CRE loan Appetite in a high rate environment

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I am writing this in August 2023, and I have been hearing people complain that lenders don’t want to make loans. There is some truth to Commercial Real Estate loan volume being low, but there are several reasons behind the low CRE loan appetite.

First, Banks make their money primarily from leending money. And I say primarily, because there are a couple of other business models out there that rely on charging a lot of fees. But in reality, Banking is not complicated. We borrow money either from a depositor or from another institution, and we lend it out at a higher rate. The difference between those two rates is the Net Interest Margin or NIM. Periods of low interest rates tend to compress net interest margin, but nowadays the reason for the NIM compression is that Banks need to pay a lot more for deposits and not every loan is set at a floating rate so our top line margin is being squeezed.

Second, there is no two ways about it lending on some types of Commercial Real Estate are almost toxic. I am talking about the office sector. Vacancies have not bounced back, people don’t want to return to the office, the smart employers are jumping on the bandwagong and reducing footprint, valuations will not come back for a while. I am not saying that office real estate is dead forever, I am saying that the cash flows are smaller, and the ability to debt service is tighter. You hear a lot about the market not hitting bottom yet, and people talking about conversions to residential when in reality only a small percentage of office buildings qualify for that.

Finally, It is not so much the banks not wanting to do loans, it is a matter of demand. Commercial real estate loans are being priced north of 8%. This makes a lot of the properties unfeasible at their current selling price. The rental income does not provide enough net operating income to repay the debt service from the loan with the kind of cushion that commercial banks want. I would say that this is the biggest reason behind the lower demand.

Banks will still want to do loans and price them on a floating rate whenever possible. For the real estate loans, we would ask the borrower to enter into a SWAP to manage the interest rate risk, and we would make money from selling the SWAP. On top of that, we are being much more selective about the deal and the sponsor.

Author: Commercial Loan Underwriter