Banks and CRE Owners are Rethinking their CRE Portfolio

In 2023, financial institutions primarily concentrated on liquidity and the effects of swiftly-increasing interest rates on investment portfolios. In 2024 and beyond, forward-thinking leaders are evaluating how commercial real estate (CRE) portfolios can help unlock profits that extend beyond the loan portfolio. Sure, there are challenges ahead, but here are a few ideas to help your bank and your borrowers collaborate and use those challenges to your advantage:

Opportunities for your Borrowers:

Blend and Extend on Existing Loans – Do you know the remaining value of existing low-rate debt? Can it be used to make an extended loan more feasible? Consider asking these questions when a customer wants to “wait for rates to come down.” Considerations could include a one-time ability to reset the rate lower in exchange for additional equity capital in the project or an extension of low rates in exchange for a meaningful fee.

Should we advance new capital? – Don’t put your head in the sand when this question comes up. The typical response for troubled loans is to avoid advancing more capital, but this could be counterproductive if it ensures that the property value will continue to degrade. In many instances, new capital may be just the cure the property needs! Limited advances for deals that will increase the amount and duration of the property’s income stream can substantially benefit property value over time. Solutions that incentivize equity risk-sharing on new income opportunities – regardless of existing property values – can not only avoid eroding property value, but can position the property to outperform peers in occupancy and income, ultimately prevailing through the market downturn.

Introductions for Capital Solutions -When borrowers don’t have the resources or savvy to bring a property through difficult times, introducing these borrowers to new streams of capital can result in a win for the borrower and the bank. While the new capital’s return expectations often seem unacceptably high, taking a fresh look at an asset’s position is often the best assessment of a property’s true value. Sometimes an outside look can tell you when previous valuations are no longer realistic. Accepting these terms can be painful, but finding a way to incorporate this incremental capital can solve the overall issue of stability and ultimately lead to an acceptable exit.

Understand and Accept the Historic Shift – We have seen dramatic changes in work and lifestyles since 2020, and the reversal of the multi-generational trend of migration to coastal population centers has brought about profound changes in real estate values for some property types. These unfortunate properties currently face a future that was unimaginable just a few years ago, with values as little as 10% of what they were when the loan originated.

For those who face these unique challenges, it’s critical to avoid denial and instead, take decisive action. These properties are expensive to carry and maintain, and incurring those costs isn’t going to bring them back their previous value. Expert opinion and sober judgment are paramount here. Location is worth noting here as well: an office building in downtown San Francisco is different than an office building in North Dallas. Expertise regarding specific markets is a must.

Take a Hard Look at the Economic Value of the Loan – A realistic view of a loan’s fair value may open the door to less painful possibilities. For example, in many types of real estate such as industrial and multifamily, cap rates have moved up with interest rates, but not as far or as fast. This means that declines from peak property values are low in proportion to the bank’s decline in the fair value of their loan. If no action is taken, the value of the low loan rate will simply flow to the borrower as excess cash flow over the remaining term, and the lender will realize the drag in earnings over the same period. But for loans with challenges ahead, an incentive from the bank to pay it off may nudge the borrower to sell rather than hold out for a return to higher valuations. While settling the loan may require a near-term write-down, redeploying the proceeds at market rates means that write down will be recaptured in due course without facing the main risk event for the loan.

Opportunities for your Bank:

Sale Lease-Back – Strong CRE Partners could be a good capital and liquidity solution for banks with sale-leaseback transactions on bank properties. Whether it’s branches, office buildings or OREO, there continues to be capital interested in purchasing commercial real estate, particularly properties with an existing income stream. A good sale lease-back solution could be the right answer for some banks that are challenged for capital and liquidity due to the current interest rate environment. The total progress that can be achieved with this strategy depends on the book value of the branch and office network, but for many banks, it can meaningfully change their capital and liquidity profile. Unlocking that additional liquidity and capital can make way for right sizing bank’s underwater balances sheets and/or creating substantial new lending capacity.

Don’t shy away from making new CRE loans – Banks willing to provide financing and sell properties at realistic valuations can see significant improvement in their profitability without meaningfully adding to their risk exposure (driven by the historic rise in interest rates). Loans originated today with long-duration income streams have a vastly different risk profile than those originated when interest rates were less than half of what they are today. For these newly-capitalized properties to find similar stress, interest rates would need to exceed peak levels reached in 1981.

Find creative CRE partners – CRE partners can provide liquidity to banks and eliminate problems by purchasing performing and nonperforming loans and OREO properties. Some CRE groups are now doing private debt originations from 1st mortgages to mezzanine financings. These can be useful sources of new capital for a struggling property that still has long-term promise when the risk profile is too great for the bank.

With foresight and flexibility, lenders and borrowers can work together to find solutions in today’s sea of challenges. For those who assemble the right resources and approach with a creative mindset, the solutions to today’s challenges in the CRE portfolio can be the springboard for many future successes.

Thank you to Matt Reddin at DD&F for co-writing this blog.

Dan Andrews
CEO and Managing Partner