Today’s post is written by Michael Green, Senior Commercial Loan Originator with Counsel Mortgage Group, LLC. Mike writes monthly on the commercial mortgage market. Check back each month for his commentary.
As the CRE market continues to retreat-pause-advance and repeat, driven by economic and political uncertainty, community banks and credit unions are recalibrating their lending strategies – often in subtle but significant ways. These smaller financial institutions are navigating the challenging CRE landscape in spite of rising refinancing risks and changing borrower behavior.
An encouraging trend among these lenders is their ability to renew or reprice many loans without much of a problem. These smaller lenders operate in different CRE markets than their large and mid-size counterparts, have different balance sheet allocations, and have different regulatory parameters than large banks. (Ref: Basel III Accords)
While much of the CRE sector historically focuses on the 10-year Treasury note or benchmarks like the federal funds rate or SOFR, smaller banks are paying closer attention to the 5-year point on the yield curve. This focus is tied to the common 3 to 5-year loan cycle … borrow, pay interest only, then refinance. This segment of the yield curve has exhibited more volatility than the 10-year, prompting banks to take a more cautious stance. To mitigate risks lenders are offering borrowers hedging devices. For instance, borrowers are allowed to choose between floating rates and locking in fixed terms through mechanisms like up-front fees, 30-day rate windows, or back-to-back swaps. (Other conditions may apply.)
Post-COVID, tighter underwriting has become the norm. Banks are seeing a notable uptick in loan modification requests, especially for financing originated in 2023 and 2024. This is in sharp contrast from the low-rate environment of 2020 to 2022, when many refinancings were based on the relatively stable 5-year Treasury yield hovering around 40 bps.
Improved margins have further reduced pressure to cut deals. Banks with CRE loans on the books done in a low-interest rate environment can improve their margins with currently higher rates. Loans issued during the height of the pandemic – in the 4% to 5% range – behave very differently from today’s loans which currently span from 7% to 9%. This disparity is influencing loan performance and prepayment behavior. Newer debt from 2023 and 2024 may have prepayment rates approaching 30%, including modifications. In contrast, loans from 2020 to 2022 are seeing only about 5% prepayment.
Perhaps most telling is a structural shift in the composition of CRE lending. Community banks and credit unions now hold a significantly larger share of CRE loans than they did pre-COVID. Yet most of the looming maturities are still concentrated among larger banks. As those institutions scale back their CRE exposure, smaller banks are stepping in. With debt maturities accelerating, community lenders are playing an increasingly larger role in supporting the sector.
Many of the smaller and mid-sized (regional) banks utilize SBA loans when the property and borrower qualify. The size of these loans is less “bulky” on the balance sheet, and tie up less reserves due to the insurability of the loan.
In this currently unstable environment, the CRE buyer/borrower has choices. Sorting out the details of an opportunity provides its own complexities. Considering a loan along with a CRE acquisition or re-financing adds to the mix.