The office real estate market’s woes are well known. But the current commercial real estate picture also shows resilience in retail and hospitality properties—and even the office category can still present opportunities depending on the particulars.
That’s according to chief credit officers at community banks representing the West Coast, the East Coast, and the Midwest. At a recent RMA event, they shared their perspectives with RMA on CRE—the “bread and butter” that drives their revenue and loan growth, as Michael Smelko of NexTier Bank in Butler, Pennsylvania, put it.
The bankers, who spoke at an RMA Annual Risk Management Virtual Conference session, said two notable issues have put a damper on commercial real estate—the aforementioned depressed office market and rising interest rates.
In cities including Cleveland and Pittsburgh, some downtown office building tenants are continuing to pay on their leases but no longer occupy the space, indicating that pent-up risk will be realized as leases mature and aren’t renewed, Smelko said. “We really have pulled back on office space in general,” he said, though his $2.2 billion institution continues to consider lending for office properties that have “exceptionally strong” tenants and sponsors and that are located outside of central business districts and downtown areas.
Other CCOs expressed similar sentiments about pulling back from office. To consider financing an office property in the current environment, the deal would have to be “right down the middle of the fairway with very strong sponsorship,” said Robert Healy, chief credit officer of Country Club Bank, a $1.2 billion institution in Kansas City, Missouri. Call-center office space has been hit particularly hard, emptying as employees have easily transitioned to working from home, he said.
The rapid rise in interest rates that began in early 2022 has created a broader concern for commercial real estate, even for projects that successfully completed their construction phase and were fully leased up, Smelko said.
“The industry got a little comfortable with the historically low interest. Cap rates were low and amortizations were long. As a result, every project worked on paper,” he said. “Maybe some folks that haven’t been in the business as long thought that was the norm. And it’s not the norm.”
On the bright side, the level of CRE delinquency and losses overall remains very low from a historical perspective, so credit quality has remained strong, Smelko said. Even with an uptick in problem loans, as of late 2023 conditions have not translated into actual losses for his bank.
Additionally, over the past several months, potential borrowers have become more amenable to deals with stricter underwriting criteria and recourse lending terms than they had been, the bankers said. “It’s an interesting dynamic now, where things are swinging back a little bit,” Healy said.
The bankers also cited other positive areas in commercial real estate: industrial, warehouse, medical office, multifamily housing, retail, and hospitality. Hospitality properties have rebounded from the pandemic period and are now outperforming even their pre-pandemic levels, Smelko said.
“If you had a certain amount of money—if you had a choice between two loans—right now I would rather do a really strong hospitality credit than an office,” he said.
Retail has been surprisingly strong, considering the discussion about its supposed demise even before the pandemic, said Jeff Brunoehler, chief credit officer of Midland States Bank, a $7.9 billion institution in Effingham, Illinois. Grocery-anchored retail centers have been particularly strong, and with little new retail space being built, in some markets it may make sense to repurpose office space for retail over time, he said.
“Retail has been very resilient,” Smelko agreed. “No one’s been able to figure out how to get your hair cut, or your nails done, or get a bite to eat virtually yet.”
Especially in the current environment, lenders need to manage the risk in their CRE portfolios by looking forward and not relying too much on past debt service coverage ratios, capitalization rates, and appraisals, said Christopher Colella, chief credit officer of the $2.2 billion Commercial Bank of California, based in Irvine.
“I can’t make a loan and collect it from cash flows from the past,” Colella said. “As you’re reviewing these appraisals, remember they’re relying on transactions that already closed. If you see a negative trend, they don't necessarily look forward to what the cap rates may be in a higher rate environment.”
Healy advised that credit officers take another forward-looking strategy: Try to predict where the next problems will come from in their loan portfolios. Then find those loans, review them and see what can be done to mitigate the issues.
At his bank, Healy’s team looks at loans maturing in the next 24 to 36 months, checking on variables from the initial underwriting, keys to success, and key risks. They verify liquidity and examine the sponsor’s potential resources for refinancing and resizing the loan, then work with the borrower to groom expectations. Risk assessment invariably relies on the quality and quantity of cash flow, he said.
“We’re not in the same type of situation that we were in the pandemic, but we learned some lessons from it,” Healy said. One lesson: Keep in frequent contact with your customers.
“If there’s a departure in the borrower’s behavior from what you’re used to, don’t write it off. It could be an indicator of something larger going on beneath the surface,” he said. “Follow your instincts.”
The panelists also advised fellow bankers to know which sponsors will and won’t honor their guarantees without a fight, and to track market trends to keep up to date on their property and industry concentrations.
Bankers need granular data on tenant and property type concentrations to better understand their exposure, Smelko said. Certain tenants, such as accounting firms and the aforementioned call centers, are more likely to embrace work-from-home arrangements, for example. It’s also important to ensure that the basic reporting is current, including financial statements, rent rolls, and annual reviews.
“There's been an enhanced focus, or call it renewed enthusiasm, for making sure that we have current financials and are doing the annual review and not just saying, ‘Well, they're paying, so everything must be okay,’” he said.