Episode 1
Episode summary
How are commercial real estate (CRE) loans, and this year’s bank crisis related? And why should small businesses care? Gusto’s Lead Economist Liz Wilke explains in this inaugural edition of The Gustonomics Podcast.
Shownotes
Is Your Bank Safe? Here’s How To Find And Assess Your Bank’s Balance Sheet [Next City]
Subscribe
Transcript
Liz Wilke (00:00:00) – Hi, I’m Liz Wilke, and this is the Gustonomics Podcast. Each week, we’re bringing you about 10 minutes of economics knowledge so you can be more informed, use the information in your business or work, or maybe just impress your friends at the bar.
Liz Wilke (00:00:14) – Whatever brings you here, thanks for checking out the podcast. This week, I’m talking about commercial real estate loans, also known as CRE loans. But really, I’m also going to talk about the banking crisis and how these two are related, or could be in the future.
Liz Wilke (00:00:31) – So, what is a CRE loan?
Liz Wilke (00:00:34) – Well, it’s sort of like a mortgage loan, but for commercial buildings. Real estate developers get loans to build or buy commercial buildings, such as a strip mall on I-40, a high-rise building in Cincinnati, or an office park in Tulsa.
Liz Wilke (00:00:51) – One really important distinction between a residential mortgage, like the one you have on your house, and a CRE loan, is the difference between the contract length and the amortization period. Now, that’s a little jargony, so let me explain.
Liz Wilke (00:01:06) – An amortization period is the length of time it would take a borrower to pay off the entire value of the property. But the contract length is the length of time the loan contract is for. With residential mortgages, these are almost always the same. So, suppose you get a 30-year mortgage. Your contract with the lender is for 30 years, and your payments are made so that the total value of the house will be paid off in that same 30 years. But that’s not the case for CRE loans. The contract length for CRE loans is usually shorter, say 5, 7, or 10 years.
Liz Wilke (00:01:45) – But the payments are calculated as if the borrower would pay off the total value of the property in, say, 30 years. That’s the amortization period. So what happens is that at the end of the contract, there’s a big payment called a balloon payment that has to be made to the person who originally made the loan. For example, if you have a 7-year CRE loan, which is the contract length, that’s structured as if it’s going to be paid off over 30 years, the amortization period.
Liz Wilke (00:02:16) – You make payments for 7 years, and then you have to pay off whatever the remaining value of the property is. And because a lot of borrowers don’t have that money on hand, they refinance the remaining value of the property under a new loan. And that point right there is exactly why we’re talking about CRE loans today.
Liz Wilke (00:02:37) – Most of the CRE loans that are coming to the end of their terms this year, meaning they need to come up with those big balloon payments, were financed way back in 2013 to 2017, when interest rates were much lower and occupancy rates were much higher. You may have seen headlines talking about the number of office buildings sitting empty. That’s relevant for us here. Refinancing this year will mean that properties will have to pay higher interest rates on their new loans, even as they’re receiving less income from rents.
Liz Wilke (00:03:11) – So if these properties can’t get new financing, or they end up not being able to make payments on the new loans that they do get, they could default. And the bank that made the loan would have to take the loss on whatever’s left on the loan. This is worrisome for community and regional banks in particular. More than 90% of community and regional banks hold up to a quarter of their total balance sheet in commercial property loans.
Liz Wilke (00:03:41) – Since the recent failures of Silicon Valley Bank, Signature Bank, and First Republic Bank, many observers are looking at banks’ exposure to CRE loans as a source of possible stress. People have been watching for signs of weakness among other small and regional banks to see how many future bank failures might be coming down the pipeline. And the total amount of CRE loans that banks have on their books is one indicator they’re looking at.
Caleb (Ad) (00:04:08) – Are you a small business owner looking for a payroll solution that’s easy and stress-free? Look no further than Gusto. With Gusto, you can easily manage payroll, benefits, and HR in one place. Our intuitive software makes it easy to onboard new employees, calculate taxes, and run payroll with just a few clicks. Over 300,000 businesses trust Gusto. with their payroll needs.
Caleb (Ad) (00:04:29) – Try Gusto today and get three months free when you run your first payroll. Visit gusto.com slash podcast to learn more. That’s gusto.com slash podcast to get three months free.
Liz Wilke (00:04:42) – Welcome back. We were just talking about commercial real estate loans or CRE loans. And you might be wondering, how should I think about this? Well, think about it this way. People in financial markets are scared about more bank failures. So they’re keeping a close eye on anything that might give them a clue about what’s gonna happen. And CRE loans are one of the big unknowns in banks’ portfolios this year. In other words, people are worried about CRE loans because they are worried about more bank failures.
Liz Wilke (00:05:20) – And of course, people are worried about more bank failures because they remember the global financial crisis of 2008, which started with a bank failure. While that’s completely understandable, we should also keep in mind that a lot has changed since 2008. And financial regulators have taken extraordinary action with the first bank failures of this year to cut off the possibility of a systemic crisis. And there are lots of supports in place to prevent this from happening again. And they seem to be working.
Liz Wilke (00:05:53) – To put it into perspective, the assets of the three banks that failed this year are basically equal to the total assets of all the banks that failed in 2008. And we’re just not seeing the same kinds of ripple effects in the economy. However, if you use a community or regional bank, CRE distress at your specific bank might affect you. If you run a business or have deposits at your bank that are higher than the FDIC-insured amount of $250,000, if your bank were to fail, you wouldn’t be guaranteed to get all of your money back.
Liz Wilke (00:06:29) – So if you run a business, you might wanna keep some extra cash on hand in a different bank that you could access for emergency use in case your bank were to come under stress. If you’re feeling very nervous about this, you can try to assess the risk of your specific bank. In the show notes, you can find a link to an article from nextcity.org about how to check the balance sheet of your specific bank.
Liz Wilke (00:06:55) – Basically, you find the amount of commercial real estate loans as a percentage of the bank’s total assets to find out how much of your bank’s portfolio is tied up in these kinds of loans. And that’s gonna be a really good first line indicator for you about how much risk your bank is exposed to. Now, a lot also depends on how many of those loans need to be refinanced in the next few years while interest rates are high and many offices are still empty.
Liz Wilke (00:07:22) – If you don’t bank at a regional or community bank, this probably won’t affect you directly, unless of course, a lot of banks fail all at once. This isn’t likely to happen, but the one big factor that’s hard to predict is people. I’ll say this many times on the show. The economy is just a bunch of people doing people stuff with other people. If people believe that small banks aren’t safe places for their money, just the existence of that belief makes risk for the bank, no matter what assets it has on its balance sheet.
Liz Wilke (00:07:59) – If people begin to believe that all at once, then there’s a much bigger problem for small and regional banks than if people decide not to believe that and go on with their lives. And that’s why the Federal Reserve has done so much to create confidence for people that even if a bank gets into trouble, their deposits will be safe, that banks can find money to pay their obligations and that troubled banks can be managed without bringing down other banks with them. That confidence is key. So that’s it for this week’s episode.
Liz Wilke (00:08:32) – We hope you learned something new and something useful for yourself and your business. Please let us know what you think of the podcast by leaving a review or share it with a friend or colleague who might enjoy it. I’m Liz Wilkie and thanks for listening. We’ll see you next week.
Caleb (Ad) (00:08:48) – The Gustonomics Podcast is made possible by Gusto, the people platform for over 300,000 businesses across America. If you’ve started a business and are ready to hire your first employee or you’re just looking for an easier way to run payroll, visit gusto.com slash podcast to get three months free. That’s gusto.com slash podcast.
