Mortgage Bankers Association Prediction on CRE Loan Volume Q&A with David Reed

Speaker A: Foreign.

Speaker B: Welcome to the Credit Union Overtime Podcast. My name is Larry and I'm your podcast host for the Credit Union webinar network. This episode features attorney and compliance expert David Reed, who will answer questions about a recent commercial real estate prediction made by the Mortgage Bankers association and and give some high points from his recent webinar new policy statements on CRE accommodations and workouts. Attorney, author, consultant and nationally recognized trainer, David Reed is a partner in the law firm of Reed and Jolly, pllc. He provides guidance to financial institutions on establishment and revision of policies and procedures, organizational compliance, collections, security, contractual agreements, regulatory matters and corporate governance. He has trained state and federal examination staff on numerous issues including BSA, ID theft, red flags, SAFE act, third party contract management and bankruptcy. If you want to learn more about this topic after the podcast, be sure to check out the podcast notes where you'll find a link to David's webinar and a, uh, coupon for 10% off exclusively for, for our listeners. So without further ado, welcome to the Credit Union Overtime podcast.

Speaker A: David, great. Thank you so much, Larry. Pleasure to be here.

Speaker B: Yeah, thanks for taking the time to visit with us today. I appreciate that and I appreciate your time and I think uh, it's going to be fun to talk a little bit about some of the recent activities that have been going on in the commercial real estate world. I know the Mortgage Bankers association, they recently made a pretty dramatic prediction about commercial real estate lending volume. What exactly did they say and how do you see that, that affecting our community financial institutions?

Speaker A: Absolutely. Well, it's a little bit like the uh, the old uh, saying, you know, may, may you live in interesting times. And with regard to the commercial real estate market, uh, we certainly live in interesting times right now. Um, the Mortgage Bankers Association, I mean uh, when they talk, pretty much everybody in this area listens and great resource for uh, statistics and for just really keeping uh, your institution in the know on what's happening over the marketplace, uh, generally. Okay, well, uh, recently they um, issued uh, two different reports. Neither of them was very good with regard to commercial real estate. Um, the one that talked about the lending volume said that the slump, which really uh, is um, a couple of years old, rather dramatic in 2022, uh, but it's going to be even WOR, uh, in 2023 down potentially as much as uh, 40 to 50% in the volume, uh, that it was in 2022. And so that's obviously among several things that have happened here in the last month or so that has everybody uh, kind of looking at this a little bit more. Um, and the second report, they did not only uh, the first report looked at volume. The second report looked at the actual delinquencies on commercial uh, real estate and it said that they're up and particularly up. We know commercial real estate has multiple sectors, right? You have office and retail and industrial, multifamily hotel, things like that. The office and retail delinquency rates um, are uh, material. Materially. Oh, easy for me to say. Higher ah Than they were uh, in the last, uh. In the last year. Um, whereas multifamily is kind of holding its own a little bit. But. But taken together the. The Mortgage Bankers association doesn't have a very good view in the short term of uh, commercial real estate.

Speaker B: Okay. Okay. How does the. So uh, you. You obviously heard about what happened with the WeWork bankruptcy uh here a couple days ago. Um, how is that fitting into all of these predictions and stuff? Is that kind of. Do you think the mortgage bankers was strangely predictive of that or do you think that was kind of already in the works? Of course it was. You know, it takes a while for that stuff to materialize. But how does all that fit in?

Speaker A: Well, I mean obviously this is a broad spectrum. We look at commercial real estate, right? When you look at all the different sectors of it, this covers a broad waterfront, so to speak. So let's just go back, um, you know, let's say six months ago or so and um, look at all of the different banking regulators, uh, that put out the uh, the guidance on working with commercial real estate borrowers. Uh, and I think that this guidance, um, probably more so uh, than what Mortgage Bankers association said. I think that that guidance put out by the different financial regulators was really looking at the WeWork, um issue because we work has been in distress now for um. Wow, you know, at least since 2022. When you look at the amount of their leases, uh that they either jettisoned or reworked, uh plus they're very, very, very uh, public statement. Well certainly within the last six months that said that their continuing viability uh, was at stake. Uh, I think that that led to that um, to the financial services uh industry getting the uh, shot across the bo. Uh prudent working with commercial um, real estate borrowers. Now, uh, they have finally, for those that don't know, uh, they WeWork, uh, has now finally uh, filed for bankruptcy. Uh, they believe, I think that they're still going to be able to uh, to continue in operation after uh, they shed all of these leases. Um, but let's not, uh, forget. I mean I, I can remember um, driving through and I, I know I was, I was on business, I, I want to say someplace in Texas. And the very first time I looked up at a building and I saw that we work, you know, at the very top of a very large office building. And I was like, wow, you know, what is that? So of course I had to look them up, you know, and I was thinking, is that a labor union? Is that some kind of a financial institution? You know, what, what is that advocacy group? And that's when I, when I saw their uh, their business model, the services that they of course they, they just really seem to be riding high again. At one point their value, uh, I want to say was close to 50 billion with a B dollars. Wow. And uh, all of these different factors that, that we have seen, you know, uh, Covid, the virtual work environment, interest rates, um, all of that has had a very, very negative effect on the marketplace and they got caught flat footed. And I think that's one of the things that we kind of need to talk a little bit is I don't want anybody to think that uh, I'm saying don't get involved in commercial real estate. I am an unabashed advocate for commercial lending, uh, especially commercial real estate. Um, but if we look at the we work lesson, uh, you need to be agile, you need to be um, three dimensional in your thought processes and know where the marketplace is. Because this marketplace is not the commercial real estate marketplace of um, five years ago, even three years ago.

Speaker B: M. So. Well, you know, you just said community financial institutions. They're, they're kind of known for being big commercial real estate lenders. In fact, I would say, well, gosh, what is the statistics? I heard a statistic the other day that said, um, 80% or more of all commercial real estate loans are carried by community financial institutions in the United States. Which is staggering. I mean it really creates that natural CRE concentration and on almost every community financial institution. So do you see the regulators really kind of cracking down on cre heavy institutions, especially in light of the wework bankruptcy?

Speaker A: Oh my gosh. I mean, absolutely. So when we look at the um, different examination or supervisory priorities put out by every agency, I mean separately, within their own examination, examination guidance, within their own bulletins or letters or whatever, um, we see the kind of trifecta of risk right now. Uh, we see interest rate risk, we see liquidity risk and we see credit risk. And all of those, uh, have impacted commercial real estate and precepts of safety and soundness. Let's remind ourselves, safety and soundness doesn't mean are the depositors, are there money going to be safe? No, safety and soundness means is the institution going to remain in business and if it doesn't remain in business, it fails. Is it going to take any money out of the insurance fund? Well, concentration, risk is one of those items that is always, always, always on the radar screen of examiners. And they're afraid, of course, that, that somebody is going to get into an area, uh, over commitment. And then because of all the other factors that are going on in a rapidly evolving marketplace, we could, we could add in, you know, borrower preferences, we could add in real estate values, we could add in, uh, technology, we could add in, you know, uh, you know, the near banks and fintechs and all of those. Um, but examiners are absolutely going, uh, to be looking at this. Uh, m. Several of them have already issued guidance on it. Um, again, the, the modification or workout guidance that was put out by all the regulators on commercial real estate I think is just the, I think it's just the beginning. So this is an issue and it's not new news that every institution needs to be able to tell its story effectively.

Speaker B: Yeah.

Speaker A: And if it has a larger, uh, concentration in a particular area, it needs to be able to show that it understands the dynamics of that area. So it understands how commercial real estate works. It understands the moving parts. It understands the local moving parts. Right. Because the marketplace in Reno, uh, Nevada is not the marketplace in Boston. It's not the marketplace in Roslyn, Virginia. It's not the marketplace in Miami or Dallas. You have to understand all of those individual components.

Speaker B: Yeah.

Speaker A: Um, and I, I think a lot about Silicon Valley bank and, and the various other larger, uh, institutions that have failed, uh, you know, over the last, uh, year or so. And the examiners, regulators generally are, are still sorting through the lessons that they should have learned, uh, before sbb, uh, failed. And, and one of those is when you see these emerging risks on the balance sheet, uh, in their case, of course, it was, it was liquidity. But when you see that, um, you know, you have to ask immediately or early in the process, all right, tell me how you see this going. What are your predictions, you know, what are your shock testing parameters and what happens if this goes, um, if this goes down? I mean, you know, a rough, uh, metaphor is it's a little bit like the, you know, residential real estate right now. I mean, I have a lot of clients that are looking to say, all right, well you know, if we try to bring on this book of business, uh, you know, new construction, let's say, or you know, other types of product, you know, at the current interest rate, you know, whatever it is, let's just pick seven and a half. What happens if we put a lot of money out there right now? Right, because we've had a lot of tightening of standards, especially in commercial real estate. But again the rough metaphor is so in like consumer um, you know, real estate, somebody puts all that money out there and then you know what happens when interest rates come down, uh, you know, 100 basis points? Well, well, we know what's going to happen. I mean there's going to be, there's going to be refi. They're going to, they're going to lose that business. Is it really worth it, you know, getting into that right now? And if they do get into it, you know, what is, what is the um, equation for how they maintain that loan? You know, maybe a one time interest rate reduction or whatever it is. And we've seen that very, very regularly. But we have a lot, we have a number of newer players in commercial real estate who may not have experienced uh, this type of market before.

Speaker B: That's true, that's true. And you know, I know a common practice that I've seen is where you know, uh, the financial institution will put on, oh, they'll do an amortization, say 15 years and they'll put in three year resets or five year resets. And you know, when interest rates were sitting at. Yeah. Where they have been for so many years. Yeah, that was all great and fine and dandy. But now you're looking at those resets happening. What's going to happen to these borrowers that have, you know they were, they were, they had a rate for, fixed for three or four years or five years at three and a half percent and suddenly they're looking at a readjustment to eight at renewal. What's going to happen to them?

Speaker A: Yeah, that's exactly right. And you know, and we don't know. So I think that's why the uh, that initial workout guidance uh, for CRE was, was put out there. But yeah, you know this is, it is almost, you know, the perfect storm on the horizon. Um, I mean, so you know, you have uh, like let's look at office space. You know, even with the movement of maybe the federal government, uh, trying to get their people back in live, um, many larger private companies talking about at least a hybrid work, uh, environment that has come in a little bit. Uh, and then you can stay at home. Um, you know, we're, we're looking at uh, much, much, much different, uh, you know, use requirements and you have uh, a lot of leases that when they've come up, uh, people have decided, okay, we're not going to get space. Well, my daughter's company is a great example. About 300 employees in Northern Virginia.

Speaker B: Okay.

Speaker A: And uh, they just so, uh, you know, timing being what it is, uh, in 20, I guess 20, um, their lease was coming up for um, renewal and they had had a 10 year lease prior to that. They were in active negotiations and lo and behold, you know what happens. March of 2020, Covid hits and so everybody goes home. And of course this is a, you know, this is one of those, it's like a hundred year flood, right? Yeah, yeah. Uh, you know, it's one of those once in a lifetime kind of events. Everybody knows where they were when the states of emergencies were put in, but suddenly they're in the driver's seat because now by the terms of their, of uh, their commercial lease, they're month to month, which they're kind of happy with. But you know, they know that they only have like six months to be able to do that and they have to make a decision. So they have everybody home and so what do they do? Uh, they go to outside advice. Next uh, thing, you know, they come up with this hoteling concept that listen, we're going to allow you to work hybrid for an extended period of time and whatever contracts you have to come in and work on, we'll let you work on. She's a data analytics. And so what they did is they um, halved. They reduced by 50% their floor space.

Speaker B: Wow.

Speaker A: And instead of going for a ten year lease, um, they kind of saw what was happening in the environment. They went for a five year lease.

Speaker B: Nice.

Speaker A: Uh, and the savings on both square, uh, footage, um, even cams and, and certain other things. Now granted, this is lease environment. Somebody had to fund that property, um, was incredibly dramatic and we're seeing that over and over again. Um, you know, COSTAR is showing that the statistics on the average square footage, um, for um, you know, office lease has declined by, by almost 25% when compared to pre pandemic. And so we, we are seeing so many different changes out there, uh, that you know, we hope there's some stability coming back to the marketplace. Right. I, I, I say sometimes that you know, some, some innovation happens, um, because of um, you know, inspiration.

Speaker B: Yeah.

Speaker A: But, but some of it, maybe even the better type, happens because of desperation.

Speaker B: Yes.

Speaker A: And so we're seeing this market reevaluate itself, figure things out. Some properties are going into different uses. Many, many commercial real estate lenders have kind of backed up saying, okay, we're going to figure what, what's going on and, and that may allow the marketplace to reset as we move into 2024.

Speaker B: Yeah, yeah, no, that makes sense. What for the folks listening on the podcast, uh, what other factors related. I know we kind of talked a little bit about how the signature bank and the Silicon Valley bank failures, uh, reflected some of this and I know you talk about that in your webinar too, the new policy statement on CRE accommodations and workouts that you did recently for us and you did talk about, you brought up the Silicon Valley and signature bank failures and with that, um, with what could potentially happen to institutions that are heavily reliant on commercial real estate lending. Um, can you explain, just kind of explain that connection for me real quick?

Speaker A: Sure. Well, I mean, first of all, let's remember, anytime there's an institution failure, the regulator is going to come in and do their version of an after action report. The name varies across each of the regulator, but the bottom line is they're going to look and say, okay, what happened? And it's typically a combination what happened within the institution, what happened within the examination, what happened within the regulations, what happened within the marketplace. And uh, they, they kind of do what, you know, that retro analysis. What should we have done?

Speaker B: Yeah.

Speaker A: So again in Silicon Valley bank, now that they're kind of unpacking everything that they, they see that a number of different analysts, uh, even investors and things like that knew, well before that, you know, that Black Friday of failure, that there were issues, that their liquidity stance was down, that they had gone long on the treasuries, uh, that there were some, ah, some pretty significant uh, balance sheet issues. Uh, and yet nobody acted until suddenly they sold those, uh, sold those securities, took that $2 billion loss and then over the course of 24 hours, uh, they had 42, um, I want to say $42 billion worth of money. Yeah, uh, leave the institution. That is liquidity. That just walked out. No stops, no nothing. It was out there. And then of course they're, they're on the rocks at that point. And that's even blinking, you know, the issue that 95 of their uh, uh, dollars on deposit were unsecured, you know. Uninsured. Uninsured, yeah, yeah, because of the uh, you know, the fdica, um, you know, coverage limitations.

Speaker B: Yeah.

Speaker A: So, uh, whenever that happens, everybody looks. And now suddenly the standards are kind of tightened a little bit. Nobody wants to have their name or their, uh, agency attached to a failure like this. I mean, even now you look at, you know, you look at the regulators in California look, you look at the fdic, you look at the uh, Federal Reserve, the, and there's a lot of subtle, and in some cases not so subtle finger pointing. You should have done this, you should have done that. Uh, so they are definitely looking at this tighter. They're looking at the coordination between the board, uh, with its risk appetite and policies, the management team, its communication with the board, uh, and then how people are, um, testing things again. You just go back to that basic shot, testing 101. Right. You know, I remember what Warren Buffett said, you know, years and years ago, and somebody was asking him a question in some town meeting or something, and they said, well, you know, what is your opinion on shock testing? And this was, I think maybe after, um, the mortgage backed securities failure, um, in 08. And well, shock testing, he goes, I want to find out what voltage kills the patient. And I want to test just below that. Just below that.

Speaker B: I like it, I like it. Sounds like, sounds like good wisdom from Warren Buffett.

Speaker A: Oh, yeah.

Speaker B: So what other factors, uh, should our listeners be watching out for in managing the risk in their commercial real estate portfolios as we kind of wrap up today?

Speaker A: Well, again, I mean, uh, Tip o' Neill said years and years ago, the, the former speaker of the House, uh, Congressman in Massachusetts, a little piece of trivia. He took, he took over John F. Kennedy, Kennedy's congressional seat when John, uh, Kennedy became a senator. So he'd been around for a while and he, he created this phrase that said all politics is local. Right. Meaning. Yeah, people are looking at national events, they're looking at national security and, and, and the economy nationally. But at the end of the day, people want to know what's going on in their area. So that's the first thing that I would say. What's going on in your area? Um, you know, and right now, you know, we, we have, um, there's a little bit of uncertainty on the supply and demand side. I mean, you know, what's, what's going to happen with these different properties? I mean, is retail space going to be converted to suddenly, um, you know, specialized medical space or data storage space, our office buildings going to be converted, uh, to residential buildings? I mean, remember we have that odd dichotomy where there's you know, in many m markets there, there's a glut of office space, uh, but no residential space.

Speaker B: Yeah.

Speaker A: So, so they need to understand about that. They also need to remember, um, for every one of the um, commercial real estate deals that they have, you know, how are those being funded? I mean are, are there tenants? Are there, you know, is it owner occupied? What, what type of, you know, um, uh, property is it again, multi, family, uh, you know, office, hotel or whatever? Because every one of those has a different set of, of control, uh, factors. And what is the impact of interest rate on all those? Right. I mean, you know, if you have interest rate, uh, you know, coming uh, due, um, you know, adjustable rates are uh, you know, like you said, the three year, the five year, uh, you know, loan outs, um, what's that going to look like when suddenly that person goes from you know, 2 or 3% to suddenly 8%. I mean that's a, that's a huge, huge, huge, huge deal. And I mean, let me just tell you just almost by analogy, um, I have a dear friend of mine who does uh, all uh, it's consumer real estate. And uh, the biggest issue that he is facing right now and just you got to think about this, you know, and just think about how far this goes. One of the biggest issues that they have that his firm is counseling on is the fact that many financial institutions have lost their expertise in adjustable rate loans.

Speaker B: Huh.

Speaker A: Because when things were near zero, but when you can get a loan for you know, 2, 3%, why possibly do an adjustable rate? I mean obviously liquidity, cash flow, things like that. But they were putting on more and more and more and more paper at just uh, at fixed rates. And so they lost that expertise. So now, now that those are coming back in again to allow these deals to happen, right, to put out the three, the five year bump, whatever it is, the ten year bump, in some case they're having to regain all of that expertise. And, and we are seeing that uh, in the um, in the accommodations and workouts for commercial real estate. So, so they need to understand, um, you know, all of that. The last thing that I would point out, and this is one of those things that is so locality specific, is um, we've had so many, can remember so many different factors here. We've had so many different lenders that have kind of pulled back and we have a lot of this commercial real estate that's just not moving for any number of reasons. People are trying to figure out, all right, Are we going to tear down this mall and just, you know, sell the land, you know, get it rezoned and sell it for whatever? Are we going to turn it into a casino? Are we going to turn it into medical space? Are we going to turn it into assisted living? I mean, I've seen all different kinds of, uh, transformations, but because we've had so few of these transactions in certain areas, you know, the ability to figure out, um, you know, comparative pricing on this property, um, is difficult. Um, the final thing, and I think you kind of mentioned it before, just make sure. And this kind of goes into what we talked about in the webinar in the new policy statement on, uh, CRE accommodations and workouts. Just make sure that the board is, um, involved. It understands the risk. We understand that commercial, uh, loans need to be presented in a little bit of a different way to our boards. Make sure they understand the risk, make sure that they are, are regularly, uh, in the loop with regard to what's happening in the marketplace and what's happening, uh, with the particular institution's portfolio.

Speaker B: Yeah, yeah, that makes sense. Well, thank you, David. I appreciate you spending the time with us today, um, and to our listeners. If you enjoyed today's podcast, please check out David's webinar titled New Policy Statement on CRE Accommodations and Workouts. Podcast listeners can enter the coupon code policy10. That's P O L I C Y10 at ah, checkout for 10% off your webinar purchase. More details can be found in the episode notes. You can also find links to check out other webinars by David read and our LinkedIn, Facebook, Twitter and blog. Before I close the podcast, I would like to thank our credit union League partners, David Reed of Reed and Jolly, pllc, and you, the listener. Until next time, thank you.