Bank Contagion 1.0: Regional Banks' Struggles Threaten Commercial Real Estate Funding

The recent failures of regional banks have raised concerns about the commercial real estate (CRE) industry, as roughly 80% of commercial real estate lending in the US is provided by banks with assets of less than $250B. The fear of broader contagion is likely to curtail regional banks’ lending activity, which could leave a huge swath of CRE investors struggling to find the money.

The small and midsized banks are the backbone of the type of commercial real estate investing idealized by the industry. These banks are the major providers of lending to small businesses. Despite the aggressive interest rate hike campaign by the Federal Reserve last year, regional banks continued to make commercial real estate loans. However, the recent takeover of Silicon Valley Bank and Signature Bank by regulators, and First Republic Bank needing emergency cash infusions to stay solvent, has caused fear of a continued deterioration of confidence.

The Federal Reserve, the Federal Deposit Insurance Corp., and the U.S. Treasury Department have moved swiftly to try to shore up confidence in these institutions. However, regional banks could potentially face a devastating effect if depositors decide to move their funds to stronger players, reducing liquidity and available funds from these small and regional banks for lending to customers. This would mean less liquidity in the market, pushing commercial real estate values, already being called into question because of higher interest rates, further downward.

Banks are also grappling with $270B in commercial mortgages scheduled to mature this year, the highest number on record. Many borrowers will have a tougher time paying those off with interest rates far higher now than most were at the time of their initial underwriting.

To free up their balance sheets of CRE debt, some regional banks may turn to the securitized market. Regional banks could potentially sell their existing mortgages to investment banks, which in turn would bundle them and sell to investors in the CMBS market. This would allow regional banks to free up financial capacity to make new loans at today’s higher rates. However, many regional banks are likely to be out of the lending picture for the next year. If regulators fail to stem the panic, it could be even longer.