Banks have long counted on the boiling frog theory: If you put a frog in a pot filled with tepid water and gradually heat it, the frog won’t notice how hit it is until it eventually boils to death. So, it’s no big surprise that banks count on depositor frogs to be oblivious to current rates leaving their money in tepid low- or zero-yielding deposits. Nothing like banks enjoying a good spread on their money while replacing low-yielding assets with higher-yielding ones. However, in this current economic climate of Fed tightening, the pot just boiled much faster than expected. The frightened frog (aka depositor) feels the heat immediately and jumps out of the pot ASAP before it’s too late. Other panicked frogs follow suit and a bank run ensues.

The problem for many banks over the past nine months has not been the amount of the Fed’s considerable rate increases—it has been the pace and rapidity of those rate increases that has brought everything to a boil. In less than a year, the top end of the target range for the federal funds rate has spiked to 4.75% from 0.25%, with another 50 to 75 bps likely to come. That’s a rapid boil we haven’t seen the late 1970s and early 80s under Paul Volcker. In the current environment many banks are in the bind of having to pay much more to borrow but not being able to increase the yield on their booked assets at the same pace. Simple illustration: they can charge more for new mortgages, but they’re stuck earning low rates on the vastly larger number of mortgages they already issued in the past. Making matters worse, in the case of large depositor withdrawals, is that liquidity is everything and nobody wants to sell bonds far below par value due to the ​ Fed’s rapid rate-raising campaign. That’s just a scalding!

When it comes to CRE lending, it’s not cheap for banks to borrow with the Fed Funds target rate sitting at 4.50% to 4.75% with an imminent increase looming. Booking a little profit and protecting yourself from getting into a pickle translates into passing higher rates on to the borrower as noted in my December blog that addressed bank borrowing costs, financing concerns, and the inverted yield curve.

As Peter Coy explained in The New York Times this week, sophisticated depositors (think Silicon Valley Bank customers) and institutions will rush to pull their money out of a bank if they can gain a better rate of return on their money with another institution. The tipping point is negative news reporting that creates the herd mentality stampede. Even if depositors still think a bank is solvent, they will withdraw their money over FOMO (fear of missing out).

Last weekend I received a deluge of texts and emails from clients about Silicon Valley Bank’s insolvency. Everyone was asking the same question: Should they should pull accounts from two Southern California-oriented CRE lenders? Feeding into the social media driven anxiety, I told them to keep their funds in the banks up to the FDIC insured limit and to move the rest out.

Contagion is real and nobody wants to risk being bailed out by Uncle Sam (aka the taxpayers). I appreciate the concerns of systematic bank failure, but as Wharton School professor, Peter Conti-Brow, noted in a recent WSJ article, “The uninsured depositors of Silicon Valley Bank (SVB) are not entitled to this extraordinary government benefit, and they received it anyway.” I agree with Conti-Brow that we should let capitalism play out without government intervention -- the way it is supposed to do.

A concentrated group of wealthy depositors far exceeding the FDIC insured limit of $250,000 can fuel growth but the knife cuts both ways as in the case of SVB. As many know, recently failed Signature Bank is also one of the largest lenders to the New York City multifamily sector. Meanwhile First Republic, under pressure as we went to press, has a large real estate loan portfolio on the West Coast. Both banks have fallen victim to once loyal clients, who were heavily invested in real estate, pulling up anchor for safer harbors as recently reported in the WSJ. The question is this: how far does the contagion reach to established CRE relationship lenders?

The nation’s largest banks — Bank of America, Citibank, JPMorgan Chase and Wells Fargo — have held up better than the regionals. That’s generally due to having more diversified portfolios of smaller balance account holders and on-book investments. Not the megabanks have seen a tidal wave of new money coming in from regional/local bank defectors. That’s good for the big banks, but not ideal for CRE lending. Shrinking deposits and the talk of tougher capital and liquidity requirements at the regional bank level hurts the middle market real estate operators and owners who have come to depend on the regionals’ flexibility and personal touch in their loans. By contrast, lending at the Too Big to Fail behemoths is done on a more structured institutional approach. As you can imagine, that’s not ideal for your NNN, small apartment building or strip retail real estate borrower.

End of relationship banking?

Recent events will “take the edge off relationship banking where you put all your accounts in one place, observed Ivan Gold, of counsel at Allen Matkins Leck Gamble Mallory & Natsis LLP in a Law360 interview this week. In addition to seeing more diversification, Gold expects to see a lot of banking activity over the next few weeks and months, that may stall [developments], “whether it be product initiatives or real estate development or whatever ways a particular company was using a [regional bank],” explained Gold. ​ “It may hit a pause button until we see a portfolio of those loans being sold to another institution," Gold added. "I think we're in a heavy wait-and-see mode for a few weeks, a month or maybe more."

In addition to Signature, regionals such as New York Community and Apple Bank, have long done the bulk of the lending to multifamily rent-stabilized places. “We're talking a million units of housing,” observed Jay Martin, executive director of the New York City Community Housing Improvement Program, in a Law360 interview. “If they stop lending, owners will have very limited resources to go for lending, whether refinancing or doing short-term lending for repairs," Martin added. "So that automatically means lending will get more expensive because they'll go to bigger, too-big-to-fail banks with higher interest rates."

The bulk of my own financing business nationwide is dependent upon the local bank and credit unions relationships I’ve fostered over the years. I’ve found these institutions to be very amicable and willing to go the extra mile when the real estate asset or borrower is in their lending footprint -- sometimes even when there isn’t a direct correlation.

There is no doubt that Fed tightening and blurry economic tea leaves have impacted CRE lending among local banks and credit unions. More conservative underwriting and rate floors are the protective measures du jour, thus insuring health and prosperity. The good news is that local banks and credit unions are open for business, happy to serve local communities that depend on them and vice versa.

As the backbone of small and middle market real estate financing, that last thing the locals need is higher reserve requirements or other knee-jerk regulatory actions. This will just slow their CRE lending to a trickle, limiting them to serving only best in class borrowers and assets. That’s the antithesis of what is needed in turbulent times.

Banking by nature has inherent risk, but the industry relies on probability theory to spread that risk out as noted in a recent opinion piece by Nathan Myhrvold. Depositors need surety, especially in this age of the immediate misguided tweet. That’s where the FDIC’s voice helps stem the systemic death spiral of the banking industry at large.

CRE lending does not like volatility. So, let’s keep our fingers crossed that the contagion has been quelled. Let’s also remain optimistic that the Fed can continue its march to fight inflation, and that markets will settle down enough to allow transactional volume to pick up. As an old colleague of mine, Joy Construction Principal Eli Weiss Weiss told BisNow this week "Historical upward rising interest rates are not stemming inflation as hoped, but rather eroding asset prices at a pace that is causing real damage — and now realized losses." ​ Weiss’s observation is accurate since the expected rate of return today is higher than it was yesterday. Isn’t that the price to pay for betting on lofty pro-formas in a low-rate environment that was stimulated by cheap debt? ​

Not every deal will pencil out today, but at my desk there are numerous borrowers buying and there is plenty of cash-out refinancing with positive leverage, along with the upside potential of cap rate compression and a refi into cheaper debt if the inverted yield curve indeed foreshadows a recession as it so often does.

Meanwhile, a client of mine is in contract to purchase a well located NNN casual dining sports bar franchise with a healthy rent to sales ratio at a 7% cap fueled by 6.1% debt. That deal gets a checkmark in my book. If your relationship lender can no longer make it pencil, feel free to reach out. We’re happy to arm you with market intelligence to get the deal done.