Why the Collapse of SVB Could Portend Distress for Commercial Real Estate

The collapse of Silicon Valley Bank (SVB) sent shockwaves through the economy this past week, raising concerns about a full-scale banking crisis. And while SVB was unique in certain ways, its struggles with liquidity in the face of duration mismatches and declining collateral and asset values is an issue that many other banks are likely facing, especially those that have heavy real estate exposure, which could mean trouble for the commercial real estate market in the coming months.

Credit Tightening and Higher Rates

At a basic level, the recent banking crisis will likely lead to tighter credit markets as liquidity concerns will only exacerbate the existing state of higher interest rates and increasingly stringent underwriting guidelines.  This additional tightening will likely further challenge projects that are already having a difficult time refinancing in an environment with higher-than-expected rates. But on closer examination, some of the same issues that caused SVB's liquidity crunch could cause distress for real estate-heavy banks too, which could upend the CRE market more than people might expect.

Delayed Effects of Pandemic-Era Accounting

The run on SVB happened in part because a substantial portion of its loans were made to startups, many of which are now struggling or winding down entirely due to the lack of venture funding. And while some of SVB’s woes may be attributed to higher-than-usual client liquidity needs and a general lack of proper risk management, many lenders with significant real estate holdings likely suffer from a similar maturity mismatch coupled with declining asset values. To understand why the issue is likely larger than most suspect, it’s important to recall what was happening just a few years ago: as the country was in lockdown many in the real estate industry, especially veterans that lived through the aftermath of 2008, were preparing for distressed assets to hit the market en masse - a phenomenon that didn’t really occur as banks mostly extended loans (with some conditions attached) hoping the assets would recover in due time.  And an important yet little-discussed factor in banks' willingness to play ball with these loan modifications, aside from good politics and legal hurdles to actually exercising remedies at the time, was that the Fed relaxed certain reserve and accounting rules for banks, essentially allowing them to hold bad loans without holding additional reserves on account of such loans.  And perhaps this made some sense at the time since printing money to be disbursed through the banking system only to then require banks to hold it all in reserve would be counterproductive.  But where does that leave us now?  Probably with a lot of these loans still on the books for these lenders at a time when conditions are deteriorating further and prominent office landlords are now defaulting on loans, all of which may be further compounded by the failure of the banks that issued letters of credit to many office tenants further hurting the credit profile of these assets.  And as people start taking a closer look under the hood at these banks in the aftermath of the SVB debacle, I wouldn’t be surprised if we start to see the delayed effects of these pandemic policies play out.  Whether the issues are severe enough to turn liquidity concerns into solvency concerns remains to be seen.  

So What For CRE?

For now, it’s not clear how things will play out and if the Fed’s latest measures will bring some stability back to the system.  But even if a banking crisis is averted, we could still see banks tighten and potentially sell lower-quality loans as they repair their balance sheets. This issue may even be exacerbated by the fact that the smaller banks that constitute a significant portion of real estate lending are particularly likely to be affected by these issues, creating further challenges for those looking to finance assets and potential opportunities for those looking to deploy rescue capital or acquire solid but over-levered assets. And for what it’s worth, I’m not the only one who thinks this could be an issue: the Fed published an article saying as much in 2021!