Summer 2023

On June 29th, federal regulatory agencies released a Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts (Policy Statement). Many critics immediately derided the document as yet another excuse for regulators and regulated lending institutions (banks and credit unions) to “kick the can” and “extend and pretend” in the face of a widely predicted commercial real estate collapse. You can find the Policy Statement here.

Our view is a bit more nuanced, as the Policy Statement strikes us as reasonable or even prudent, if it’s applied in a reasonable and prudent way.  Accommodations as outlined in the Policy Statement will not prevent all losses stemming from a wave of commercial real estate distress but will provide some additional time for borrowers with a proven willingness and ability to recapitalize and/or turn around troubled properties. Lenders documenting a detailed understanding of their collateral position and borrower’s capacity will benefit from reduced regulatory scrutiny in the near term, and perhaps smaller losses and stronger asset quality in the long term.  The risk lies with lenders who, knowingly or unknowingly, use the guidance as a carte-blanche opportunity to avoid addressing loan quality issues that are better dealt with forthrightly. One also has to wonder about consistency of enforcement across multiple regulatory agencies. Will the differing regulatory bodies enforce the guidance in a consistent and reasonable manner, or will they overshoot in the wake of recent embarrassing bank failures?

The Policy Statement is not new. The document largely reiterated guidance first issued in 2009 at the depths of the Global Financial Crisis (GFC), with minor revisions related to accounting changes incorporated since 2009. Taken at face value, the policy guidelines strike us as reasonable, commonsensical even. If a creditworthy borrower has performed in accordance with the loan documents and the lender can document their willingness and ability to support the loan obligation as-is or modified/extended/restructured at market terms, why wouldn’t this be considered a reasonable solution? As much as we’d love to see every loan deemed a loan sale candidate, the simple fact is that “kicking the can” with strong borrowers that demonstrate a commitment to the collateral and loan is often the optimal long-term solution.

As is often the case, however, the devil is in the details.  The justification to modify a loan is only as solid as the data supporting it. Will lenders rely on stale appraisals with lagging comps and unjustified hypothetical assumptions? Will lenders scrutinize and adjust for higher cap rates, higher expenses (multifamily and senior housing) and high capital expenditures (office). How will higher cost and lower availability of primary market debt capital factor into hold periods? We’re not picking on appraisers here, their job is very difficult when sale transactions are down 50%-70%. However, appraised values are (very) lagging indicators and often unreliable when markets inflect directionally and/or asset classes undergo secular shifts in demand. Ask anyone that has liquidated malls how accurate their appraisals turned out when compared to ultimate sales value.

Will lenders have access to the appropriate guarantor information to make informed decisions? This includes recent documentation proving out liquid assets, global cash flow and details around contingent liabilities. The Policy Statement explicitly requires this level of detail; “they have always paid on time” is unlikely to satisfy regulators.  Sophisticated lenders with seasoned teams and robust data collection and analysis policies will have an advantage in this regard.

Will lenders rely upon deep pocketed institutional sponsors to support nonrecourse loans because of the relationship? While there are exceptions of course, most seasoned lenders realize that sophisticated institutional sponsors are economically rational actors and often the first to exercise the put option embedded within any nonrecourse loan agreement. The current sponsor knows better than anyone the collateral value and future prospects for the asset. One can be virtually assured that if the lender gets the keys (so to speak), the debt is impaired.

Also missed by most, but not all, is the very different monetary policy backdrop in the current environment versus CRE downturns over the past 30 years. Historically, CRE downturns are accompanied by overall recessionary conditions under which the Federal Reserve is cutting the Fed Funds Rate. This of course reduces short-term rates and all else equal, banks’ cost of capital. Today’s environment is the opposite, with the Fed in a hiking cycle, likely to last through 2023. Viewing the chart below, it’s very easy to see how lenders could provide interest rate relief to borrowers for many years following the GFC and still maintain an attractive spread to their marginal cost of capital. Today, this is not possible and, broadly speaking, most lenders need to increase the weighted average coupon in their portfolios, not decrease it.

Further complicating matters is that the Policy Statement implicitly requires that to avoid criticism, modifications be at “market” terms. Even if a 4% interest-only extension could be made to work economically, one would be hard pressed to convince an examiner that these terms are “market” with Fed Funds at 5%+.

The Policy Statement seems like reasonable and prudent guidance to well-informed lenders.  It will not, however, solve fundamental problems at the collateral level, nor does it provide a gateway to below market interest rate relief and/or any other out-of-market accommodations.   For borrowers willing and able to support impaired credits, and the lenders clearly evidencing such, the Policy Statement guidelines can provide needed flexibility for the borrowers and lenders to weather the storm. Alternatively, the Policy Statement guidelines create the risk that lenders misinterpret or misuse the guidelines, thereby delaying and increasing inevitable losses, and/or regulators do the same, creating an unnecessary capital and expense burden in an overzealous attempt to save face.

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