Hawkish Fed deters regional banks from shedding CRE risks

The tightening stance of the Federal Reserve is narrowing opportunities for some US regional banks aiming to lessen their exposure to commercial real estate (CRE), according to insights from investors, analysts, and legal experts.

In response to the changing landscape post-pandemic, characterised by increased office vacancies and plummeting property valuations, banks, particularly smaller regional and community banks, have sought to reduce their substantial CRE exposure. However, the rise in US rates in recent years has left their fixed-rate loans mispriced compared to prevailing market rates, heightening default risks and potentially weakening their balance sheets.

Sam Graziano, Managing Director at Chatham Financial, highlighted the urgency for banks to shed this exposure to avoid losses and bolster liquidity. Since the onset of bank collapses last March, some regional lenders have offloaded billions of dollars of loans to private investors to mitigate risk and enhance liquidity. Additionally, some banks have opted to purchase insurance against potential losses on loan portfolios from investors to optimize capital allocation.

However, nine investors, analysts, and lawyers engaged in such transactions indicated a declining interest among investors to acquire CRE assets from banks. This shift follows a recent reversal in investor expectations regarding the Federal Reserve's monetary policy, with expectations for rate cuts being pushed further into the year.

The increased risk of defaults in segments of the CRE market, such as offices and multifamily homes, has deterred investors. Property valuations, particularly for office buildings, have plummeted by approximately 25-30 per cent from their 2019 peaks, exacerbating concerns surrounding maturing loans.

Investors voiced reluctance to engage with high-risk CRE portfolios, emphasizing the difficulty in modelling loss probabilities compared to consumer or corporate loans. Consequently, regional banks may face steep yields, reaching high double-digits, to secure insurance on CRE loans compared to single-digit yields on other loan categories.

Despite efforts by banks to execute trades to mitigate risks, challenges persist. Matt Bisanz, Partner of Mayer Brown’s financial services regulatory practice, revealed ongoing efforts to facilitate risk transfer trades on various asset classes, including performing CRE loan portfolios. However, the success of these endeavours remains uncertain and could potentially unsettle investors if executed at significant pricing discounts.

David Meneret, Founder and CIO of credit hedge fund Mill Hill Capital, cautioned that addressing CRE exposure challenges may be a prolonged process requiring years to resolve.

(With Reuters inputs)