Posted on May 1, 2023
What Could Recent Turbulence in the Banking Industry Mean for Commercial Real Estate Values? LPA’s Appraisal Experts Weigh In
There’s an argument to be made that, more than any other factor, uncertainty is bad for business. Where there’s uncertainty, there’s an elevated sense of risk. And, where there’s risk, paralysis can take hold.
The current state of both financial and commercial real estate (CRE) markets would seem to support this thesis. Uncertainty has become pervasive due to liquidity issues at several prominent regional banks. Although plenty of analysis has been offered regarding the unique circumstances that led to the precipitous collapse of the most well-known of these institutions, the ripples from its failure have been felt throughout the entire banking system.
Specifically, those looking for answers — and assurances that this event is different from the financial sector woes that helped trigger The Great Recession — have trained a microscope on smaller banks. Given that these institutions, defined as those holding assets of less than $250 billion, may be responsible for almost 80 percent of CRE lending in the United States, “serious” doesn’t begin to describe the implications for industry stakeholders.
Now that observers have zoomed in on the banks that disproportionately serve property owners, buyers, and investors, what do they see?
- According to one study, 186 individual banks could face insolvency “even if only half of their depositors decide to withdraw their funds.” These banks are grappling with the declining value of mortgage-backed securities and long-term government bonds, much as the banks that triggered such tremendous concern in March were. And, because regional banks are a pillar of CRE lending, any shakiness in that sector will naturally ripple through the rest of the industry.
- $270 billion in CRE loans are set to mature in 2023. Approximately $80 billion of that debt is secured by wobbly property assets: office buildings, especially Class B and C buildings that have not been modernized to account for post-COVID changes in workplace culture.
- The assets sold from one failed bank fetched just 77 cents on the dollar. Whether or not this fire sale effectively creates a new baseline for property values, it provides a glimpse of how devalued CRE assets may become as overleveraged stakeholders become more desperate for equity.
- The Fed is unlikely to hit the brakes on raising interest rates any time soon. Their reasoning? The acute pain of a credit crunch (a near-inevitable result of the higher price of borrowing and tighter lending policies) is preferable to the fever of inflation.
- Calls for more stringent bank regulation have already been heard in Congress. There appears to be growing sentiment — and political will — to “reimpose some of the Dodd-Frank requirements that were rolled back in 2018.”
It’s neither comprehensive nor exhaustive, but the above list paints a fairly grim picture. Still, as any accomplished, principled commercial appraiser would ask about any data relevant to real property values, is it accurate?
In that spirit, we’ve turned to our own CRE valuation experts for guidance.
Keep reading to learn how Mario Caro, MAI, AI-GRS, SR/WA, Senior Managing Director of LPA San Antonio (and our firm’s practice leader in right of way and eminent domain), Brent Elliott, MAI, AI-GRS, Senior Managing Director of LPA Houston, and Drew McFarland, MAI, AI-GRS, Senior Managing Director of LPA Dallas, are maintaining a clear vision of the markets they serve despite the shadows cast by recent events.
What’s Been the Most Critical — or Impactful — Consequence of the Uncertainty Surrounding Regional Banks and Commercial Real Estate?
In Drew’s professional opinion, the impact has been immediate and dramatic. “What’s happened since mid-March has made CRE lenders much more focused on ensuring their collateral is being valued accurately,” he says.
Meanwhile, according to Brent, the volume of transactions is down. “When money was cheaper, there were a lot more buyers and sellers on the market. We also saw a lot more refinancing of deals to lock in lower interest rates. Now, spreads are much less favorable, and credit committees are showing reluctance to sign off on loans they would have approved a year ago.”
But caution among lenders isn’t the only factor affecting velocity. “Due diligence is always critical, but especially so now. The more due diligence is required, the longer the appraisal process can take,” Drew explains.
Mario, meanwhile, is keeping his eyes on the horizon. “There’s no question that banks are holding portfolios of assets that can only be offloaded at steep discounts. Real property isn’t the only one of those investment assets, but it’s getting the most headlines right now,” he observes. “If interest rates continue to hover around 5 percent and the Fed continues this game of chicken with inflation, CRE may be in for a rough ride for the next 8-12 months.”
Should Lending Dry Up and Transaction Volumes Decline Further, What Could That Mean for Commercial Property Values?
To Mario, this scenario spells trouble. “Any time the cost of capital increases, there’s a likelihood of price softening. Since interest rates and capitalization rates generally work in tandem with each other, I can’t help but think property values will eventually depress across the board.”
But he goes on to note that “some sectors will be beat-up more than others. Office and, to a certain extent, multifamily appear to be assets with the largest targets on their back. Industrial, self-storage, and lodging are generally understood to be in a better position to weather this storm.”
Brent believes that non-bank lenders (NBLs) could pick up the slack. “There will always be buyers and sellers. They will just have to look at other resources for capital,” he says. Mario adds: “More players in the game is good for investors and good for values. More lenders lending fuels transactions and makes capital available to a greater pool of borrowers and investors. But, with $4.8 trillion stashed in money market funds, many potential players are hesitant about investing in much of anything right now.”
Brent sounds an additional caution regarding so-called shadow lenders. “The capital they supply tends to come at a significant cost to the buyer — and at the expense of the property’s market value.”
Drew views the availability of financing from both a buyer’s and a seller’s perspective. “Sellers should be very realistic with current market values, as the cost of borrowing has increased significantly. Buyers, on the other hand, could be in a better position to negotiate. Fewer transactions mean scarcer market data, making it more difficult to agree on the value of any given property,” he points outs. “That tension could lead to correction with respect to some property values.”
Brent concurs. “At some point, everyone is going to need to be told what a fair, true value for their property is. The market, whatever its current condition, largely determines that value.”
How Has LPA Pivoted in Response to All This Uncertainty?
Much as they did during the pandemic, our CRE valuation experts have been extremely proactive in taking extraordinary measures to ensure their reports contain credible— and actionable — business intelligence.
“We are being held and are holding ourselves to higher standards,” Brent says. “We’re talking to as many market participants as we can even as we track down the most recent sales data and include the most current cap rates in our appraisals.”
Drew relates that he and his team “continue to maintain the highest level of quality for each appraisal document. Accurate reports containing the most current available data could not be more important right now.”
Mario’s experience has been much the same as Brent’s and Drew’s. But he calls special attention to proptech’s role in helping his team maintain LPA’s reputation for accuracy and 100-percent on-time delivery. “We’ve had to stay nimble by improving the technology and efficiencies we’ve gained through that technology to compile and organize large amounts of real-time data quickly,” he reveals. “Doing so allows our appraisers to draw informed, market-based conclusions and equip our clients with accurate and supported valuations.”
Our clients clearly appreciate the efforts we make on their behalf. If you’re interested in partnering with a commercial appraisal company that’s the fastest-growing firm of its type in Texas, contact us today.