David Paul Morris/Bloomberg
Nearly two years after concerns about the commercial real estate sector intensified, underwater CRE debt continues to threaten bank balance sheets.
But now, tariff policies are roiling the markets, and fears of a recession, or even so-called stagflation, are appearing more realistic. While not all CRE loans pose the same level of risk, experts predict banks will likely take more lumps in 2025.
Bankers and other industry participants have been hoping for nearly two years that the Federal Reserve would lower interest rates, which would make refinancing some of their troubled loans more manageable. While rate cuts started last fall, they now appear to have stalled.
Adam Mustafa, co-founder and CEO of advisory firm Invictus Group, said he’s more nervous about CRE loans than he was six months ago, due to what he sees as a higher risk of a recession or stagflation.
Matthew Bisanz, a banking lawyer at Mayer Brown, said CRE concern is a “slow-moving train,” and the Trump administration’s deregulatory regime isn’t mitigating any of the risk.
However, after banks spent much of the past two years working with borrowers to stave off foreclosure and building their own reserves, the industry may now be in a better position to swallow bad debt if and when it materializes.
Here’s a look at what banks are considering as they manage their CRE exposures this year.
Tale of two vintages
The commercial real estate debt that poses the most risk to banks is loans they originated before interest rates shot up, and on assets whose values have plunged, like many Class B and C office buildings. But many portfolios are starting to look more attractive to potential buyers, said John Toohig, head of whole loan trading at Raymond James.
“When you find the right deal and the right offering in the right location and the right sponsor, there are multiple bids and a very, very vibrant market,” Toohig said. “There’s still the divergence, though, of yesterday’s paper. Loans that were originated in ’21 or ’22 — those are still very challenged.”
Toohig said he thinks transaction activity will still be selective and gradual, but the conversation is being brought to the table for the first time in a long time.
When banks were dealing with deposit pressures from high rates and the valuations on real estate assets dropping off in 2022 and 2023, they pulled back on lending in the CRE sector.
In 2022, net new commercial real estate loans across U.S. banks grew by nearly $318 billion, according to an analysis of call report data by Invictus Group. In 2023, such loans increased by just under $70 billion. Last year, banks added only $1.8 billion in CRE loans.
CRE loans from early 2022 or before are a “double whammy” for banks, carrying more risk and weaker yields, Mustafa said.
The flip side, he said, is that loans made in 2023 and 2024 are proving to be the opposite — showing a lower risk profile, since they were structured for a higher-rate environment, and bringing stronger returns, because CRE valuations were down from their peaks at the time the loans were made.
But even though new CRE loans may be less problematic now than they were three years ago, many smaller banks don’t have the capacity to originate the debt, Mustafa said.
“There are certainly more banks today who are just capital-strapped, who can’t even make a CRE loan even if they wanted to, because they’re focused on working out problem loans or growing and preserving capital,” Mustafa said. “They’re playing defense, not offense.”
‘Middle innings’
Many banks have come up with solutions to ease pressure on borrowers, like prolonging the tenor of loans or working with sponsors to bring more equity to the table. The tactics — often tagged with epithets like “extend and pretend” or “delay and pray” — have been encouraged by regulators.
Toohig said it’s still too early to tell if extend-and-pretend strategies have rescued banks. Hopes for big rate cuts haven’t come, and many sponsors are out of equity to pump into maturing loans, he said.
“Is ’25 the year where sellers start to capitulate, call a loser a loser, and move on?” Toohig said.
But clearing the balance sheet and moving forward may not be detrimental. Lenders have used the time they’ve bought to build reserves, reduce their CRE loan concentrations, raise capital or pivot to other lines of business.
“You’re not seeing banks have to take huge defaults or huge repossessions, at least at the level where it trickles up to a regulatory concern,” Bisanz said. “That’s why I think it still is the middle innings.”
Some banks are also getting creative with CRE deals. Ryan Riel, chief real estate lending officer at Eagle Bancorp, said the Bethesda, Maryland-based company is working with existing CRE clients on loans that make sense.
Eagle, which has $11.1 billion of assets, is about to close on a loan to convert an office building near downtown Washington D.C. into apartments, he said.
Riel thinks distress in the office building sector, leading to foreclosures or other lender-led sales, will provide a reset for the properties. The movement of that inventory, primarily properties in the Washington, D.C., area, “will create an environment where redevelopment can occur,” he said.
Trump’s regulatory regime
While the Trump administration has generally made banking deregulation a priority, scrutiny of smaller and regional banks with large CRE loan portfolios hasn’t let up, Bisanz said.
Hundreds of banks, whose bread-and-butter is lending against real estate, have triggered a regulatory benchmark for scrutiny — CRE loans that make up more than 300% of risk-based capital.
Many banks, including Eagle, have made strategic shifts in the last couple of years to reduce their concentrations of CRE loans, especially after Wall Street punished companies that broke the 300% mark.
Bisanz said that the Trump administration’s efforts to cut staff at regulatory agencies, which are under review, could be negative for CRE-heavy banks. With fewer examiners, it may be more challenging for regulators to spend time analyzing the nuances of banks’ loan books, he said.
“Even I can calculate the 300% ratio for CRE, and I’m just a lawyer with spreadsheets,” Bisanz said. “Where I think it will be difficult is where you have a bank that says, ‘Look, I’d like you to look more closely at my book because it’s actually high quality.’ Or, ‘I’d like to talk with your supervisor, because I think you should let me expand my CRE activities.'”
Mustafa thinks it’s also possible that Trump-era regulators will be more willing to let banks fail, which could put more pressure on the management teams of banks with large CRE concentrations.
Eagle Bancorp’s Riel said that the focus on safety and soundness within CRE lending doesn’t seem to have changed. Nor does he think it should in the current environment.
“The regulators have done a good job of working with us and allowing us to work with our customers,” Riel said. “At the same time, there’s been a fundamental shift in valuations for office properties, specifically.”
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