What makes CRE risk in 2024 and beyond different from recent bank failures?

All eyes are on the Federal Reserve for interest-rate timing and the careful policy navigation required as inflation sticks around. But for the Fed, and for the banking industry at large, there’s another underlying concern that persists: commercial real estate (CRE) exposure and its particular vulnerability to higher-for-longer rates.

The Fed and other regulators have made clear they have CRE under close watch. And they’ve conceded that not all lending institutions will make it out unscathed. In fact, April brought the first CRE-linked banking failure of 2024 with Republic First. This is most likely not a one-and-done scenario, the officials have warned. But contagion? Not so fast.

“We have identified the banks that have high commercial real estate concentrations, particularly office and retail and other [property types] that have been affected a lot,” Fed Chairman Jerome Powell said in congressional testimony earlier this year. “This is a problem that we’ll be working on for years more, I’m sure. There will be bank failures, but not the big banks.”

Powell’s springtime remarks followed a similar red flag from Treasury Secretary Janet Yellen, who told lawmakers that bank regulators are working to address risks tied to rising vacancy rates and lower valuations for office buildings in traditional economic hubs.

Both officials tied these stressors to the post-pandemic rise in remote work, as well as higher interest rates, which have challenged refinancing CRE debt.

“I hope and believe that this will not end up being a systemic risk to the banking system,” Yellen said in February, also emphasizing that the risk lay with smaller, not larger, banks.

Kelly Brown, founder and CEO of Ampersand, has 30 years of banking and financial services experience. Waukesha, Wisconsin-based Ampersand connects organizations with large deposit and treasury management needs with competitive offers from financial institutions, plus provides other consulting services. Brown talked recently with BAI Senior Editor Rachel Koning Beals about what makes the CRE picture different from other banking industry challenges as well as what familiar patterns in risk management may be emerging.

For Ampersand’s Brown, regulators and banks alike must consider, if they haven’t already, tighter capital requirements, especially for financial institutions heavily exposed to CRE. They could additionally pursue more stringent LTV ratios for CRE loans.

Banks, meanwhile, should undertake portfolio diversification, tighter underwriting enhancements and strategic disposals, says Brown.

The good news for the risk-wary, she stressed, is that an impressive number of banks are doing just that.

BAI grabbed a few minutes with Brown to explore what else was top of mind from her vantage point as the industry faces the uncertainty that comes with CRE burdens and a still cloudy interest-rate picture.

Here’s a snapshot of the conversation, edited in part for length and clarity.

BAI: The CRE situation and any potential for contagion, or broader market disruption, follows relatively soon on the heels of the Silicon Valley, Signature, etc., failures. And although the source of the risks may be different, is there significance to the size and scope of our current level of risk tolerance, response to the CRE situation, so soon after a big scare?

Brown: The timing is significant. This CRE situation again tests the resilience of market risk tolerance. And there can be an overreaction, which hurts the industry, and an underreaction, if we think risks are too isolated, or we underestimate broader implications, which clearly hurts the industry. We had a financial crisis in 2008 to 2010 because of an underreaction.

BAI: Because ripples from the CRE market could be a slowly unfolding issue given lagging economic factors, rolling debt maturities, etc., what are the risk implications? On one hand, there is more time to respond and get protections in place? Market reaction to one or two high-risk developments at a time? On the other hand, a drawn out, nagging problem perhaps because the industry can’t just rip off the Band-Aid and then recover, so to speak…?

Brown: Yes, that’s the nature of rolling debt, differing timeframes, how much time left on deals. On some deals, more time to mitigate some of the risks, such as renegotiating loans or selling off assets. Or, if incremental failures, a gradual response. Are we talking about a series of isolated failures, which is much different than a systemic failure.

And here’s where a snapshot of every bank may vary. A more seasoned CRE portfolio could have very different credit quality. The acumen of credit committees will really stand out here and responses will be swifter. We won’t see what we saw in 2008-2010. For starters, because of 2008-2010, the CRE situation unfolds against much stronger capital positions now, and the regulatory environment is stronger. Credit quality is quite good now for those who’ve earned it. Restoring confidence is the key.

BAI: Talk about a new technological age for risk measurement – advanced analytics and machine learning models. And give us a status update on adoption among both traditional banking and/or arguably historically slow-to-adapt regulators.

Brown: It’s a game-changer now. More accuracy. More precision. Predictive capabilities and that’s huge, which we’ve seen in banks with greater than $10 billion in assets. And believe it or not, regulators will embrace a lot more technology, at least proactive risk-management regulators will get behind it.

BAI: What strategies might banks and credit unions consider right now?

Brown: No doubt underwriting has gotten tighter; less push for emerging market exposure, less for high growth, much more “sticking to their knitting.” Banks have stronger capital positions. But for local economies, it’s true that getting more capital is not easy right now. Subordinated debt markets have all but closed up. If you’re a bank with capital, you are protecting it at all costs, keeping that strong balance sheet.

BAI: CRE scrutiny comes as the market is getting ever tougher for traditional banks facing nonbank, meaning basically traditional tech, competition. Is there enough banking might overall to be this choosy in capital markets? Does CRE risk contagion impact all equally, meaning these other sources will be as risk-averse?

Brown: In 2022, for both banks and nonbanks, it was all about the ease of getting a deal done. Competition was coming from everywhere. Deposits were a challenge. But that’s shifted. Innovation on the fintech side is all great. But fintechs don’t understand banking. And bankers are bankers, not tech people at their core. Success is in partnering. For bankers, their advantage is really understanding the borrowers. They are close to their borrowers. They might understand a certain sector: a physicians’ practice, an ambulatory healthcare center, you get the idea. I also think you are increasingly going to see the regulator play disruptor, addressing vulnerabilities. And addressing CRE vulnerabilities could be a huge piece of it.

In fact, we have an example to draw from. Community banks. Their credit quality, broadly speaking, is incredible. It’s the regulatory reaction from 10-15 years ago, we see that in practice today.

BAI: What didn’t I get at that is important as we consider what’s next for CRE risk and the banking sector broadly?

Brown: There is a connection I can make that I’m not sure every organization is making, but more should. And that is treating ESG and DEI criteria as more than a box to check. It, too, is impacting the valuation with CRE. It changes the overall risk profile, especially when you have a lot of decision-makers who don’t embrace ESG or DEI factors, which can impact positive and negative valuations on CRE. Banks and credit unions must ask about this.

So, for example, CRE firms have lost long-time legal or accounting representation because the CRE firm’s DEI practices no longer align with the law firm’s DEI practices. CRE shareholders might take a stand against soft DEI practices, but board members might dig in against DEI recognition. It’s touchy territory, but banks must know what CRE exposure exists in this area as well. No surprises.

Kelly A. Brown is Chairman and CEO at Ampersand.

Rachel Koning Beals is Senior Editor with BAI.