Bank Failures Explained: Questions, Answers and How CRE Fits In

What should I be watching at this point, and where are we in this CRE credit cycle? QUESTION THIRTEEN It’s the early days, but history has taught us that conditions can change relatively quickly so it’s good to have a pulse on things even if it doesn’t feel as if anything is sounding an alarm bell just yet (in the data, that is). ANSWER

Remember that we should be evaluating all indicators against the form of potential stress or distress it’s linked to (whether that be maturity, value diminution or cash flow). So, here are a few indicators or real-time themes that we’re watching closely as we monitor broader CRE loan health: • CMBS loan performance data can provide a real-time benchmark of loan performance across the industry at large. U.S. CMBS delinquency rates (owners that are 30 days past due on loan payment) remain very low, at just 2.1% as of April 2023 (3.0% in office). Yes, they are going up, but are still very low. For context, delinquency rates reached 10% during the GFC. For every ~3 office buildings you see in the headlines as distressed, there are 97 others that you don’t see that are cash flow positive with no current loan-related issues. • We can also evaluate cross-segment CRE debt financing against loan performance status. 3 Despite accounting for just 14% of total financing, CMBS accounts for a significant portion of troubled loans. Specifically, $88.5 billion (62%) of the total loan volume that is REO (real estate owned) by the lender, that is troubled or potentially troubled, is in the form of CMBS from 2017-2022. In total, $143 billion of loans were categorized as troubled or potentially troubled during this period. • We can monitor prevailing underwriting standards. In general, property owners are entering this downcycle from a position of strength. DSCRs are very healthy, 2.5 is the average over the 2017

2022 period, so owners have more than double the NOI needed to pay their monthly mortgage. 4 Loan matures, pay off the balance, and you’re fine. Loan matures, refinance even at a higher interest rate, and you should be okay, still cash flow positive. Especially considering that many maturities were originated in 2013-2018 when interest rates were only 120 bps lower than they are today (versus more recent vintages that were originated when Treasury rates were at record lows). It’s primarily the lower quality assets that are more exposed to weakening NOI (think low quality office) that will face the greatest challenges. • We can monitor banks’ forward-looking expectations for the credit market, proxied by loan loss reserves (LLRs) as a leading indicator or barometer for potential distress (or credit stress) because it reflects a bank’s assessment of the credit risk associated with its loan portfolio. Banks are required by their respective regulatory agencies to maintain adequate loan loss reserves to cover potential credit losses or defaults. Increasing loan loss reserves can thus signal that a bank is anticipating higher defaults of delinquencies in its loan portfolio. When a bank determines that its existing loan loss reserves are insufficient to cover potential credit losses (across the entirety of its loan portfolio, not just CRE), it may need to increase its reserves. While each bank carries varying levels of reserves depending on their profiles and unique risk profiles, LLR rates have compressed from their post-pandemic highs and are currently hovering around their historic low point of 1.6%.

3 Utilizing data sourced from MSCI Real Capital Analytics. 4 This is referencing CMBS DSCRs as sourced from Trepp and JP Morgan.


Bank Failures Explained - Questions, Answers and How CRE Fits In


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