Fallout from the pandemic is reshaping community banks’ views of commercial real estate.

Social distancing measures have restricted retail and restaurant capacity, while forcing people to rely more on digital channels for their purchases. The potential for permanent work-from-home policies is expected to alter how much office space companies need.

Those changes could have an outsized impact on small and midsize banks, where commercial real estate comprised 26.8% of total loans at Dec. 31, based on the most-recent data from the Federal Deposit Insurance Corp. CRE only made up 10.5% of loans at banks with at least $50 billion of assets.

Current challenges and impending change have forced bankers such as Edward Barry, president and CEO of Capital Bancorp in Rockville, Md., to assess his approach to CRE. The $1.9 billion-asset Capital, like other banks, could stop lending in projects involving retail and office space, restaurants and hotels. And the pandemic is altering how bankers underwrite certain loans, as well as their methods for watching out for potential issues with existing borrowers.

“There will be pockets of CRE that we probably just won’t do moving forward,” Barry said. “It’s a really mixed bag out there, and it’s just not prudent for us to lend into areas that are likely to continue to struggle.”

Banks that rely heavily on commercial real estate will need to fill a hole if they pare back, perhaps by making more commercial loans or developing fee-based businesses. Another option would be to merge with banks that are less CRE dependent.

A large number of banks could feel the need to explore those options.

More than three-fourths of lenders surveyed by PrecisionLender at the beginning of this year said they were uncertain about the future of CRE.

“There’s a sentiment that there are long-term implications from the pandemic … and real estate may be one of the casualties as we look ahead,” Gita Thollesson, a senior vice president at PrecisionLender, said during a recent commercial lending webinar.

Pulling back

Businesses also remain nervous about their long-term prospects.

A January poll by small business referral network Alignable found that one-third of small-business owners were concerned they could not pay rent on their properties which, by extension, jeopardizes their landlords’ ability to make loan payments.

The survey found even more concerning numbers in hard-hit sectors, with 57% of restaurants and bars reporting the potential for a missed rent payment, followed by yoga studios (46%), retailers (44%), massage therapists (43%) and beauty salons (42%).

That is enough to make lenders skittish about lending to certain CRE subsectors, bankers said.

Hanmi Financial in Los Angeles, where CRE made up more than two-thirds of total loans on Dec. 31, expects to “maintain more conservative underwriting standards” by “limiting origination activities within certain high-risk industries,” Anthony Kim, the $6 billion-asset company’s chief banking officer, said during a Jan. 26 earnings call.

Banks with smaller concentrations have also been tapping the brakes.

“On some property types, we’re just out of the market” Mark Mason, president and CEO of the $7 billion-asset HomeStreet in Seattle, said during a Jan. 26 earnings call. “We’re not, as a general matter, doing retail properties, office properties.”

“In times like this, I don’t feel an overarching desire to lurch at anything” to make more loans, Bradley Adams, chief financial officer at Old Second Bancorp in Aurora, Ill., said during the $3 billion-asset company’s Jan. 28 earnings call.

“There are some obvious structural things in the economy that are changing that will have longer-lasting implications,” Adams added. “That includes the appetite for office space downtown as well as what brick-and-mortar retail looks like.”

It could be a while before bankers forcefully return to CRE lending.

“While I agree better days are ahead, when it comes to vulnerable areas of CRE, with a few exceptions, we’re not seeing indications of improvement yet,” said Matthew Anderson, a managing director at Trepp.

“There’s a general sense that we can get back on track this year” as vaccines are distributed and the pandemic subsides, said Damon DelMonte, an analyst at Keefe, Bruyette & Woods. “But these sensitive industries are still very much top of mind for banks — and it could be a long time before we see new loans going into certain areas of CRE.”

Tighter underwriting

When bankers start lending again to higher-risk subsectors of CRE, they will undoubtedly be using tighter standards, industry observers said.

“We’re talking tougher underwriting and bigger down payments” to make sure “borrowers get more skin in the game,” said Charles Wendel, president of Financial Institutions Consulting.

Luther Burbank in Santa Rosa, Calif., stopped accepting applications for commercial real estate and construction lending during the earliest days of the pandemic.

The $6.9 billion-asset company, one of the nation’s biggest multifamily lenders, also tightened its standards in that sector by lowering loan-to-value ratios, increasing debt coverage ratios and raising the required reserves from borrowers from six months to 12 months.

Though the company is starting to loosen some requirements, it is doing so slowly, President and CEO Simone Lagomarsino said during a Jan. 27 earnings call.

“We feel confident in our historical underwriting and the credit quality of our existing portfolio, and we want to keep that kind of credit quality in the portfolio as we go forward,” she said.

First Northwest Bancorp in Port Angeles, Wash., has also lowered the loan-to-value ratios on new CRE deals, said Matthew Deines, the $1.6 billion-asset company’s president and CEO. It is also incorporated “enhanced underwriting” that includes stress testing CRE loans for severely distressed scenarios.

As a result, borrowers are often qualifying for lower loan amounts that they would have before the pandemic.

“We’re basically anticipating a worse-case scenario,” Deines said. “We don’t see that now, but if things did get worse, we’d have protections. We expect these things to stay in place for the foreseeable future.”

Accelerated diversification

More banks are increasing the frequency of formal credit reviews, looking for sudden draws on credit lines and other hints of potential distress.

Banks “are certainly looking closer at the loans they have — and looking more often,” Wendel said. “They aren’t finding a whole lot yet. Credit is holding up. But there’s plenty of concern that we could still see cracks in CRE.”

Those efforts provide lending officers more opportunities to talk with borrowers, Wendel said, which in turn leads to more insight.

At the same time, many CRE-heavy lenders have been putting more resources into mortgage and commercial-and-industrial lender, in hopes of reducing their dependency on commercial real estate.

Hope Bancorp in Los Angeles, where CRE made up 65% of all loans on Dec. 31, has been “adding high-quality loans with strong commercial borrowers who have not been significantly impacted by the pandemic,” Kevin Kim, the $17 billion-asset company’s chairman, president and CEO, said during a Jan. 27 earnings call.

Hope’s C&I loans, as a percentage of the overall portfolio, increased from 22% to 30% over the course of 2020.

Shifting from CRE to C&I and fee-based businesses such as wealth management or insurance requires a major commitment from banks, industry observers said.

Some banks will need to to recruit bankers from bigger competitors, said Wendel, whose firm advises to several community banks. Competition for talent is fiece, while building those types of businesses organically can be expensive and time consuming.

Bulking up in C&I will be difficult because the skillset for lenders is much different than that of CRE loan officers, and there is only so much business to go around amid the pandemic and a slow-growth economy.

Against that backdrop, more community banks are likely to consider selling to larger players rather than fight an uphill battle.

“Some can diversify — we will see that,” Wendel said. “But it’s not something every community bank can swing, that’s for sure.”

Distinguishing good loans from bad

A big challenge for lenders involves determining which loans to make and which ones of pass on. Many variables will determine the viability of a real estate loan, including the use of the property and its location.

Retail projects are a good example.

Lenders are focused on projects with tenants that have proven to be “impervious to COVID,” Mike Hendren, a senior credit officer at Pinnacle Financial Partners in Memphis, Tenn., said during a recent conference hosted by the American Bankers Association.

Grocery-anchored shopping centers and smaller properties with tenants that offer “needs-based services” like discount stores and medical treatment remain reliable lending opportunities, Hendren said. He advised against lending for big box retail properties.

Certain retailers such as hardware stores, grocers and home goods locations “have flourished during the pandemic,” Tyler Wiggers, who handles supervision and regulation for commercial real estate and wholesale credit risk at the Federal Reserve, said during a recent regulator panel hosted at the ABA conference.

“Retail development is evolving — it is not dead,” Wiggers said.

The same can be said for restaurants.

“You’ve got some businesses that have adapted and are actually doing really well, and you have others that are hurting really badly,” Barry said. “It’s not clear if and when that changes. It’s hard to argue that some areas of [CRE] won’t be greatly diminished.”

Distinctions are also being made in the hospitality sector.

While vacation travel should recover as the pandemic subsides, business travel could languish for some time as virtual meetings reduce the need for in-person gatherings.

“We’ll likely be working with our hotel clients for a couple of years,” Hendren said, though he added that the types of projects typically financed by smaller banks, such as suburban roadside hotels, are among those that have been the most resilient.

Expect banks to keep working with hotel franchisees who “will do almost anything to preserve” their franchise relationships, Hendren said. But he warned that losing a franchise tag can devalue a property by as much as 40%.

The viability of multifamily and office loans could hinge on their location, industry experts said.

Developments in major urban centers could face significant challenges. That could have a spillover effect on retail properties that rely on foot traffic from neighboring office towers.

“There has been an exodus from urban markets to suburban ones” that is hurting multifamily and office properties, Wiggers said. “There are different views on whether this is permanent or temporary.”

There will be an “evolution — maybe a revolution over the next few years” in CRE in big cities, said B.J. Losch, CFO at the $84 billion-asset First Horizon in Memphis, Tenn.

There will be exceptions, with bankers identifying Miami and Austin, Texas, as markets that could have strong rebounds. With no state income taxes and general resistance among policymakers to business lockdowns during the pandemic, those cities are attracting entrepreneurs away from more expensive and virus-restrictive markets such as New York and Los Angeles.

Apollo Bank in Miami has seen a steady inflow of technology firms and venture capitalists to South Florida, along with jobs and lending opportunities, said Eddy Arriola, the $850 million-asset bank’s CEO. But Miami’s gain, he said, comes at the expense of other cities — where the pandemic’s impact on CRE is likely to endure.

“They are coming here in droves,” Arriola said. “CRE has been incredibly resilient here. … But we are a really unique market. What’s happening here is not the norm.”

Paul Davis contributed to this report.