Commercial Real Estate Lending Headwinds, the 2024 Regulatory Focus on Credit Risk and Liquidity, and What You Need to Know
Credit Union Commercial Real Estate Loan Portfolios are under pressure. The troubled commercial real estate market is facing a record volume of maturing loans, significantly increasing prospects for a surge in defaults as property owners are forced to refinance at higher rates. Heightened regulatory focus on credit risk and liquidity signal the need for preemptive strategies. Here we present a viable solution for Credit Unions.
What brought us to this point?
Credit Union loans secured by commercial real estate have grown to $141.5 billion (92.5% of all Credit Union commercial loans) as of the end of the third quarter of 2023. This represents a growth of $54.9 billion - a 64% increase - since the fourth quarter of 2020. Due to a number of factors discussed below, many of these CRE loans may be under significant pressure, requiring Credit Unions to take immediate steps to protect credit risk and liquidity.
The pressure on CRE has been created by a convergence of factors, including a sharp increase in interest rates, rising costs and reduced operating margins, income pressure, tighter financing needs and a wall of debt maturing over the next 18 months…The imminent refinancing needs of CRE owners are another source of stress in the sector, with nearly $1.1 trillion worth of commercial mortgage loans expected to mature before the end of 2024, according to Goldman Sachs Global Investment Research. Given the balloon maturities common in commercial mortgages, many borrowers will have to refinance their existing loans at higher rates.
The Fed has hiked interest rates 11 times since January 2022 to curb inflation, making CRE credit tighter. The collapse of Silicon Valley Bank, Signature Bank and First Republic Bank in March 2023 worsened the crisis. Lenders’ caution is reflected in stringent credit policies, with loans originated only to those borrowers who have demonstrated strong creditworthiness.
There are substantial CRE loans maturing in the next two to three years. The CRE sector is likely to face a significant challenge, as, based on current market conditions, low-interest loans mature at higher rates, increasing the difficulty in refinancing. Increasing defaults at maturity would affect the weaker CRE assets, depending on asset quality, type and location.
Where are we now?
This month the NCUA issued its supervisory priorities for 2024, stating that “Economic conditions continue to change the credit risk environment in the Credit Union industry as inflation, high interest rates and borrowing costs, declining savings levels, and the end of pandemic-era stimulus and relief programs have negatively impacted some members’ ability to repay their debts. Credit unions’ loan programs expanded faster during 2022 than any year within the last 30 years, while aggregate loan performance began showing signs of deterioration in 2023. NCUA examiners will review existing lending programs’ soundness and Credit Union risk management practices, including any adjustments a Credit Union made to loan underwriting standards, portfolio monitoring practices, modification and workout strategies for borrowers facing financial hardships, and collection programs”
This month the NCUA issued its supervisory priorities for 2024, stating that “Economic conditions continue to change the credit risk environment in the Credit Union industry as inflation, high interest rates and borrowing costs, declining savings levels, and the end of pandemic-era stimulus and relief programs have negatively impacted some members’ ability to repay their debts. Credit unions’ loan programs expanded faster during 2022 than any year within the last 30 years, while aggregate loan performance began showing signs of deterioration in 2023. NCUA examiners will review existing lending programs’ soundness and Credit Union risk management practices, including any adjustments a Credit Union made to loan underwriting standards, portfolio monitoring practices, modification and workout strategies for borrowers facing financial hardships, and collection programs”Credit unions will need to maintain strong credit and liquidity risk management in 2024, due to increased uncertainty in interest rate levels and economic conditions…Member behaviors and risk relationships are also changing, thus requiring a greater focus on forecasting assumptions, forward-looking cash flows and risk projections. The combined affect creates liquidity challenges and increased risk to earnings and capital. Increased liquidity risk and uncertainty heighten the need for Credit Unions to prepare for contingency funding needs. (Emphasis added.)
According to a January 16, 2024 article in the Wall Street Journal, the troubled commercial real estate market is facing a record volume of maturing loans, significantly increasing prospects for a surge in defaults as property owners are forced to refinance at higher rates.
WSJ notes that in 2023, “$541 billion in debt backed by office buildings, hotels, apartments and other types of commercial real estate came due, the highest amount ever for a single year. Commercial-debt maturities are expected to continue rising, with more than $2.2 trillion coming due between now and the end of 2027”.
Compared to home mortgages, commercial loans have much shorter duration and typically end with a balloon payment for the remaining value of the property. Few owners can afford to pay off the full value, so refinancing is expected. When lower valuations meet significantly higher interest rates and more restrictive underwriting standards, “the math isn’t going to work,” Andrew Metrick, Director of the Yale Program on Financial Stability, warned in a December 23 Yale Insights article. Consequently, significant loan losses can be expected.
Thus far, commercial real estate loans largely continue to perform because they still have very low interest rates. And the drop in the valuation of the properties appears certain. However, as these loans become due for refinance, the painful but slow processing of commercial real estate losses could quickly turn urgent.
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