CRE borrowers are repaying early, and that's a problem for banks

A growing number of commercial real estate borrowers are apparently paying off their loans early and taking their business elsewhere — and many bankers either can’t or won’t do enough to stop them.

Banks do not break out early loan payoffs in their quarterly results, but bank executives have warned of an uptick in payoffs in the past several weeks, especially among CRE credits. Data that shows insurance companies are making significantly more CRE loans than they did earlier in the decade only reinforces the notion that the business is migrating.

The trend takes its toll in two ways. While banks charge fees for prepayments, income is lost because those fees typically total less than the interest they would have collected over the life of the loan. Moreover, early payoffs are contributing to anemic loan growth figures at many banks because bankers are having a hard time replacing the lost loans with new ones without sacrificing too much margin.

“It is definitely a factor in the slower loan growth across the banking industry, in the fourth quarter of last year and again in the first quarter,” said FIG Partners analyst Chris Marinac.

Many bankers agree that the payoffs have put a squeeze on lending.

“We are facing headwinds when it comes to loan growth with the high paydowns in our portfolio,” Kevin Thompson, chief financial officer at the $7 billion-asset Opus Bank in Irvine, Calif., said during an April 23 conference call.

Loan balances have shrunk at some banks as a result of aggressive paydowns. Net loans declined 1.4% to $32 billion from the fourth quarter to the first quarter at the $44 billion-asset People’s United Financial in Bridgeport, Conn. “Strong loan payoff activity” was a major reason, Sandler O’Neill analyst Mark Fitzgibbon wrote in a research note.

Commercial real estate investors and landlords have found they can get a better deal from nonbank lenders such as insurance companies and pension funds. Yearly originations of CRE loans by insurance companies rose 37% to $50 billion from 2012 to 2017, according to the real estate data provider CoStar.

Borrowers are trying to reduce exposure to the five-year Treasury, a common rate used for CRE loans, as it continues to rise, said Alexander Twerdahl, an analyst at Sandler O’Neill. The yield on the five-year Treasury increased 97 basis points to 2.84% between April 25, 2017, and the same date this year, according to the Federal Reserve Bank of St. Louis.

“People are trying to pay those off and lock in better funding elsewhere,” Twerdahl said.

Borrowers also have lots of cash piled up, in part because of the new federal tax law, which is allowing them to deleverage their balance books, SunTrust Banks said in its first-quarter earnings press release. CRE lending has lagged as “larger clients have strong cash flow and access to capital markets and nonbank alternatives,” the Atlanta company said.

The same was true at U.S. Bancorp during the first quarter, “as paydown activity was exacerbated this quarter by corporate clients flush with cash on the heels of tax reform,” the Minneapolis company said in its first-quarter earnings report. Average CRE loans declined on both a quarterly and yearly basis at U.S. Bank due to early payoffs.

In many cases, banks are letting these borrowers walk away, as they do not want to match the lower rates offered by rivals. However, that tactic also carries risk, since banks must redeploy the money elsewhere and if they cannot find new loans, they could be forced to park the funds in lower-yielding securities, Marinac said. Though rates are generally rising, daily volatility means a bank could invest in securities at a lower rate than previously.

The decline in CRE loans at SunTrust “has been intentional as more pricing and structures … do not meet our return hurdles or underwriting standards,” the company said in its earnings report. Average commercial real estate loans held for investment fell 0.2% to $5.2 billion in the first quarter compared with the previous quarter.

Other bank executives identified early payoffs as a problem during the recent round of first-quarter earnings reports.

“We expected the CRE paydowns to slow and they really haven’t,” Chris Myers, CEO of the $8 billion-asset CVB Financial in Ontario, Calif., said during an April 19 conference call. Many of the paydowns at its Citizens Business Bank unit have been a result of owners selling commercial properties, as opposed to refinancing for a lower rate, Myers said.

“They’re cashing in and doing something else with the money,” Myers said.

The rash of early payoffs has not hit all segments of the banking sector. The $2 billion-asset River City Bank in Sacramento, Calif., has not seen elevated payoff levels because the bank attracts "borrowers who tend to be at the higher quality end and they don’t plan on prepaying their loans,” said CEO Stephen Fleming. About 80% of the bank’s loan book is in CRE credits.

Other banks have devised strategies for dealing with borrowers who might pay off loans early, Marinac said. The $7 billion-asset Eagle Bancorp in Bethesda, Md., charges higher interest rates on CRE loans in exchange for terms that make it easier to prepay. It is a gamble that has paid off as EagleBank has won new lending business in the Washington area as a result, Marinac said.

But for many other banks, the paydown trend is likely to persist as long as rates keep rising and borrowers try to get better deals elsewhere.

The $17 billion-asset Bank of Hawaii “really had something of an explosion” of payoffs in the first quarter, CEO Peter Ho said on April 23. That “frankly masked a pretty good [loan] production quarter.”