Lenders Prepare for Increase in Bad Real Estate Loans

Commercial real estate lenders foresee an increasing number of bad loans in their portfolios, which could limit their ability to provide financing at a time when borrowers are already having trouble getting it.

Banks and commercial mortgage REITs have in recent quarters been adding to their best-faith estimates of future bad loans.

Blackstone Group’s commercial mortgage arm, for example, jacked up its estimate from about $125 million at the end of 2021 to $326 million last year. Bank OZK’s expected loan losses rose more than 25 percent during that time, from $289 million to $365 million.

Blackstone Mortgage Trust CEO Katie Keenan said on the company’s February earnings call that the uncollectible debt is expected to come primarily from the REIT’s office loans.

“Three of these loans are backed by office properties that are bearing the brunt of the post-Covid realignment in demand, most notably a significant reduction in government tenant office utilization,” she said. “Meanwhile, commodity office in cities that were already experiencing slowing growth prior to Covid is facing the sharpest headwinds.”

The bad-loan reserves — known as current expected credit losses — are required under a new rule from the Federal Reserve and other regulators to prevent some of the mistakes from the Great Financial Crisis.

Previously, banks were able to rely primarily on historical data to calculate the buffer they needed for future losses. But in the run-up to 2008, lenders had enjoyed a long period of relatively low losses. When the music stopped, they were unprepared to deal with the enormous quantity of bad debt on their books.

The Financial Accounting Standards Board and regulators like the Fed in 2016 changed the accounting standards, requiring lenders to do a more detailed, forward-looking analysis of expected losses. The new rules, which took effect in 2020, also expanded requirements beyond banks to non-bank lenders such as mortgage REITs.

Across the banking sector, these reserves are trending up toward levels seen during the height of the pandemic, when it seemed like there would be a tidal wave of bad debt.

Expected losses peaked at about $245 billion in late 2020, according to ratings agency Fitch. They came down until late 2021, when banks started bracing again against interest rate increases. The loan loss reserves stood at $195 billion at the end of last year.

“It is reasonable to assume loan loss reserves will increase,” Fitch credit ratings officer Julie Solar said in an email, citing the expectations for a recession.

For individual lenders, any increases this year in reserves may depend on how quickly — or slowly — they have already moved to anticipate losses.

TPG Real Estate Finance’s reserves ballooned from about $46 million in 2021 to nearly $215 million last year. CFO Bob Foley said in late February that the company’s reserves were “larger, sooner than some of our peers,” citing TPG’s outlook on loan-to-value ratios, interest rates, unemployment and other factors.

Of particular concern to the real estate industry is that the new accounting standards could make it more difficult to write new loans. Credit loss reserves reduce the capital a lender has on its books. That capital level determines how much lending a company can do.

Rob Gilman, co-head of the real estate group at the accounting firm Anchin, said that with the recent failure of Signature Bank and general shakiness in the lending markets, things are only going to get tougher for borrowers.

“If banks are taking reserves on real estate loans and now they’re going to have less to lend out, either you’re going to have more fees or higher rates,” he said.