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Are CRE foreclosures on the horizon?

Nearly a year into the pandemic, big questions loom about the future of commercial real estate portfolios.

Namely, how much longer can banks offer deferrals on loans that have soured during the pandemic recession, are foreclosures inevitable, and how quickly could foreclosure rates rise if the spigot opens?

Bankers, who have struck a largely reassuring tone about their ability to manage the credit risk, are likely to face such questions starting Friday when JPMorgan Chase, Citigroup and other big banks begin to report fourth-quarter results. But they may wind up giving more nonanswers than answers because the economic outlook remains fuzzy at best.

The 2021 U.S. Real Estate Market Outlook compiled by CBRE Group predicts that “real estate conditions will start 2021 in a state of flux” as some sectors “grow strongly” while others will keep struggling. The lack of clarity on asset pricing won’t help, CBRE Global Chief Economist Richard Barkham said.

“Banks will forbear and forbear until they see the value of the underlying asset, and then they might foreclose because then they can crystalize their losses,” he said. “We think 2021 will be quite a strong year in economic growth … but as we turn the corner and price discovery [happens], I think you will see more banks foreclosing,” especially on hotel and retail loans.

Although commercial estate as a whole has held up better than expected since the pandemic upended the U.S. economy, the sector is becoming more distressed. The latest research from the Federal Reserve shows 1% of all commercial real estate loans were delinquent as of Sept. 30, up from 0.68% at the end of 2019.

To be sure, the latest percentage is comfortably below that of all real estate loans, where delinquencies were 1.92% at the end of the third quarter. But it’s the first time the rate for commercial real estate loans has hit the 1% mark in five years.

Bankers say they are closely and regularly monitoring their commercial loan portfolios. They’ve also had more latitude to offer deferral and forbearance programs under the Coronavirus Aid, Relief and Economic Security Act, and at the same time have built up massive reserves to cover losses.

Brian Foran, an analyst at Autonomous Research who covers regional banks, said the circumstances of the macro-environment make it nearly impossible for bankers to project how bad the portfolios might get and when. The nation’s coronavirus vaccine rollout is behind schedule, and the latest employment report showed that 140,000 jobs were lost in December, the first net decline in payroll since the spring.

“I think they’ll be optimistic from the standpoint of, ‘Look, we built a lot of reserves in 2020, so we have some cushion, but we still don’t know,’” Foran said when asked what bankers might say during calls on fourth-quarter results. “Unfortunately, there’s not a whole lot of clarity they’ll be able to give.”

At an industry conference in December, PNC Financial Services Group Chairman and CEO William Demchak said the Pittsburgh company’s criticized assets in real estate — “think about hotels, think about retail” — are “not getting better, they’re getting worse” while “office space is going to struggle” depending on its location. Meanwhile, multifamily loans “behaved pretty well,” but “massive drops in rent” in metro areas such as New York City and San Francisco will “have impact,” he said.

At the same conference, Darren King, chief financial officer at M&T Bank in Buffalo, N.Y., said a portion of the bank’s commercial real estate borrowers that requested forbearance have returned to regular payments. However, some CRE loans may end up being reclassified as troubled restructurings or nonaccrual, he said.

“We’re feeling positive with what we’re seeing, but also recognize we’ve got a ways to go yet,” King said.

This week Bharat Masrani, president and CEO of Toronto-Dominion Bank, which operates a $420 billion-asset U.S. subsidiary, was similarly upbeat during a separate industry conference. He said he expects TD’s commercial real estate exposures, which he said are mostly in major metropolitan areas in largely grade A-type properties, will be “manageable” over the long run.

“And we are well reserved should the situation turn out to be a lot different than what we are expecting,” he added.

Jennifer Demba, an analyst at Truist Securities, said bank management teams are telling her they don’t expect to incur “any real [commercial real estate] losses until the middle of 2021.” But continued hiccups in the vaccine rollout will put further strain on commercial real estate loans, she said.

“What’s the demand for the vaccine, how fast can it get rolled out, and how can the efficacy get better?” Demba said. “The stock market is pricing in the second half of the year for normalization. If [the rollout] doesn’t improve, it could be fourth quarter or 2022. I think that’s the biggest wild card, to be honest.”

As of Tuesday morning, 9.3 million people had received their first dose of the vaccine, according to the Centers for Disease Control and Prevention. The Trump administration, which aimed to vaccinate 20 million people by the end of 2020, shifted strategy Tuesday saying it would release all of the vaccines instead of holding some back for the required second dosage.

For now, banks are stuck in a credit “gray zone” of uncertainties, Foran said. Will people go back to the office or keep working at home? Will they want to return to in-store shopping? Will they go out to eat and stay in hotels and travel for business?

“Those are different versions of the same question: Has the pandemic been a temporary pause or a permanent change?” Foran said. “Those are the known unknowns for banks. Some things are going back to normal, and some things are permanently changed, and we could take an educated guess [at what’s going to happen in each area], but ultimately we won’t know until we get through this.”

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