Will Lending Policies Cause A CRE Credit Crunch?

June 06 4 min read

In the United States, the growth of the financial sector (banking, asset management, insurance, venture capital) contributes to the growth of the overall economy. This is because our financial system, comprised of large, liquid markets offering diverse financial products, makes it easier to fund investment and growth and insure those investments from loss.

Since these financial institutions interact with a wide range of consumers and businesses, monetary policy largely shapes their investment decisions. Additionally, since many banks in the United States are businesses themselves, they make their decisions with profits in mind, including the return and risk of their investments, such as credit risks (return OF capital) and liquidity risks (selling loans). This way, when a bank issues a loan, it creates money—a heavily regulated privilege.

The Federal Reserve is the central bank of the United States and shares supervisory and regulatory responsibilities of domestic banks with the OCC (Office of the Comptroller of the Currency, aka the Treasury) and the FDIC. With a dual mandate, The Federal Reserve uses both banks and the setting of interest rates on reserve balances to achieve this goal, which has served as the ample reserves policy framework since the Global Financial Crisis.

Changes to the IORB (Interest on Reserve Balances) rate impact the federal funds rate (the rate at which banks borrow and lend to each other) and transmit to other economic rates. For instance, how much banks charge consumers and businesses for loans and more restrictive lending criteria. In addition, changes in the interest rate impact the valuation of assets, which in turn impacts the credit and liquidity risks of the loans collateralized against those assets.

Commercial Real Estate Specifics

A tightening of monetary conditions will impact real estate more heavily than other industries, in part because real estate relies on significant debt, and those debts need the ability to be repaid to be repriced.

As interest rates rise and credit withdraws from the system, greater emphasis will be placed on CRE asset valuations. Collateral valuation is critical as it drives key lending criteria such as loan-to-value ratios (LTV), Loss Given Default (LGD), Debt Service Coverage Ratio (DSCR), and Current Expected Credit Loss (CDCL).

Thus, banks are likely to reduce lending as collateral (loans on buildings and development projects) in the process of being repriced. In addition, the abundance of capital in the aftermath of the fiscal stimulus provided during the pandemic incentivized banks to take bolder risks than would normally occur to place excess savings.

1. Loan Origination & Due Diligence Criteria – Credit criteria loosened during the pandemic, and the underwriting methodology employed allowed special accommodations to combat the negative effects of the pandemic. This coincided with increased capital from credit events (venture funding and SPACs) and fiscal stimulus events. Loans of this vintage may have been of lower credit quality as the FDIC allowed banks to offer borrowers special accommodations during the pandemic, deferring or skipping payments, extending additional credit, and not necessitating the reporting of delinquent loans. FDIC examiners have been directed to exercise significant flexibility in facilitating credit expansion to combat the impacts of COVID-19.

2. Construction Costs & Capital Expenditures – There was a sharp increase in the price of materials, labor, and time required to finish construction projects during the pandemic. In addition, there was an increase in capital expenditures for maintaining existing buildings and retrofitting existing buildings to meet pandemic health guidelines.

3. Interest Rates & Borrowing Costs – A common feature of commercial real estate is that it is heavily financed; a large portion of CRE debt is non-amortizing, meaning that the debt is never paid off but is constantly rolled over until the building is ultimately disposed of. The portion that needs to be refinanced at the end of the borrowing term when the entire balance is due is known as the balloon payment. This finance system has worked exceedingly well when asset values rose and interest rates fell but is untenable when either of those conditions is not true. If asset values decline, additional funds will be needed to meet LTV ratios. And, if interest rates rise, debt service ratios fall, with additional financing required.

4. Stranded Assets – Commercial real estate is undergoing a fundamental shift in the uncertainty of the desirability of assets. Due to pandemic disruptions, traditional city usage patterns are transforming, with work-from-home seen as an increasingly permanent feature. This will create stranded assets, obsolete office buildings, dead malls, unfinished apartment projects, and vacant industrial buildings. These buildings have decreasing current cashflows and little prospect of future cashflows, which means an inability to be repriced and an inevitable default. There may be a mismatch between debt holders and real estate holders, who may eventually become the same person. When a bond goes to zero, you are left with a worthless piece of paper and a broken promise. When a building goes to zero, you are left with a headache for the local community, property taxes that still need to be paid, and insurance commitments that still need to be met. When an asset becomes a liability, the market for that asset shrinks considerably.


The steps taken by the Federal Reserve are to tighten monetary policy, and interest rate-sensitive industries, such as real estate, will be among the first to feel its effects.

Our monetary framework was changed in 2008 to deal with the Great Financial Crisis, and it was changed in 2021 to allow for greater money creation. The loans issued during that period will be challenged relative to other existing loans due to the idiosyncrasies of the pandemic. Those loans had lower due diligence requirements, higher costs, and lower borrowing costs and were made with different assumptions as to land usage patterns.

Monetary policy seeks to rectify these issues by tightening lending standards and restricting capital which may lead to problems in the ability of these loans to be refinanced or these properties to be sold. Commercial real estate is different than other types of collateral, and losses are likely to be non-homogenous; certain banks with specific CRE concentrations, especially in speculative development in certain areas of the country, are likely to feel these impacts disproportionately.

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