By: Jay Lucas, Director, Risk Advisory
Economists indicate we are moving from inflation to stagflation, which presents a unique set of challenges, and it is creating a perfect storm for businesses, lenders, and policymakers alike. The combination of slowing economic growth, rising costs, and layoffs really complicates decision-making at every level. As the Fed wrestles with how to balance inflation control and economic activity, it leaves many sectors, especially commercial real estate (CRE), in a precarious position.
The shift in focus to stagflation, where inflation remains persistent even as growth slows, puts additional pressure on the Federal Reserve’s monetary policy. Some economists project that interest rates are expected to end up around 4.0% at the end of 2025. This may be their attempt to strike that fine balance, but it also means maintaining tighter credit conditions that could provide opportunities in CRE. With borrowing costs coming down, it becomes easier for property owners to refinance, developers to get new projects off the ground, and businesses to expand their physical presence—all of which could help economic growth.
Commercial Lending:
The CRE market continues to send mixed signals. While demand has driven property values to historic peaks and vacancy rates have been improving overall, the recent uptick in multifamily vacancy rates suggests that there are still pockets of vulnerability, especially as the broader economic challenges persist. The strong growth in the CRE loan market, fueled by refinancing and new developments, reflects optimism, but it also raises alarms about concentration risk.
Historically speaking, community banks, concentrations in CRE and Acquisition and Development Construction (ADC) portfolios remain a key business strategy. In some ways, these concentrations are almost inevitable—local community banks often have a deep understanding of their markets and rely on a smaller set of industries or property types to drive their portfolios. However, this makes them particularly vulnerable to shifts in market conditions or sectors that might underperform, like the recent challenges in the multifamily market.
Regulators increasing their oversight of concentration risks is a natural response, especially given how cyclical the real estate market can be and the vulnerabilities that can arise when banks are too heavily exposed to any single segment. While many banks have historically managed these risks well, thanks to strong, proactive risk management practices, it is becoming even more crucial to stay ahead of potential issues. Early intervention will be key, but it is easier said than done when market dynamics are shifting quickly.
For businesses, particularly in the CRE sector, the key to navigating this uncertainty lies in adaptability. Being flexible and thinking ahead is essential. Tenants wishing to renegotiate leases, while they explore alternative supply sources, might mitigate the impact of tariff-induced price hikes affecting their businesses. Additionally, investing in operational efficiencies can help improve margins and make businesses more resilient in the face of changing market conditions. Proactive management will help maintain occupancy levels.
When managing portfolio composition, it is important to consider the long-term sustainability of these solutions. While short-term relief measures can stabilize businesses or projects, the true test will be how lenders and business owners adapt to the evolving economic environment and the new economic challenges.
The combination of increased regulatory scrutiny, changes in administration, and a heightened focus on credit risk management is creating a more complex environment for financial institutions, especially when it comes to managing credit risk in today’s volatile economic climate. A deeper dive into points to consider:
Risks in Loan Portfolios from Relaxed Underwriting:
The trend toward more lenient underwriting guidelines, particularly in government-backed loans, has increased risk exposure. While the federal guarantees provide some level of protection, they don’t eliminate all the risks associated with poorly underwritten loans. With a push to AI and automation, a quick review process can result in a lack of deep scrutiny, leading to more vulnerable portfolios. If these loans start defaulting in larger numbers, financial institutions could face not only financial losses but also the risk of losing the guarantee altogether, which makes portfolio management and ongoing monitoring even more critical. Strengthening underwriting processes and introducing more robust post-disbursement monitoring could help mitigate some risks.
Unfunded Loan Commitments:
Unfunded loan commitments are a particularly tricky area. Institutions often commit to loans that they may not immediately fund, but if there is a surge in cash-out demands, they could be caught unprepared. Construction projects that have buildout periods greater than nine months could experience significant cost overruns due to increased cost of imports. Monitoring construction draws and borrower liquidity requirements will need to be reviewed frequently. Requiring borrowers to maintain higher levels of equity in their projects helps create a financial buffer against potential cost increases. Borrowers with more skin in the game are generally more motivated to manage the project effectively and stay within budget. Higher equity reserves also reduce the risk to the lender, as it ensures the borrower has more capital invested in the project, which can help absorb some of the financial risk if costs rise unexpectedly. A larger equity cushion could also provide greater flexibility for lenders in the event of a default or if the project faces significant delays.
Investing Strategy in a Volatile Market:
Economic instability or market downturns significantly impact the investment strategies of financial institutions. A fluctuating market can lead to volatile asset prices and, in some cases, reduced investor confidence. For institutions, balancing credit risk with investment strategies is crucial to maintaining portfolio attractiveness. A comprehensive review of current investment strategies in light of market conditions, perhaps reallocating or diversifying investments, can help mitigate the risks associated with market volatility. Additionally, institutions should maintain a strong focus on their loan portfolios, as a well-managed portfolio can provide a buffer against market instability, even during difficult times.
Early Defaults in the SBA Small Loan Programs:
The surge in defaults in small business lending programs like the Community Advantage loan program is an issue that has garnered a lot of attention recently. The fact that these defaults are highlighted in audits by the Office of Inspector General (OIG) underscores the need for a more thorough and proactive approach in credit risk assessment. Early defaults often signal a gap in the loan vetting process, either in the form of weak underwriting standards or insufficient financial projections with start-ups that have a negative impact on loan performance. Financial institutions may need to revisit their risk and scoring models and focus on strengthening their due diligence before lending, even in government-backed programs, to avoid these costly defaults.
In light of these challenges, financial institutions must take a more rigorous and strategic approach to credit risk management. Regular reviews of underwriting standards, stronger risk monitoring, and more thorough stress testing of loan portfolios and liquidity will be essential. Institutions also need to keep an eye on regulatory changes in oversight and remain adaptable to evolving reporting requirements from bodies like the FDIC and OCRM.
Given these factors, all the Regulatory bodies are calling for enhanced attention to credit risk management practices. Institutions need to integrate risk assessment processes and strengthen their monitoring to meet both regulatory requirements and shareholders’ expectations. Without proper systems in place to track exceptions and assess credit risk at the borrower relationship level, it becomes difficult to ensure that reserves, such as the CECL, are accurately reflective of potential risks.
Supply chain disruptions could indeed have an impact on multiple industries, and we are likely to see lingering effects in the coming years, especially in agriculture, manufacturing, hospitality, and retail. These industries are tightly interwoven, so a disruption in one sector can cause ripple effects across the entire system. With the uncertainty in global trade, geopolitical tensions, and fluctuating demand patterns, it is difficult to predict exactly how long these disruptions will last or what their full impact will be.
Lenders have been operating in a relatively flexible environment with relaxed underwriting and other policy exceptions, but that approach might not be sustainable long-term, especially as risk factors mount. I agree that a more proactive approach to portfolio management is needed, where ongoing monitoring of businesses lending in today’s environment is warranted. The traditional method of approving loans based on financial projections alone is no longer enough to ensure the long-term success of small businesses, especially in an economy that is constantly shifting.
The importance of SBA guarantees that they provide a critical safety net; they don’t absolve the need for diligent, ongoing performance management. The guarantees can’t protect businesses from bad decisions or external shocks if the monitoring system isn’t robust enough to catch potential issues early on.
Moreover, as delinquencies and criticized assets rise, the role of SBA guarantees becomes even more crucial. These guarantees provide a layer of protection for lenders, but they also need to ensure businesses are meeting expectations and are in a position to sustain their operations long term, and the guarantees remain valid.
In this environment, small businesses, regulators, and lenders need to communicate openly and frequently. More frequent check-ins, data-driven insights, and clear action plans could provide the guidance that small businesses need to stay afloat. This kind of collaborative, proactive approach could ultimately lead to better financial health for the small business sector as a whole, allowing them to navigate these tumultuous times with more stability.
Should borrowers show signs of needing financial relief or request a short-term extension or even a loan modification, be sure to take this time to document the file.
- Require interim financials to properly see if the business has maintained normal operating levels.
- Clearly document what the sources and uses of funds will be used for.
- Require management to demonstrate how they plan to turn around the loss of revenues and return to viable operations. Maybe an updated business plan is called for.
- Review your collateral to ensure its condition and that liens positions are properly perfected.
- Verify and properly document liquidity
- Evaluate borrower and guarantor contingent liabilities.
Agricultural Lending:
Tariffs can create a cascade of challenges for the agricultural sector as well, and their impact on agricultural lending is particularly concerning. The primary issue stems from the increased input costs that farmers face when tariffs are imposed on imported goods, such as machinery, fertilizers, chemicals, and feed. This can significantly raise operational expenses and narrow profit margins for farmers. Some areas of consideration:
Increased Input Costs:
Imported goods will have an increased cost of essential agricultural inputs. For example, imported fertilizers, chemicals, equipment or machinery parts, farmers face higher prices for those inputs, which are critical to their daily operations. Higher input costs mean that farmers must either absorb the additional cost, decreasing their profit margins, or pass those costs on to the greater market. In the worst-case scenario, these increased costs can lead to farmers not being able to afford critical supplies, ultimately affecting their productivity and crop yields.
Stricter Credit Terms:
Lenders are often more cautious during periods of economic uncertainty or when industries are facing headwinds. In the case of agriculture, if farmers are struggling with rising costs and reduced profitability, lenders may perceive them as higher-risk borrowers. As a result, financial institutions could tighten credit terms, either by increasing interest rates, requiring more collateral, or reducing loan amounts and shortening terms. This makes it more difficult for farmers to access the capital they need for operational costs, expansion, or investment in new technology. Stricter credit terms can further exacerbate the financial strain on farmers, leading to potential defaults or the inability to capitalize on growth opportunities. We would expect an increased reliance or need for USDA and FSA funding alternatives.
Reduced Market Access:
Farmers may experience new limitations and the ability to access international markets for their products. Should a country impose tariffs on a specific agricultural export, farmers in that country may face difficulty selling their goods abroad, especially if competitors in other nations don’t face the same tariff barriers. This is particularly important for crops or commodities that rely heavily on international trade, such as cotton, peanuts, soybeans, wheat, or corn. Reduced market access could force farmers to sell their products at a lower price or hold onto their inventory for longer periods, impacting cash flow and profitability. This has raised issues with smaller family farms having to be acquired by larger operations.
Impact on Rural Economies:
The agricultural sector is often the backbone of rural economies, and any disruption in farm profitability can ripple through local communities. Reduced farm income means less spending in local markets, fewer jobs in agricultural support industries, and overall economic stagnation. This can have far-reaching consequences for small businesses and infrastructure that rely on the economic activity generated by farming.
Mitigate Agricultural Lending Risks:
Financial institutions that work with agricultural clients need to be aware of tariff-related risks and adopt strategies to support farmers during these turbulent times. Here are some potential actions:
- Lenders can offer more flexible loan structures, such as deferred payments, lower interest rates, or interest-only terms, or longer repayment periods, to help farmers weather the immediate impact of increased costs. By adjusting loan terms to better fit the current market conditions, lenders can help reduce some of the financial pressure on farmers.
- Take advantage of government lending programs such as USDA and FSA. The programs provide guarantees that are vital to funding annual crop production.
- Lenders can offer advisory services to help farmers improve their operations, reduce costs, and enhance productivity. This could include guidance on improving supply chain management, exploring new markets, or implementing more cost-effective farming practices. Lenders can help direct farmers to state-provided services to help improve operations.
The agricultural sector is extremely vulnerable to shifts in economic policies like tariffs, and it is essential that lenders and federal and state policymakers collaborate to create a support system that enables farmers to adapt and thrive despite these challenges. Financial education and prudence with economic assistance are important in supporting rural economies.
The road ahead will require a strategic approach from all parties involved—financial institutions, small businesses, farmers, and regulators. Balancing immediate relief with long-term sustainability is crucial, as short-term solutions must not undermine the resilience of businesses and farms long term. This delicate balancing act is essential for not only surviving economic volatility, but also for positioning these sectors for future growth and stability.
