All eyes are on commercial real estate (CRE), following stress in the financial sector. It’s clear that the failures of both Silicon Valley Bank and Signature Bank will result in stricter lending standards, amid a period of already tightened credit. However, it’s unclear where the commercial real estate market stands—some suggest it’s the next shoe to drop, others claim only one sector is really at risk.
More from Fortune: 5 side hustles where you may earn over $20,000 per year—all while working from home Looking to make extra cash? This CD has a 5.15% APY right now Buying a house? Here’s how much to save This is how much money you need to earn annually to comfortably buy a $600,000 home
Unlike Morgan Stanley’s almost apocalyptic tone, with analysts forecasting a “peak-to-trough CRE price decline of as much as 40%, worse than in the Great Financial Crisis,” Bank of America seems to suggest that commercial real estate will hold steady, while echoing the office sector’s diminishing value, in a research note published last week.
According to Bank of America analysts, the U.S. commercial real estate market faces two key challenges in our post-pandemic world. The first? High inflation that’s forced the Federal Reserve to raise interest rates in an attempt to rein it in. That’s made it much more costly to service new and maturing commercial real estate mortgage debt. The second challenge, which has already directly affected the office sector, is remote work.
Still, Bank of America (BofA) analysts argue that those challenges are manageable for 3 key reasons, distancing themselves from the next shoe to drop narrative.
“We examine these challenges in the context of improvements to the commercial mortgage underwriting process in the post-Great Financial Crisis (GFC) era,” Bank of America analysts wrote. “We conclude that the challenges are real and significant, but, for several reasons, they are manageable and do not represent a systemic risk to the U.S. economy.”
Let’s take a look at the 3 key reasons behind BofA’s “manageable” CRE outlook.
1. There are multiple financing tactics for CRE borrowers to avoid defaulting on their debt
Bank of America analysts say 17% of CRE debt will mature this year, but they expect loan modifications and extensions to become commonly used tactics. That could mean that borrowers who employ such tactics may avoid some of the higher cost fueled by the economy’s high interest rates or the potential of defaulting on their debt, directly addressing the first challenge presented by Bank of America analysts.
Additionally, along with loan modification, property repurposing has become a standard practice in the market, according to analysts. That can serve as another option in the case that a borrower’s debt is set to mature at a higher rate.
2. Office properties—the sector most at risk—are only a small percentage of all CRE loans
“Work from home (WFH) and the broader phenomenon of de-urbanization have diminished the need for and intrinsic value of at least one sector of the CRE market, the office sector,” Bank of America analysts wrote.
There is no question that the office sector is facing significant headwinds fueled by the work-from-home era that’s lasted in the post-COVID world. However, the office sector’s rising vacancy rates and falling property values is not indicative of the overall health of the commercial real estate market.
Bank of America analysts claim that office properties account for around 23% of CRE loans maturing this year, but that’s only 3.8% of all commercial real estate, which is “a comparatively modest figure,” in their view.
3. Improvements to underwriting post-GFC mean these loans are less risky
There are two critical parameters within CRE mortgage underwriting, along with trends that have emerged following the Great Financial Crisis (GFC) that can offset the risk ahead, according to Bank of America analysts. Of the two critical parameters, the first is the debt to service coverage ratio (DSCR), which measures the borrower’s ability to pay. The second is the loan to value ratio (LTV), which measures two things: the loan recovery potential if a borrower defaults on their debt and the borrower’s ability to refinance following maturity.
In the post-GFC era, analysts claim they’ve observed two trends—debt to service coverage ratios are materially higher and loan to value ratios are materially lower. Both trends signal a shift from the lax underwriting in the pre-GFC era, according to analysts.
“The decline in LTV from 70% in 2007 to a low of 52% is significant; substantially more equity is required upfront nowadays, which means loans are far less risky,” Bank of America analysts wrote.
Along with improvements in underwriting, the sector’s price growth over the years has led to increased equity which can also serve as a buffer to risk, risk diversification across lender types, and a significant increase in bank capital post-GFC, has led to Bank of America’s assessment that the challenges ahead for commercial real estate are manageable.
“We think CRE contagion risk for the broader economy will be both minimal and manageable,” analysts wrote. “We think credit tightening will occur, but that is a necessary part of business cycles and will help reduce excess CRE capacity.”
This story was originally featured on Fortune.com
More from Fortune:
5 side hustles where you may earn over $20,000 per year—all while working from home
Looking to make extra cash? This CD has a 5.15% APY right now
Buying a house? Here’s how much to save
This is how much money you need to earn annually to comfortably buy a $600,000 home