A commercial real estate apocalypse?! Part 4: CRE loan portfolios

AUTHOR’S NOTE: I presented a speech on this topic in early December 2019, before COVID-19 was part of our daily news. Now, with the introduction of COVID-19 and everything it introduced into our world (such as social distancing and shuttered bars and restaurants), the long-term outlook for most commercial sectors turned from questionable to bleak. This series presents a likely scenario for commercial real estate, as well as actions you should take to prepare your credit union.

In the last several parts of this series, we discussed the possibility of a commercial real estate apocalypse.  The CRE apocalypse is predicated on past and future impacts from Amazon, big money, 5G and artificial intelligence, and changing consumer habits (including the current pandemic).  I prognosticated that certain CRE sectors might crash in the next 5-7 years.

Susceptible CRE sectors 

CRE sectors that are most susceptible to an apocalypse: 

• Retail  
• Restaurants
• Single-use facilities (think gas stations, bowling alleys, etc)

Retail will continue a shift to online, causing retail structures to continue to drop in value. Restaurant lending has always been risky, and delivery options and changing consumer habits have eaten into the margin that existed (or actually often didn’t exist) for restaurants. And single use facilities, which were already risky, will remain so. Many face tech disruptions. Consider, for example, the convenience store/gas station: electric cars will continue to proliferate, eating at volumes (and, by extension, margins). 

Businesses and properties in these sectors were struggling before the pandemic, and the pandemic shut down just pushed them over the edge.  

Addressing Existing Exposure to Threatened CRE Sectors

If you’re looking for a tool to identify high-risk businesses, you should review the NAICS High-Risk codes which include the sectors noted above. If you are exposed to loans supporting properties and/or businesses in these sectors, there are a number of actions you should take:

• Increase internal scrutiny – Increase the frequency and intensity of your internal reviews for high risk loans over a certain amount, moving reviews to no less than semi-annual.  This will allow you to more quickly spot trouble.  The intensity of your review should increase as well.  
• Assess property valuations – Consider obtaining a BPO (Broker Price Opinion, aka Broker Opinion of Value). The information you gain will help you determine your exposure 
• Site visits – A site visit should be part of every internal loan review. A site visit provides you the opportunity to examine the property’s condition, evaluate customer traffic, and visit with the member-borrower
• Increase external reviews – An external review by a person or firm with a fresh set of eyes can identify problems you may have overlooked. I’ve found that staff, because of familiarity with borrowers, can overlook borrowers and their condition  

You can also encourage your borrowers to take actions to improve their outlook (as well as yours).  While these may seem intuitive to us, we can’t assume borrowers have objectively assessed their situation and taken appropriate steps.

• Conserve working capital – Encourage borrowers to conserve working capital
• Explore other lending options – Encourage borrowers to explore other lending options, including other financial institutions, SBA loans, etc
• Negotiate with landlords – For borrowers leasing space, a frank conversation with their landlord could yield valuable concessions
• Unload properties and businesses – For the right business or property, now may be the best time to sell.  This could be especially true for businesses located in Opportunity Zones (OZs), which offer unique tax deferral/elimination opportunities for investors.  Unprecedented amounts of money are sitting on the sidelines, with investors interested in the tax benefits that OZs provide. Investments in OZs must be made by December 31, 2021, so the window is closing shortly
• Bite the bullet – In some cases, no amount of time or money is going to change the outcome. In those situations, you and your borrower may be in better shape over the long-term by moving quickly toward a sale or liquidation

Less Susceptible CRE sectors 

CRE sectors that are less susceptible to an apocalypse: 

• Multi-family
• Light industrial
• Warehousing

Considerations for Less Susceptible CRE Sectors

The CRE sectors listed above have a bright future, and each of these sectors will post strong results for the over the next 5-7 years.

Many credit unions have significant exposure to multi-family. While the outlook is favorable, we should continue to remain diversified. One subsector within multi-family for which the future is uncertain is the senior market. Many developers across the country have bet big on the senior market, with mixed results.  While developers stand to gain big with success, lenders stand to lose big with failure. I would recommend a “wait-and-see” posture while the senior housing market shakes out.

I foresee light manufacturing benefiting greatly as manufacturing jobs are moved from other countries to the U.S.  I believe the pandemic has highlighted the impact of having so many industries – particularly those impacting our health and safety – based outside the U.S.  I believe consumers will take a closer look at the “country of origin” for the products and services they consume. As well, I believe the government will provide favorable business conditions for “on-shoring” of manufacturing jobs. 

Warehousing has enjoyed a fantastic ride as online shopping and delivery has exploded.   I foresee that ride continuing for the foreseeable future.  

Conclusion to the Series

During this series, in addition to considerations for our CRE portfolios discussed in this article, we also discussed the neighborhoods in which our branches reside, and options for our branches as real estate.  The need for physical member service locations will continue to decline (but certainly not disappear completely).  Now is a great time to consider the physical assets impacting our credit union, whether our own branches as real estate or the assets supporting commercial loans to members.  CRE values for your branches and in susceptible industries are likely at their greatest value right now, so moving now to capture the value or minimize the downside is the most prudent thing to do.