Bank Regulators Urge Flexibility in Commercial Real-Estate Loan Workouts

Bank regulators are taking a page from their playbook of the 2008-09 financial crisis to help lenders weather the approaching tidal wave of troubled commercial real-estate loans.

In a new policy statement issued last month, the Federal Reserve, Federal Deposit Insurance Corp. and other regulators gave banks a road map of how to extend and restructure loans without necessarily having to take losses. The 90-page statement reiterates guidance already in place but also adds to it with a section about short-term workouts.

Much of the policy urges flexibility. For example, the policy states that in certain situations banks can modify loans without taking a loss even if the properties backing them are worth less than the debt.

Banks can work out loans in this way if borrowers have the willingness and ability to repay their debts, the policy states. Regulators are encouraging “financial institutions to work prudently with borrowers who are, or may be, unable to meet their contractual payment obligations during periods of financial stress,” says the policy statement.

The new guidelines, modeled on policy issued in 2009, have come out during a profound slump for owners of office buildings, malls, apartments, warehouses and other commercial property. Over $1 trillion worth of loans backed by these assets will come due this year and next year, according to data firm Trepp.

Many loans already have begun to run into trouble because they were made when interest rates were at historic lows. Refinancing them is difficult given the increase in interest rates last year and the tightening of lending standards at many banks.

“There’s a ton of commercial real estate that was not priced for the rate outlook we have going forward,” said Jade Rahmani, an analyst with Keefe, Bruyette & Woods.

Making matters worse, many office buildings, which make up one of the largest commercial-property sectors, are facing an existential crisis because of pandemic-era changes in the workplace. Demand for space and office values have cratered as many companies have allowed employees to work from home all or part of the time.

Rampant uncertainty has pushed commercial-property sales to their lowest level in years. Investors purchased only $130.5 billion worth of U.S. commercial property the first five months of 2023, a 61% decline from the same period last year, according to data released last week by MSCI Real Assets.

The banking industry spotlight turned to commercial property earlier this year after the failures of Silicon Valley Bank, Signature Bank and First Republic. Bad commercial-property debt had nothing to do with those collapses. But after they happened, investors and analysts began looking for other sources of strain on the banking system.

Commercial-property owners say that ever since the bank failures, regulators have been pressuring banks to reduce their commercial property exposure. “Since the failure of the regional banks, regulators have come on very hard,” said New York developer Scott Rechler.

Rechler and other industry executives praised the new bank policy issued last month. “This is a bridge to the other side,” said John Fish, chairman of the Real Estate Roundtable, an industry organization. “It’s what the real-estate industry was asking for.”

But others in the real-estate industry say they doubt the policy will have much impact given the size of the approaching wave of loan maturities. Also, some critics of the policy warn that it could prove to be a drag on the economy if banks wind up extending billions of dollars’ worth of doomed loans rather than dealing with the problem now.

“Basically, what you have is a decaying asset,” said David Shulman,

Bank regulators also were criticized in 2009 when they encouraged banks to be flexible in restructuring ailing commercial-property loans. Some called the policy “extend and pretend” and predicted bad results for the economy.

But that strategy worked. As the economy started to recover after the crisis, real-estate values rebounded, and many of the loans that were modified and extended were paid off in full.

Critics note that conditions today are much different from what they were in 2009. For starters, interest rates were much lower back then and were instrumental in the commercial-property boom after the crisis.

Also unemployment was much higher back then. As the economy started growing, tens of thousands office jobs were added, reducing office vacancy.

Today employment already is at a high level. And, even if jobs are added in future years, it might not make up for the high office vacancy due to new remote and hybrid workplace strategies.

“There’s such a substantial part of the office market that is antiquated,” said Joshua Zegen, co-founder of Madison Realty Capital, a real-estate private-equity firm.

In the current cycle, some owners of healthier office buildings have been able to modify and extend loans. In June, for example, developer Tishman Speyer said it had finalized a one-year extension of a $485 million loan backed by a Midtown Manhattan office tower that’s 97% occupied.

But distressed commercial property and defaults have begun mounting up at banks. For example, Wells Fargo earlier this month reported that it had increased its reserves set aside for potential commercial-property losses to $3.6 billion in the second quarter, up from $2.7 billion in the first quarter.

While the new bank-regulator guidelines urge flexibility, they also tell banks to take losses when loans likely won’t be repaid. A large appendix lists a range of hypothetical workout scenarios including some that involve examiners disagreeing with banks and instructing them to classify loans as unhealthy.

The policy notes that every situation is different and leaves it up to bank examiners to make on-the-ground decisions. The new guidance “does not set bright lines” by being “overly prescriptive,” the policy states.

Write to Peter Grant at [email protected]