The commercial real estate debt market crumpled last year, weighed down by historically aggressive interest rate hikes, but one little-watched corner of the sector has stepped in to fill the void partially.

Regional and community banks have grabbed a larger market share of commercial real estate loans as banking giants like JPMorgan Chase, Bank of America and Wells Fargo have retreated from the market.

“The local and community banks have really stepped into that space that the debt funds were in before,” said JLL Executive Managing Director Gerard Sansosti, who co-leads the firm’s national debt practice. “I don’t think they’re under the same scrutiny that the money center banks are.”

Small and regional banks are picking up the slack left by major banks as they pull back on CRE lending.

But regional banks, with assets between $10B and $100B, and even smaller community banks can only fill so much of the vacuum, and if the Federal Reserve continues to raise rates, they will start to pull back themselves before too long, experts told Bisnow.

“Unless there is more clarity to the market and the capacity loosens up a little bit, I believe [smaller banks] will get selective,” Sansosti said.

Banks overall have taken a larger market share in CRE as other lenders, such as debt funds, CMBS, and insurance companies all saw activity plummet. Banks made up 46.4% of all nonagency commercial and multifamily lending in the U.S., up from 23.1% in the same period of 2021 and 30% in the second quarter, according to CBRE. Banks made up more than 30% of lending in the second quarter, according to a CBRE report.

Michael Riccio, CBRE senior managing director and author of the report, told Bisnow that community and regional banks were the main players during this period.

He said the volatile interest rate environment “essentially shut down” lending activity from major money centers. Overall loan closings dropped by 11% from the second quarter of 2022 and 4.7% year-over-year.

Truist Financial Corp., one of the country’s ten largest banks with nearly $550B in assets, pulled back on commercial lending as its underwriting raised projected interest rates from 5.5% in the middle of 2022 to between 7% and 7.25% today, said Mark Hancock, senior vice president of Truist’s commercial real estate lending division.

“We’re taking care of our existing clients,” Hancock said. “We’re trying to get creative where we can without breaking our guidelines.”

As a result, Tony Marquez, the president of commercial banking at Bethesda, Maryland-based EagleBank, said he’d seen more traffic through his door among developers and real estate investors.

“There is a clear indication from my vantage point that we’re getting more looks at different deals because some of the larger banks have not been as active in the past year,” Marquez said, adding that loan growth for the regional bank was 2.2% in the third quarter compared to just 1% in Q2.

Smaller banks are able to fill this void given they receive less scrutiny from banking regulators compared to money center institutions, Sansosti told Bisnow. Money centers are subject to annual federal stress tests and limits on how much commercial real estate lending they’re able to add to their balance sheets.

Michael Barr, the Federal Reserve’s vice chairman of supervision, warned last month that the central bank could tighten stress test requirements further, even though 33 of the largest banks passed those stress tests last summer, indicating they could weather a severe recession and continue to lend, Banking Dive reported.

Smaller banks see the vacuum left by money centers as a way to grab more market share, Commercial Real Estate Finance Council Executive Director Lisa Pendergast said.

“If you’re one of the few games in town, then you have more opportunity to ensure your loan is as creditworthy as it can possibly be,” Pendergast said.

However, there are limits to the size of loans these banks can make. Most regional banks don’t lend more than $40M to $60M on any deal, Riccio said, which means investors and developers have to go to multiple banks to cobble together enough debt for bigger projects.

“They’re not going to do a $200M loan,” Sansosti said. “They’re filling a need, but it’s more in that small to medium-sized loan.”

For now, Sansosti said the smaller banks have the upper hand, pushing potential clients to open accounts and make deposits in exchange for loans while tightening their underwriting standards.

But unless the Fed ceases its interest rate hikes or reverses course in the event of a severe recession, smaller banks may soon have to pull back themselves, Sansosti said.

Some regional banks have slowed down already. Bridge Logistics Properties, industrial development and investment arm of Bridge Investment Group, has historically relied upon regional banks and debt funds for its projects, Eastern Region Managing Director Greg Boler said.

Boler said Bridge is getting construction loan quotes for a future project, but with higher interest rates pushing up borrowing costs, the quotes so far are “all pretty expensive.” It’s forcing Bridge this year to pivot toward acquiring warehouses instead of developing new ones.

“We killed a lot of deals. We did keep one deal that we were bullish on because of this location and the basis from a rental rate increase,” he said. “Nobody is going to be in a rush to catch the falling knife.”