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Commercial Real Estate Resilience: Lenders Foresee Falling RatesLock Icon

9 min read

Most bankers aren’t very smart, according to banker John W. Allison.

John Allison

“Sometimes they forget too quick,” he said.

But the president, CEO and chairman of Home Bancshares Inc. of Conway also says they learned a crucial lesson as today’s high-interest lending environment shaped up: Borrowers must put up a bigger stake to get financing.

That fact alone, Allison says, argues against a widespread “commercial real estate doom loop” scenario that some experts have predicted, pointing to serious exposure to potentially bad loans at many regional lenders.

Bank OZK of Little Rock is often mentioned as one of those banks, but Allison said Bank OZK CEO George Gleason has one of the best commercial lending operations in the country.

“There might be some problems for people who loan with less equity in deals,” said Allison, who concedes that high rates have depressed commercial lending. Lending at his Centennial Bank was off about 40% in the last quarter of 2023, he said. But he and other bankers and experts surveyed by Arkansas Business expect rates to cool off this year, and for most “smart” bankers to weather the storm.

“Back in ’04, ’05 and ’06, we [bankers] helped create the problem that happened in ’08,  ’09 and 2010,” said the colorful and outspoken Allison, who was a successful young manufacturer before getting into banking in 1983. “Customers weren’t putting any money in a down payment into the deals. I remember someone telling me so and so is doing a $5 million deal over here, Johnny, and I said tell him we’ll do it for him for 15% down, which was too little.”

But the borrower already had financing with almost nothing down, Allison recalled.

“Well, when we hit a bad economy, the people that borrowed the money just pitched the keys to the banks. They said, ‘I don’t have any money in it. Just let the banks take over.’ But this cycle is different. Most of the banking space is safer because of the equity contribution from borrowers.”

Allison pointed out that many deals that worked at a 3% or 5% interest rate won’t work at a 9% rate. And he said borrowers with a 33% stake or more in a project aren’t likely to toss the keys to their lender.

After some initial shock and market chaos last year, commercial project borrowers adjusted to stricter equity requirements, said Chad Rawls, executive vice president and chief commercial banking officer at Simmons Bank of Pine Bluff.

“As banks reacted [to rising rates] and tightened standards in regards to construction loans or stabilized commercial real estate, the deal economics changed for developers,” Rawls said. “What we’ve seen as of late is that those developers have kind of found a more normalized approach to their deal economics. It requires more equity to get the leverage points right.”

Deals require a new approach to cash flow at the higher interest levels, Rawls said. “You’ve seen those borrowers come around to the new world. Deals at 4% interest don’t look like deals at 8½%. And the shock that that caused has become more readily acceptable.”

Caution Advised

Both Allison and Rawls pointed to their banks’ conservative history in commercial lending.

“Simmons Bank has been conservative by its nature for a long, long time,” Rawls said. “And so when we saw interest rates really going up, it made us a little more conservative faster than some others.”

Banks with commercial projects on the coasts, or in Chicago or Miami, might face real exposure to loan failure, Rawls said. “It’s probably a real phenomenon in those types of areas. But when you look at Simmons Bank and other Arkansas-based banks, our footprint looks a lot different.”

However, Bank OZK was the lead example in a Sept. 6 Wall Street Journal article headlined “Real-Estate Doom Loop Threatens America’s Banks.” The article notes that the bank “has billions of dollars in commercial real estate loans, including for properties in Miami and Manhattan, where it is helping fund the construction of a 1,000-foot-tall office and luxury residential tower on Fifth Avenue.”

The Journal piece suggested that Bank OZK and other regional banks with commercial loan exposure could face substantial blowback if a troubled market of high interest rates and steep inflation in construction costs persists.

An analysis by Rebel Cole, the Lynn Eminent Scholar Chaired Professor of Finance at Florida Atlantic University, found that through the third quarter of 2023, Bank OZK had the second most exposure to commercial real estate loans of all U.S. banks, trailing only Live Oak Bank of Wilmington, North Carolina.

Cole computed that Bank OZK’s commercial real estate loan total stood at at 584% of its total third-quarter equity of $4.9 billion “These statistics are based upon my calculations using publicly available call report data downloaded from the FFIEC’s [Federal Financial Institutions Examination Council] Central Data Repository,” Cole wrote in a LinkedIn post this month. “For comparison, the aggregate industry total CRE exposure is 116% of total equity ($2.61 trillion vs. $2.25 trillion). This did not end well back during the Global Financial Crisis.”

Simmons Bank was 42nd on Cole’s list at 321% of its $3.45 billion in equity.

And yet just six weeks after the Journal’s article, in late October, Bank OZK announced record third-quarter income of nearly $170 million, a 32% increase over the third quarter of 2022. Diluted earnings per common share were a record $1.49.

The bank’s provision for credit losses was $44 million in the third quarter of 2023 compared with $39.8 million a year earlier and $51 million for the first nine months of 2022.

Bank OZK was in a quiet period leading up to its fourth-quarter earnings report this month, and Gleason said he couldn’t talk to Arkansas Business for this article. The bank was scheduled to issue its fourth-quarter earnings statement on Jan. 18, a day after this issue went to press.

In a third-quarter earnings call on Oct. 20, Gleason said the quality of Bank OZK’s commercial projects was a key strength.

“The reality is that the quality of our sponsorship, the quality of our new construction projects, combined with the low leverage loan-to-value, loan-to-cost metrics of these projects has contributed to the excellent performance of our portfolio so far during this cycle,” Gleason told analysts on the call. “We continue to think that those are fundamental ingredients, great sponsorship, great state-of-the-art new assets, low loan-to-value, low loan to cost, that will continue to help our portfolio perform very well on a relative basis to the industry going forward.”

Allison, the Home Bancshares chief, said the liquidity crisis that hit the industry with the failure of Silicon Valley Bank of California and Signature Bank of New York last spring simply left many banks with little money to lend.

SVB “got Goldman to sell their bonds and the loss was incredible,” Allison said. “What is the value of a security that’s yielding 1½% or 2% in an environment when loan rates are at 7, 8 or 9%? That’s what killed those banks.”

The bond sale news spread quickly, depositors rushed in for their money, and SVB and Signature failed spectacularly. Any commercial loan crisis would be more gradual, Allison said, and bankers have grown a bit more savvy. “There’s no substitute for experience,” he said.

Home Bancshares “built a war chest of capital and a fortress balance sheet” for meeting hard times head-on, Allison said. The bank has reserves and capital comparable to JPMorgan Chase, he said. “HOMB has one of the biggest loan reserves in America” and has been recognized for years as one of America’s safest bank stocks, he said. “I may not have as much capital as Jamie Dimon, but I’m damn close.”

‘Pockets of Pain’

Still, there is no question that the lending slowdown has depressed real estate investment, including commercial projects. Heifer International is suing after a deal to sell its Little Rock headquarters to an entity called OneHealth fell through. OneHealth was working on behalf of Lyon College of Batesville to build veterinary and dental schools on the Heifer campus near the Clinton Presidential Library.

After OneHealth missed a deadline in the purchase agreement, according to Heifer, OneHealth CEO Merritt Dake wrote an email citing “the need to shore up construction financing in a commercial real estate lending market that has turned decidedly unfavorable … .”

David O’Connell, a strategic adviser for Datos Insights of Boston, predicts “large pockets of pain” for regional banks that are over-concentrated in commercial real estate. “I can shift my gaze up and look several miles eastward toward downtown Boston, where I used to work for 20-plus years,” O’Connell said during a teleconference interview. “I’m never going back. Office towers are going to struggle,” as will brick-and-mortar retail projects, he said.

“We have commercial banking operations that have kicked the can down the road a couple of times with one- or two-year maturity extensions. That can only be kept going one or two more times at the most. Sooner or later those loans are going to start going bad.” But he doesn’t expect many banks to face calamity from commercial loans as Silicon Valley did by over-concentrating on tech companies. “It’s going to hurt, OK, but Silicon Valley Bank was really anomalous.”

What a Difference a Quarter Makes

University of Arkansas finance Professor Tomas Jandik seizes on today’s commercial real estate conundrum with both hands.

Tomas Jandik

“On one hand, you can’t say [bank exposure to potential loan defaults] is no longer a big deal, because I don’t think that’s exactly correct,” Jandik said in a phone interview this month. “But on the other hand, asking now in January is much different than it was in September or October.”
Back then interest rates were at their highest in years, inflation was taking a big toll on project and construction costs, and borrowers looking to refinance loans faced sticker shock, he said.

“There was a potential that many of the borrowers were going to be defaulting,” Jandik said, referring to the third quarter of 2023. “But between then and now, luckily, the inflation threat subsided, and interest rates on all loans went down because the Treasury rate went down quite substantially.”

Commercial lending rates that were well above 7% didn’t decline in direct proportion with the 10-year Treasury rate, which was 4.98% on Oct. 19 but down to 3.98% on Jan. 11.

“The Treasury rates went down basically a point, and commercial loan rates declined, but not that much because there is still an added risk,” Jandik said. Demand for commercial real estate may decline in the wake of the COVID pandemic, for example, he said.

Fear of defaults has eased, he said.

“But let’s say the bank needs to sell existing loans to somebody to satisfy people who want to withdraw deposits from those banks; suddenly, that is a problem,” Jandik said. Those loans would be saddled with low interest rates if they originated several years ago, and would have to be sold at a discount.

“Just recently I saw a report [by Professor Rebel Cole of Florida Atlantic University] that computed loans in the real estate space divided into the equity of the bank,” Jandik said. “Bank OZK was the second-highest in terms of this ratio in the United States among hundreds and hundreds of banks that were tracked.”

He said Bank OZK’s geographic diversity of loans in big U.S. markets might be a strength, though. “If my bank is heavily involved in commercial real estate, I would prefer for the bank to be geographically diversified,” Jandik said. “You don’t want to have all the loans in one market that could suddenly collapse, be it New York, be it San Francisco or be it Miami.”

If 2024 goes as expected and the stock market does well and the Federal Reserve continues to rein in interest rates, Jandik said, the default risk will continue to ease. “But on the other hand, we may be just one bump from interest rates going back up and markets going down.”

Jandik is keeping his fingers crossed.

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