Why are regulators looking at Commercial Real Estate (CRE) as acute problem and what should Banks do to reduce the $2.2 trillion delinquency?

-????????? Real time Analytics & Cloud Problem

Current State:

·?????? CRE includes office space, multi-family housing, rental properties, and retail space. Among all these subsectors, office real estate presents the biggest concern, with vacancies growing the fastest post pandemic.

·?????? $2.2 trillion loan payments are due by 2026.

·?????? However, there is huge difficulty in refinancing and potentially leading to delinquency with lower revenue generation from the property because of hybrid work, higher interest rates and sinking valuations. ?The national office vacancy rate reached an at all time high by Dec,23 at 19.6%. Previous high was 19.3% which was reached only twice in last 40 years.

·?????? As of Dec 2023, the noncurrent rate for CRE by banks with assets > $250 billion has increased to 4.11 % with 3X increase YoY from dec 2022 and 10% + increase QoQ from 3.72 % in Q3, 2023. The FDIC defines the data as “non-owner occupied, nonfarm nonresidential loan past due and nonaccrual rates.”

·?????? The amount of bad property debt is higher at big banks than their existing reserves against it. According to FDIC filings - “The average reserves at JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, Goldman Sachs and Morgan Stanley have fallen from $1.60 to 90 cents for every dollar of commercial real estate debt on which a borrower is at least 30 days late” which means they need to have adequate reserves to cover for losses should situation worsen.

·?????? Smaller Regional Banks and Community Banks have even higher exposure to CRE. Across all US Banks with assets > $100 billion, CRE is ~12.5% of total loan portfolio. For community banks (assets < $10 billion, CRE represents 38% of their loan portfolio).

·?????? For Banks with asset size < $20 billion, they hold more than 56% of CRE loans

·?????? NYCB (NewYork Community Bancorp) holds 57% CRE loan of total loans and reported a revised $2.7 billion loss in Q4 2023 leading to sharp decline in valuation from $10.8 billion to $2.6 billion. NYCB has got temporary relief with former Treasury Secretary Steven Mnuchin’s Liberty Strategic Capital agreement to invest more than $1 billion rebounding the stock from <$2 to >$4.

·?????? Every bank does not provide adequate information on exposure to Office Space. ?

FDIC recommendations & Best Practices:

Follow sound risk mgmt. practice with six key risk-management actions to reduce CRE concentration:

1.?????? Maintain Strong Capital Levels – Prepare for unexpected losses while contemplating for cash dividends.

2.?????? Ensure Appropriate “Allowance for Credit Loss (ACL)” – Analyze at least quarterly.

3.?????? Manage Construction & Development sector and CRE Loan Portfolios closely – Inbuilt Loan business observability & tools which provides management lens into the portfolio, what if scenarios for adverse scenarios.

4.?????? Maintain updated Financial & Analytical Information – Key is understanding borrower’s funding source, financial situation, ability to pay and provide timely trigger of adverse trends. ?Capture latest information on borrower financial statements, including property cash flow statements, rent rolls, guarantor personal statements, tax return data, and other income property performance information. Such institutions emphasize global financial analysis of obligors, including in relation to pending loan maturities and lease expirations, as well as the concentration of individual property owners, builders, or developers in a loan portfolio.

5.?????? Bolster the Loan Workout Infrastructure - Ready network of legal, appraisal, real estate brokerage, and property management professionals.

6.?????? Maintain Adequate Liquidity and Diverse Funding Sources – Maintain a stable and diverse range of funding mechanisms including establishing and testing access to the Federal Reserve Discount Window

Execution Capability & Best Practices – “Moving from Periodic or Quarterly to Real time Platforms.”

A.????? Real time Data Capture – Banks must have capability to capture real time data when published to capture all the information of obligor, property appraisals, concentration, and funding sources along with macro-economic signals (occupancy rates by geo etc.)

B.????? Capture all unstructured information – Capture payment & other terms from the contract documents, Capture information from footnotes of Obligor’s financial statements, Capture network of network through documentation.

C.?????? Risk Management Analytical Platforms – Ability to perform feature engineering leveraging both Classical AI and Gen AI using “Real time structured and unstructured data and their historical trends”, Network strengths with “what if” scenarios to identify the various actions & options for loan diversification, concentration risk with traceability to the data sources.

D.????? Risk Management Production Platforms – Integrated risk management platform with self service capability to risk managers to dial up & dial down the policies for loan decisioning and provide alternate offers for refinancing for distress customers.

E.?????? Experience, Feedback & Personalization – Maintain a balance with Customer’s experience and feedback loop method to capture customer provided information with consent management & privacy and establish personalized offers based on overall relationship and Long term Value.