Advice

Stress In Focus

Posted on June 14, 2023 Published by

In our May blog, we looked at the critical need for community banks and credit unions to evaluate their commercial loan portfolio. We do this by using a process called “stress testing.” This month, we look a little closer at a couple of commercial real estate market segments that may deserve some special attention with Stress In Focus: the multifamily segment and office segment.

Commercial Real Estate

The multifamily market has benefitted from some positive trends in the past several years. But it is not immune to some headwinds that will pose challenges to investors, developers, and tenants. Overall construction costs can put pressure on developers, impacting project feasibility and profitability. Increased construction costs lead to higher rental rates which, in turn, impacts affordability for tenants. Fannie Mae’s latest job forecast is for a 1.1% decrease in jobs (approximately 2 million) over the next year. Recession concerns and reduced available cash flow due to inflation and higher interest rates have negatively impacted tenants. Pandemic-era tenant protections, such as eviction moratoriums and rent freezes, are disappearing.

However, skyrocketing house prices and a doubling of mortgage interest rates are making first-time home buying unaffordable. It is, thereby, propping up demand for multifamily properties. That said, the national average vacancy rate as of December 2022 was 6.1%, up 1.2% year over year. Vacancies are expected to continue to increase during 2023, albeit at a slower pace, to approximately 6.25%. An increase in rent concessions is projected during the first half of 2023. This is due to a large number of in-process projects come on the market over the next 12 to 18 months.

Pandemic Effects

The office market segment was particularly hard-hit during the pandemic. The average nationwide vacancy level is at 18.6%, up 5.9% from the last quarter of 2019, according to Cushman and Wakefield commercial real estate services. While there has been some level of recovery as employees head back to the office, the adoption of a hybrid work arrangement with home/office balance has impacted not only the amount of space required by employers, but also the type of space as tenants demand more amenities and additional technology support.

The pandemic also created a deep divide between the prime and secondary office building segments. Prime buildings have been less impacted by the reductions. Whereas secondary tenants in older buildings look to shed unused or under-utilized space. This is driving vacancies higher until this inventory is either removed through demolition or converted. Further, high vacancies and higher construction costs are likely to keep developers and construction lenders on the sidelines in the near term.

In each of the above industry categories, several factors come into play for a robust “stress test” of a particular project or borrower. Each institution should look forward 12 to 24 months at what projects will be coming due for renewal. The project can then be stressed under different scenarios of interest rates, vacancy levels, rents, and expenses. Lenders and credit personnel should conduct a breakeven analysis for each of the above factors and compare them to existing market conditions. Each of the breakeven cash flow calculations can then be analyzed individually or collectively to assess the project risk.

Stress In Focus

Every institution needs to remain very “clear-eyed” about its market demographics in terms of assumptions for improved employment levels and/or wage increases to absorb the impacts of inflation on personal cash flow while simultaneously supporting higher rents. It would also be prudent to compare the breakeven results to assumptions included in the most recent appraisal. Significant variations to the underlying appraisal would argue strongly for obtaining a new appraisal. Further, cap rates have risen 0.75% to 1.0% over the last year. This will impact the collateral side of the risk analysis as well.

If all this “stressing” is stressing you out, the team at Enlighten Financial can help through identification of higher risk industries or individual borrowers and conducting necessary portfolio analysis. Keep Stress In Focus. Oh, what a relief it is!

 

Richard Rudolph is Senior Consultant at Enlighten Financial, a specialized consulting firm that focuses on loan review and risk management services to community banks and credit unions. Enlighten Financial has made it our business to shed light on the complex financial landscape. We lead clients in the right direction. We work with financial institutions and other providers to mitigate risk. To talk to Rick directly, please call: 920.445.8133.

Image by Mohamed Hassan from Pixabay.

Tags: ,

Comments are closed here.

“The staff at Enlighten have been available for questions, in addition to the engaged work that they do. They've been very helpful as a resource beyond the major audit.”
— Meghann Kasper, Chief Credit Officer, Bank First
“Enlighten gives us a very good second set of eyes on our transactions. They're not afraid to challenge us on some of the work that we've done, which is what is needed. I don't need to pay somebody to tell me I'm good, I need to pay somebody to tell me where I've made mistakes.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“Enlighten provided industry best practices that weren’t going to show up in an audit report. They would say, ‘Hey, I noticed you do this. This is really unique, you do a really great job of it.’ And then they might add, ‘Some other clients that I have are doing something like this.’”
— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors.”
— Bill Beardsley, President, Michigan Business Connection
“The staff at Enlighten have been available for questions, in addition to the engaged work that they do. They've been very helpful as a resource beyond the major audit.”
— Meghann Kasper, Chief Credit Officer, Bank First
“Enlighten gives us a very good second set of eyes on our transactions. They're not afraid to challenge us on some of the work that we've done, which is what is needed. I don't need to pay somebody to tell me I'm good, I need to pay somebody to tell me where I've made mistakes.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“Enlighten provided industry best practices that weren’t going to show up in an audit report. They would say, ‘Hey, I noticed you do this. This is really unique, you do a really great job of it.’ And then they might add, ‘Some other clients that I have are doing something like this.’”
— Bill Beardsley, President, Michigan Business Connection
“By questioning some of our methodologies, Enlighten has helped us say, ‘Okay, this is where we need to train staff better and focus on so that they understand what they're doing better.”
— Robert McPherson, VP of Risk Management, Peoples State Bank
“The organization of the communication — before, during, and after the reporting process — was certainly better with Enlighten than what I've experienced with a lot of auditors."
— Bill Beardsley, President, Michigan Business Connection