What Role Do Banks Play in Commercial Real Estate Investing?
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Commercial banks are some of the largest financial institutions in the country. They play a critical role in the economy by providing loans to buyers that generate interest for the bank so they can turn that money into more money.
Unfortunately, the crucial position commercial banks play in lending means that bank failures can cause major ripples in CRE markets. Due to several recent high-profile commercial bank failures, many CRE markets are in flux.
Let’s take a closer look at how commercial banks perform and how they can fail.
What Is a Commercial Bank?
A commercial bank is any bank that offers checking accounts, savings accounts, Certificates of Deposit (CDs), and loans to individuals and businesses. Most people in the US do their banking with a commercial bank.
Commercial banks can be distinguished from investment banks, where the latter mostly offer large institutions and major investors financial assistance.
Historically, commercial banks have had physical locations, but an increasing number of commercial banks operate entirely online. The lack of physical location reduces the costs of providing financial services.
How Do Banks Lend Money for Commercial Real Estate?
The main role that commercial banks play in the CRE sphere is providing developers and sponsors with loans for purchasing and developing commercial properties.
Banks use their customer deposits to loan funds to investors and businesses to buy property. As borrowers pay back these loans, the bank makes money on the interest they generate.
Banks generally “thank” their depositors for storing their money with them by paying them some interest as well. This is referred to as a bank account’s annual percentage yield, or APY. And while APY increases as the Federal Reserve hikes interest rates, it almost never outpaces the interest rates that banks charge on their loans.
Average Interest Rates on Savings Accounts & Commercial Mortgages
The average savings account interest rate is 0.29%, while commercial mortgage rates range between 5% and 18%, depending on the type of loan. Charging borrowers a higher interest rate than interest rates paid to depositors is a major way banks make money.
Banks also make money by securitizing commercial loans and selling pieces of them to investors who can profit from the interest. Banks can then take the capital from those investors and give out more commercial loans, repeating the process.
Why Are Banks Important for Commercial Real Estate?
Banks are important for the CRE sphere because they increase the amount of available capital and liquidity in real estate markets. When banks lend depositors funds, they create credit, which stimulates productivity and finances consumer spending.
This practice is called fractional reserve banking and is a widely used method for raising capital for investment projects in most developed countries.
The Risks of Commercial Lending
Commercial lending activity depends heavily on broader real estate conditions. Because the entire system relies on people paying loans with interest, widespread loan defaults can deplete a bank’s capital base.
As economic conditions get worse, depositors might pull funds out of banks, further decreasing available capital for lending. In the worst case scenario, banks won‘t have enough money to pay depositors back.
This potential for bank runs is one reason why most countries have central banks that regulate commercial bank reserve requirements.
These regulations require banks to retain a specific percentage of depositor funds, so they can repay depositors if there is a public rush to withdraw funds. Regulations exist to curtail risky lending behavior from banks.
The Role of Interest Rates
Interest rates play an important role in regulating bank lending behavior because they determine how likely banks are to issue loans. When interest rates are low, banks can offer a large number of loans with a decent interest spread. Also, low interest rates make it cheaper for borrowers to borrow money.
High interest rates, in contrast, can reduce bank lending behavior. When interest rates are high, it’s more expensive to borrow money, so banks issue fewer loans.
In the US, the Federal Reserve sets interest rates to stabilize the economy. One way the Federal Reserve can reduce overzealous lending behavior is by raising interest rates. However, rising interest rates can have other negative effects.
What Happens to Commercial Loans If the Bank Fails?
If a bank doesn’t have enough money to pay depositors, it becomes insolvent and can fail. In the US, the Federal Deposit Insurance Corporation (FDIC) insures depositors’ accounts up to $250,000. Regulating agencies then take over and sell the bank’s assets to cover any of its debts.
In the case of CRE loans, the most likely outcome is they are purchased by another lending institution. The lending institution now owns the existing debt and collects interest and principal payments. In other words, you will still have to pay your commercial loans even if the lending institution goes under.
History of CRE Lending and Bank Failures
The most recent spate of commercial bank failures is not the first time that overzealous lending activity has caused an economic crisis: During the 1980s, increased economic activity and deregulation of lending contributed to a massive boom in CRE lending activity. As the market shifted in the early 90s, many banks went belly up as their funds virtually evaporated overnight.
Similarly, deregulated lending activity was also a major cause of the 2008 recession. Lowered interest rates and relaxed lending policies allowed major lenders to issue loans and sell loans in the form of mortgage-backed securities.
As housing prices started to fall, banks found themselves stuck with trillions of dollars of bad securities. The ensuing government bailout was politically controversial but got the economy started again.
Commercial real estate prices also dramatically dropped during COVID as a result of decreased office demand due to business closures and the switch to remote work.
According to a report from Reuters, smaller regional banks in the US held about 33% of their assets in CRE at the end of 2022. Some experts believe that a combination of rising interest rates and falling office occupancies could lead to another recession in 2023.
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