Commercial Real Estate Lending Trends to Watch in 2023

Mitch Woods: Thanks for tuning into today's episode of Lending Made Easy. , today we're gonna have a great topic to discuss, , for all of the bankers out there, trends in commercial real estate, hot topic in banking right now, but actually a real special treat. On today's episode, we've got a guest with us, the one and only Mike Horrocks, a true sage of commercial lending here to share his knowledge with us.

So, Mike, welcome to the show. 

Mike Horrocks: Hey, Mitch. Thanks. Excited to be here. just a little bit about me for those who, don't know me. I've been with Baker Hill now for 21 years, and during that time I've ran everything from our professional services to our marketing, and now I head up the strategy around our product management. So, really excited to be on this call. And, even though I've been here for 21 years, I also came from banking where I started out with Zion's Bank and I was responsible for pricing and profitability initially. And then I did a term as a commercial lender where, we did everything from, doing the business development to the underwriting and financial analysis and taking it finally to loan committee. So lots of fun, great memories there with Zion's Bank. 

Bryan Peckinpaugh: Well, the market's changed a little bit since you were a, an active commercial lender Mike.

Mike Horrocks: Yeah, no, it has a little bit. Exactly. So yeah, the market's changed a bit.

Mitch Woods: Yeah. Well, that's a great segue though, for today's episode we're talking all about commercial real estate. So, Mike, let's just start it off, with the changing dynamics in CRE lending, what do you see as one of the biggest challenges for bankers in 2023?

Mike Horrocks: it's, it's interesting when you talk about commercial real estate and, what's happening in CRE I think we started to see some shifts, even probably after the, the Great Recession right back in 2008. but obviously the pandemic. Just put everything in, in change, right?

All of a sudden, properties and that had, massive office space and, and, that kind of focus, were abandoned basically. I mean, I remember coming into the office here during the pandemic and, it. . It seemed pretty light at times, right? When a lot of us were working remotely. I never worked remote. I have five kids. I wasn't staying home, man. This was my sanctuary, right?

But, when you look at that, and I think just overall, the entire industry's changed, but you have these buildings that are gonna last for you know 50 years, right? And have to adjust. And one thing I thought was really interesting is just even in our local market, there's a couple downtown, in Indianapolis, there's some, commercial real estate properties that were originally designed for, big tenants that would be going in there with, hundreds of employees and setting up cubicles, just everything that you'd expect in that classic CRE environment.

And they're now having to pivot and think about, Hey, I might have to turn this into. another C, but it's consumer real estate, right? I'm having to turn it into residential type property. and all of a sudden take that office space and turn it into a high-end loft. And that's how they're thinking about, having to repurpose and redesign that, that is not what those bankers that, originally did that construction loan or are, are, supporting that now, ever intended for that property to be. .

Bryan Peckinpaugh: Nor nor did the city. I mean, , that's, that's a, that's a piece of it too where, as, especially as these loans come up for maturity, Mike, that I, or even if I'm doing a, an annual review or maybe a distress review if I'm looking to modify it or, change the terms of the loan, I've gotta factor that into my traditional credit underwriting process, If it's, like you said, if it's shifting from one seat to another, if we're, if we're taking it from an office space to a, a residential space, is it gonna get zoning approval and what does that compare to, the other properties that are already there or being shifted?

And, it's a complete shift in, how you think about the credit quality of that, that property. it, it's gonna be interesting. I, I think I saw. There's about 12 billion in total CRE coming due in 2023. So there's gonna be a significant percentage of that that's gonna have to go through these types of,thought processes as they, as they shift.

You, brought up the pandemic. I think it's also interesting is that gonna, do you think that will see a, a potential boom in the construction side of things? Because as. you, you mentioned those potentially vacant, office buildings, but I think even for the new CRE coming on the books, people are gonna want new and different approaches to the buildings as that than they had before.

Will we see a shift to, to some new construction at at the same time? Maybe we see a slip in the traditional commercial.

Mike Horrocks: Yeah, I think, I think we're gonna see definitely a shift, right? I think you're gonna see, a shift and, and I think you're gonna see definitely more,CRE and residential and, retail. You're gonna see more hybrid properties out there. I think that's definitely something that you're gonna see, more and more.

I, I, I don't see a slowdown in construction. It seems crazy, right? there's a couple major projects. Every once in a while you hear about something where, they started doing the dig and then they stopped. But,I think when you start to look at a, smaller, more hybrid projects, I, I don't see a slowdown on that right now.

Bryan Peckinpaugh: Yeah. I think in some markets even look, seems to be speeding up.

Mike Horrocks: Yeah. No, exactly. I mean, yeah. Yeah. You go to Nashville, the construction crane is the city flower. And it's everywhere. It is. They, they have not slowed down one bit. when we go down to visit our clients there, it's, it, they're, they're cropping up everywhere. yeah. So, Mike, as we think about not just the, the underwriting of new but servicing of old, what kind of things do you think people should be thinking about as it relates to that, that credit quality?

What, what's gonna be top of mind as you see this shift to people moving to consumer? Obviously that's move away. rent rolls as an example to,totally different view of, of what's gonna repay the loan. I think about things like,strip mall type lending that may have relied on an anchor tenant.

And you said, Hey, I, as long as I keep these. Two to three major retailers as an example, I'll be okay. Or if office building these one or two, tenants in the office building, as we, as we see wholesale shifts as, retailers, shutter, as organizations go completely remote, what, what do you think's gonna be the, the most important from a credit quality perspective?

I mean, when I think about like just the traditional, strip mall, right? As you, as you drive around in your local neighborhood and you go to the, the strip mall and there may be, 10 tenants there, right? The, the, the wonder that I have is, How many of those 10 are really good businesses versus, what one's the zombie in there?

And how many zombie businesses do I have where it, maybe they got, a few people coming in, but they're a breath away from closing up and not being able to pay the rent. And so I think that's where, especially. institutions need to be thinking about, how they can consume that data.

And, and we have a couple of really cool partners. like I know,both our friends at Equifax and Experian have solutions where they actually will look at that property address and pull credit on all the different businesses there, right? And so that you can have an overall view of that health.

And I think that's something that's gonna be absolutely critical for institutions to do is, is look at the health, be beyond just the, the, the person that they lent to. Just not the, the owner of that property, but the, the folks that are paying that rent roll It's beyond that.

Bryan Peckinpaugh: Yeah. Get getting beyond just are you collecting rent to what, what might be those, maybe macro factors that, cause them to be gone tomorrow. That, that that'll, that will be an interesting concept. I mean, we certainly have seen it even in the office aspect of it, right? Where plenty, even though there's a push to be back in office, there's a lot of folks, as you mentioned, Mike, we, we have continued to be office first through the pandemic.

I think there's a lot of value in having people together and collaborating. But for every organization like Baker Hill that is, is promoting the, the in-person collaboration. There's one that's saying, we're gonna go pure remote and, and then you gotta start judging are those factors that are to the benefit of the business or is it to save money? And, and what does that mean, and what does that tell you to,the industries you're serving and you know what, like you said, the health of the other businesses that, make up the, the property, as it as it shifts to consumer.

Mike, where, where I have that shift that something that was a legacy office moving into high-end consumer loft style apartment building, what do you think that does to, the underwriting and ongoing? So let's say, let's say you have a, a office building that is coming up for renewal in September of this year, and, you start to see that they're, they're looking to make the shift to,consumer real estate location.

How would you think about that? How would you look at, processes that they have to go through and, and potentially considering extending that loan further?

Mike Horrocks: Yeah, I think it introduces, some really cool opportunities, And some threats at the same time. when you think about like the opportunity side of it, I've now potentially change that into a 30 year obligation with someone. And I'm, and I'm probably looking at a different type individual.

This is now I've moved into my high net worth private banking type person. If you're, if you're looking to buy a loft. So I'm hopefully having a little bit less. credit risk. Now, I say that also knowing that in 2008 that was the same group that was the strategic defaulters, right? That that basically abandoned their homes and went someplace else.

So, it's, it's a double edged sword there. But I do think you're looking at folks that will give you, now you have that 15, 30 year type, that can be behind that, That, that would be able to support that. And to me that kind of levels out some of the, the threats I have quarter to quarter on a business.

But at the same time, you mentioned, like the city, right? All of a sudden you have to think about what else is happening around that property, that, that would continue to attract folks, if crime changes, if retail's not there, if you know what's gonna attract that,residential into CRE spot, right?

That would be top of mind for me when I'm thinking about that.

Bryan Peckinpaugh: Yeah. and, take, taking a view, Mike, from a technology perspective. So when you think of a platform like, our NextGen commercial Loan Origination System,it's always been important to look at your. overall portfolio and where you are, maybe overexposed and CRE has traditionally been, you could argue an overexposure for, for financial institutions.

How do you see that changing? Do you, you see a need to then further segment, your, your types of CRE and drilling into different types of analysis than maybe people have in the.

Mike Horrocks: Yeah, I, I definitely see that the, the one shift that I think, it's, it's, we mentioned LOS, right? And that's what we're known for as the Loan Origination System. but it's, You mentioned portfolio, right? And it's that portfolio monitoring, in my opinion, that now has to be taken to the next level.

JP Morgan came out with a, a great study and they were talking about it. 65% of all business owners expect a pretty sizable recession in 2020. Only 55% of the CRE owners expect a recession in 2023. Now, those CRE owners are gonna get paid by the same people who expect a recession. And so something's not quite right there, right?

When you have more people that expect it to be bad, but the people that own the property, are reliant on those other individuals. Something's not aligned, and I think that's where. , a again, going back and monitoring,having a, a, an ability to look at properties and monitor and identify, Hey, here's a tenant, here's someone that's in that space.

I need to go ahead and monitor, see what their behaviors are. And if you have that either, through, on you data right? Or through some kind of third party, to me that's absolutely citical.

Bryan Peckinpaugh: Yeah, absolutely. And we, we haven't talked much on here about, what we think of as portfolio monitoring versus portfolio management, but, I, I couldn't agree more, Mike. Now more than ever it, it's moving away from that traditional portfolio management, which is reporting, it's segmentation, it's where.

Where, where do I have my anchor tenants? where, where's that gonna lock down some of my CRE lending. And as you said, when we think about portfolio monitoring, it's a proactive behavior based approach and, and I think that's gonna be what's so critical in 23 and beyond, is you've gotta build up that base of what are the behaviors in your markets that are risky?

What are the behaviors in your markets that indicate opportunity? And, how do I get ahead of those? How do I put, put tools in the hands of the team, having those nightly rules fire to find the, the behavior changes for me, and put that in the hands of people that that can work on 'em. We did a great webinar a couple months back, that I'd highly encourage everybody to go listen to. you can find that on our Baker Hill website that, some of our clients that are using that behavior-based approach, have some great insights for everybody. and I think it'd be a great opportunity for you to reach out to others at Baker Hill to talk about what that behavior-based review could do for you, especially as we see these, these shifts and potential downturn in,CRE and other commercial segments in 23.

Mike Horrocks: Yeah, absolutely. Like you said, Bryan, Things have changed and that's gonna be constant, right? so we'll see what even happens, two years from now in this space. But it's definitely gonna change.

Mitch Woods: Yeah. Well, Bryan, Mike, thank you guys so much for your insights today and, and really diving into some of the opportunities and threats that are out there in CRE lending in, in 2023. I think some really valuable insights there. So, Mike, thanks for joining us today on, on the episode. Definitely appreciate you and, and look forward to having you back again sometime soon.

Thanks everybody out there listening to today's episode of Lending Made Easy.