As the ball drops this New Year’s Eve, we’re all ready to leave a challenging year behind. But in commercial real estate lending, the road is likely to get bumpier before things settle back to “normal.”

Following the onset of the pandemic, the bottom fell out of U.S. gross domestic product by a record 31.4% in the second quarter, before rebounding just as quickly with 33.1% growth in Q3. Despite this volatility, CBRE economists predict GDP will end the year down by just 4.0%, and rebound strongly in 2021 with annual growth of 4.25%[i].

Much of that growth will be generated after vaccines become widely available in the first half of the year, with expected growth of 5.5% in Q2 and 5.6% in Q3. But real estate will lag the overall economy, especially in those industry sectors most severely impacted by the crisis.

For now, the devastating economic effects of coronavirus along with federal and state moratoriums on evictions have combined to place immense pressure on U.S. commercial real estate holdings. According to a survey of commercial property owners by Deloitte, 36% of North American respondents expect rental collections to decline by more than 20% in the next year[ii].

The short-term impact will be a sharp rise in delinquencies, which is already occurring. Commercial mortgage-backed securities maintained a delinquency rate above 9% in August 2020, following a record high of 10.3% in June[iii].

Bright spots on the horizon:

The rise in delinquency has been led by those industry sectors most impacted by the early lockdowns and travel restrictions caused by the coronavirus, including retail, office space and hotels. Lenders should reduce their portfolio concentrations in these sectors through 2021.

But there are some silver linings amongst the broader CRE landscape. These include loans against properties within the industrial and logistics sector, particularly life sciences, warehouse and distribution, cold storage and data centers. These sectors have overperformed and in some cases thrived during the pandemic as the eCommerce and healthcare industries have expanded to meet strong demand during these unprecedented times[iv].

Location, location, location:

While CRE located in major urban centers with a high reliance on mass transit like San Francisco and New York will continue to suffer in the short term, some secondary and tertiary geographic markets are expected to recover more quickly in 2021. These include mid-sized southeastern cities like Raleigh-Durham, Nashville, Tampa, and Charlotte. The common denominator is rising demand, lower costs, a business-friendly environment, and continued strong employment growth[v].

Larger markets like Dallas-Fort Worth and Phoenix will also rebound, along with urban cores with a high concentration of tech industry, such as San Jose, Austin, Seattle, and Boston. One cautionary note: these tech center hubs first need to absorb an oversupply of new office space developed in recent years before they can fully experience a comeback.

Managing CRE portfolio risk during uncertain times:

With the CRE lending market in serious flux, it’s important for lenders to place renewed attention on their risk management and mitigation strategies. Ensure these 5 core areas are in tip-top shape before your next safety and soundness exam:

1. Double down on credit risk management: In June 2020, during the heart of the pandemic, banking regulators released new Interagency Guidance on Credit Risk Review Systems. Lenders are taking the hint, and 78% of domestic banks have tightened their CRE lending standards[vi]. According to the Guidance, all lenders should have a written Credit Risk Review Policy that is regularly reviewed and re-approved by their Board. In addition, banks should designate an independent, internal Credit Risk Review Team, responsible for designing a risk rating framework capable of identifying and managing troubled loans and ensuring proper workout procedures are in place.
2. Keep your financials fresh: Business conditions that looked strong at the end of 2019 most likely deteriorated in the second quarter. For that reason, obtaining interim financials from your borrowers is especially critical this year. Make sure you ask your property owners for updated financial information before granting any new credit or renewing existing lines.
3. Revise collateral values: According to a survey of CRE investors by Duff & Phelps, 70% of respondents expect CRE valuations to fall by more than 5% in 2020, with 31% expecting a decline of greater than 10%[vii]. It is always a good idea to reevaluate real estate collateral periodically to account for changes in property and economic conditions, but it’s never been more important than this year.
4. Accelerate your annual review timeline: Likewise, lenders should establish a regular cycle for periodic credit reviews. Although regulations allow for significant leeway in how lenders schedule their periodic reviews, a comprehensive credit reevaluation, including property site visits and financial reviews on an annual basis is considered best practice, and examiners are now focusing more on this in their safety and soundness exams.
5. Concentrate on portfolio risks: Lastly, we recommend that our clients take a birds-eye view of their overall portfolio to identify areas of over-concentration. Given the current climate, it’s important to look closely at concentrations in high-risk industries like hotels, shopping malls, and brick and mortar retail, along with office space in high-density locations. Consider ways to reduce your exposure through participations, loan covenants, and revised lending policies.

Risk management in CRE lending is a critical exercise even in the best of times, but it takes on greater urgency during periods of economic turmoil. Given the year we’ve just had, focus your energies on shoring up your risk management processes, in order to ensure you have a successful and prosperous 2021!

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[i] “2021 U.S. Real Estate Market Outlook,” CBRE. https://www.cbre.us/research-and-reports/US-Real-Estate-Market-Outlook-2021

[ii] “2021 Commercial Real Estate Outlook,” Deloitte, December 3, 2020. https://www2.deloitte.com/us/en/insights/industry/financial-services/commercial-real-estate-outlook.html

[iii] “2021 Commercial Real Estate Outlook,” Deloitte, December 3, 2020. https://www2.deloitte.com/us/en/insights/industry/financial-services/commercial-real-estate-outlook.html

[iv] “2021 U.S. Real Estate Market Outlook,” CBRE. https://www.cbre.us/research-and-reports/US-Real-Estate-Market-Outlook-2021

[v] “2021 U.S. Real Estate Market Outlook,” CBRE. https://www.cbre.us/research-and-reports/US-Real-Estate-Market-Outlook-2021

[vi] “2021 Commercial Real Estate Outlook,” Deloitte, December 3, 2020. https://www2.deloitte.com/us/en/insights/industry/financial-services/commercial-real-estate-outlook.html

[vii] https://realassets.ipe.com/news/commercial-real-estate-investors-predict-price-recovery-in-2021/10048407.article