It's not exactly a bubble, but there are dark clouds on the horizon for commercial real estate. Commercial real estate (CRE) loans are under pressure, squeezed between two external forces brought on by the novel coronavirus pandemic: shutdowns and work-from-home (WFH) arrangements. And the long-term effects could strain bank portfolios as they work to provide “prudent accommodations” to struggling borrowers. Are we in the calm before the storm? 

Several sectors—most notably hospitality, retail, and food and beverage—are still reeling from forced closures and additional government ordinances and cleaning requirements designed to slow the spread of the virus. The initial hit to the hospitality sector was the immediate impact of the pandemic on transportation and business travel, according to Michael Wear, CRC, owner and principal of 39 Acres Corporation, which specializes in bankers education and consulting in the areas of credit risk and loan portfolio risk management. “The second punch came from local government ordinances prohibiting groups and requiring extra cleaning procedures.” According to data from the Bureau of Labor Statistics, about 4.8 million leisure and hospitality jobs have been lost since February, and the sector could lose over $120 billion this year—half its revenue. 

This spring, government-ordered lockdowns forced the global business world into the largest-ever WFH experiment, with (surprisingly, to some) positive results. “There likely will be a large shift in demand for office space in the future,” said Stanley Koopmans, senior vice president – commercial relationship manager at the State Bank of Cross Plains. Regarding WFH, “Many of my customers are saying they’ve not seen a decrease in productivity, and in some cases, they’ve seen an increase. They still want office space for those employees who want to come in, but they may not need as big of a building.” Allowing employees to work from home results in significant cost-savings for businesses, especially considering office redesigns to accommodate physical distancing requirements are more costly (more space per employee). Nationwide, demand for office space could drop by up to 15%, even after the pandemic is over. 

Despite ongoing COVID-19 challenges, the CRE situation doesn’t look dire... yet. “So far, there hasn’t been a huge impact,” Koopmans said, indicating while State Bank of Cross Plains has done deferrals, many customers haven’t needed them. Associated Bank, the largest bank headquartered in Wisconsin, had completed $638 million in commercial real estate deferrals as of June 30 but expects over 90% of corporate banking and small business deferrals to resume making payments. The true difficulty for bankers will be the severity of the pandemic’s future impact on consumers. 

Watch for ‘False Positives’

Government relief programs may be artificially postponing, not eliminating, fallout from the virus. Federal programs alone have poured over a trillion dollars into businesses through direct lending, guaranteed loans, grants, and tax breaks. “Because of all the stimulus that was put in place so fast, we haven’t seen as large of an impact as we could have,” said Koopmans. “For a lot of the multifamily businesses, they’ve not yet been affected significantly because of all the money that’s been going in, but it’s definitely something that may change going forward.” 

On top of business aid, individual consumers have received a financial bump via stimulus checks and/or increased unemployment benefits. “As those programs dry up, we’ll see a lot more outcomes where people can’t make mortgage payments or don’t get take-out as often,” Koopmans said, predicting more negative impacts this winter. Sustained record unemployment numbers are a big part of that. Wisconsin’s unemployment spiked from a record-low near 3% in late 2019 to 13% in April 2020 and remains high (8.5%). 

Continued high unemployment means lots of consumer buying power is removed from the market, which negatively impacts many of the same industries already hit hard by the virus. For example, community commercial properties (a.k.a. strip malls) are another type of CRE loan that banks should anticipate struggling, even if they’re performing now. “It takes a bit of time for the tenants to burn through their cash and capital before they are late with rent,” Wear explained, calling these properties “the next wave” in risk as discretionary spending drops off the longer the recession lasts. 

Batten Down the Hatches

Whether a storm is on the horizon or not, banks should invest time and energy in evaluating their current CRE portfolios and begin evaluating prospective clients more thoroughly. “In order to quantify risk, you first have to identify risk,” said Wear. He recommends reviewing clients’ liquidity and capital positions as well as debt structures. “For current loans, it all depends on the liquidity of your borrower and your guarantors,” he said. 

Some general best practices for weighing your portfolio’s risk: 

Review every loan

Banks, especially community banks, should assess their risk exposure loan by loan for the most accurate read on the situation. The pandemic’s impact on businesses has varied widely, according to Koopmans, so bankers should assess each loan’s performance on an individual basis. “Some restaurants in smaller communities have hardly skipped a beat because of an outpouring of support from their community,” he explained. “Restaurants that are chains or have drive-through service weren’t affected nearly as much, and some are even up year-over-year.” 

Stress test prospects 

While organic loan demand and expectations for business development fell off sharply during the height of the pandemic, the University of Wisconsin-Madison's Center for Research On the Wisconsin Economy (CROWE) found a strong rebound in early-stage business formation in the state through the end of June, reaching levels seen in prior years. Businesses are also resuming growth plans stalled this spring. “We’ve been surprisingly busy with new opportunities,” said Koopmans, explaining that low rates are enticing new projects and word-of-mouth referrals from PPP lending are bringing in additional business. “With PPP, there was an opportunity to help non-clients who couldn’t get a loan because their existing financer didn’t offer them, and now they’re moving their whole relationship to us. We quickly helped over 1,000 customers and non-customers, which generated a lot of positive buzz for State Bank of Cross Plains.” 

Price for relationships

To avoid adverse selection, Wear recommends stress testing prospects’ liquidity and capital access. “Use realistic assumptions about the projected depth and breadth of economic impact in their sector as well as the timing and slope of their industry sector recovery,” he advised. With interest rates at historic lows, using relationship-based pricing packages can help community banks compete. “It’s a bidding war,” said Wear. “Relationship-based pricing will hopefully help banks get the value of a total relationship as opposed to low-bid on a transaction.” 

The ongoing COVID-19 pandemic has—and will continue to—reshape the world in many ways, but disruption makes space for opportunity. Commercial lenders who are able to accurately assess their prospects’ and current clients’ needs will be able to forge new and deeper relationships between clients and the bank. As Wear put it: “Where there’s adversity, there’s opportunity.”