mistakes commercial lending teams make when it comes to assessing CRE risk and any advice for navigating the next few months?

Horrocks: Foremost, address problems before they become catastrophes. Even the government asked lenders to offer flexibility to borrowers when possible. Short of a bailout, which poses a totally different set of hazards to the economy, you won’t be able to save every loan for every client.

What you can do is create an internal grading system to sort clients according to the severity of their situation. Then you can assemble a menu of options to offer each type of client and follow up one-on-one.

Show that you’re willing to bring creativity and compassion to a difficult task and your borrowers will thank you. There are so many amazing data providers out there that offer you insights into many aspects of risk, such as peer comparisons, tenant credit analysis, etc., that can all be aggregated into a holistic view to know your true risk and exposure.

The best commercial real estate banking relationship managers understand the importance of high-touch and personal service, but the scale of this task will require familiarity with macroscopic and microscopic data.

Rachel Koning Beals is Senior Editor for BAI.