Commercial Real Estate Issues in 2017

The following is the next installment in RMA’s Credit Risk Council 2017 Industry Insights: Perspectives from the Front Line.

In December 2015, the joint regulators issued a statement on prudent commercial real estate (CRE) lending that reminded financial institutions of existing regulatory guidance for Commercial Real Estate (CRE) lending activity through economic cycles. Now in 2017, lenders are still facing historical challenges of additional regulation as well as emerging risks from a strengthening economy and higher interest rates. With a historic recession in the rear view mirror, we are now in the fourth longest economic expansion cycle in U.S. history, and caution is warranted. Additional expansion is expected as identified by increased stock prices and higher interest rates, but lending strategies will need to account for CRE risks that result from both an expanding economy and recession.

The End of Historically Low Interest Rates

A historically low interest rate environment appears to be ending. In Q1 2017, CRE faced the end of a near eight-year cycle with a greater than 600+ bps spread between LIBOR and cap rates and a greater than 400+ bps spread between the 10-year Treasury and cap rates. (See the following graph.)

finance rates and cap rates

Sources: St. Louis Fed, CoStar 

During this time, borrowers benefitted greatly from strong project level cash flow that allowed them to earn back their initial capital and provide a return to equity investors. Rising interest rates on floating rate loans may negatively impact borrower cash flow and result in lower debt service coverages (DSC).  If the rate is fixed, then the borrower, at refinance, will likely not receive either the same free cash flow or loan proceeds that were available during the previous cycle. Higher borrowing rates will result in fewer loan dollars, assuming advance rates hold steady. As a response, borrowers will need to increase rental rates and aggressively manage operating expenses to generate cash flow that will ultimately support a refinance.  

In a refinance, bank advance rates, spreads, and covenants will ultimately determine if borrowers can pull equity out or if it must be maintained in the property. Lenders will maintain a strong position if they can charge risk adjusted spreads while maintaining conservative advance rates and meaningful recourse structures. It is now even more important for lenders to fully understand the cash equity that borrowers either have remaining in the project or the amount of initial cash equity invested for construction or acquisition. If lenders provide non-recourse financing and all invested equity has been repaid, then lenders will have only themselves to blame if the borrower returns the keys when the loan goes into default.   

Retail Issues

Thus far in 2017, many major retailers have announced store closings, while e-commerce sales continue to grow. According to the U.S. Census Bureau, “total e-commerce sales for 2016 were estimated at $394.9 billion, an increase of 15.1% (±1.8%) from 2015. Total retail sales in 2016 increased 2.9% (±0.5%) from 2015. E-commerce sales in 2016 accounted for 8.1% of total sales, while e-commerce sales in 2015 accounted for 7.3% of total sales.”  

Lenders need to understand the risks of their existing retail portfolio and determine how to best manage their balance sheet going forward by closely monitoring existing loan covenants and identifying loans secured by collateral that will be attractive through the next real estate cycle. Some retailers and retail industries will be successful with the traditional retail model of a brick and mortar location, while other retailers will likely continue to suffer from decreased sales and will continue to vacate or not renew leases. Of note, most retailers now disclose the amount of sales attributed to e-commerce on their income statement.  

Lending risk exists in all retail store types. Location is still of primary importance with retail real estate, but location can only eliminate a portion of the risk. New retail loan originations will need to be sized and structured based on the future success of the tenants and not solely based on the current rent roll and economics. Standalone retail buildings will need to be designed and built so that if the tenant vacates, replacement tenants will be attracted to the space. Additionally, regional malls and power centers may need to be underwritten for future real estate use which may include storage, grocery stores, gyms, entertainment, and even residential.   

Concentration levels and limits on retail property should be established or modified, and strategy should clearly outline a lender’s appetite to originate new retail secured loans. During underwriting, collateral-specific risks need to be addressed including the location, building(s), tenants, and leases. Full underwriting must also address the borrower’s ability to:

  1. Own and manage a retail property through a volatile macro economy,
  2. Address specific risks created via e-commerce,
  3. Improve the collateral to enhance leasing interest,
  4. And repay the loan in full given any other borrower global recourse obligations.

Current Regulatory Environment

The December 2015 Statement on Prudent Lending reiterated regulator concerns of financial institutions with weak risk management and high CRE credit concentrations. It further stated that agencies will focus on financial institutions that have recently experienced this, or whose lending strategy plans for substantial growth in CRE lending activity, or that operate in markets or loan segments with increasing growth or risk fundamentals.   

Based on call report findings, as of December 31, 2016, 517 banks and thrifts (banks) exceeded regulators’ 2006 guidance on CRE loan concentrations. This consists of 262 banks that had CRE loans greater than or equal to 300% of risk based capital and growth in CRE loans greater than or equal to 50% over the last 36 months, and 262 with C&D loans greater than or equal to 100% of risk-based capital. In Q1 2014, there were 343 total banks that violated the guidance, resulting in a 51% increase over three years.

With a Republican-elected president and with the House and Senate in Republican control, regulations on banks are expected to decrease. Although the systemically important financial institution (SIFI) threshold is in line to be raised from the current $50B amount, and some aspects of Dodd-Frank are likely to be repealed, banks should not expect less agency scrutiny on prudent lending practices, strategy, and concentrations.

Keys to being prepared for regulatory review include maintaining appropriate loan policies, underwriting standards, and concentration limits, combined with lending strategies that are responsive to the local and macroeconomic forces. Sufficient capital adequacy and a healthy loan loss allowance are critical. Proving to regulators a full understanding of credit risk may also require banks to subscribe to third party data sources that will help them to better understand property level and macro forces that impact specific collateral locations.

CCAR and Construction

Since 2009, large banks have been facing annual stress testing required by the Dodd Frank Act (DFAST) and the results are then addressed in the bank’s Comprehensive Capital Analysis and Review (CCAR). The Fed publishes economic scenarios and requires the largest banks to stress test their loan portfolios and disclose the resulting capital levels under the scenarios.  Additionally, Basel III requires banks and thrifts to disclose their high volatility commercial real estate (HVCRE) and must assign a 150% risk weight to any HVCRE exposure.  

Large banks in particular are managing their portfolios with the stress test results in mind. After the Fed publishes stress test results, banks then analyze the results to discover the loan types causing the highest capital charge. One of the worst performing loan groups in the stress test is construction lending. A possible outcome of the stress test is lower construction and more cautious CRE lending at large banks in particular. Recent data points support this possibility as follows:

  • Based on call report data, as of mid-2016, construction lending represented less than 20% of bank CRE lending. Historically, it has been as high as 40% of bank CRE portfolios, but has averaged 25% since the 1980s. 
  • Banks are pulling back slightly on CRE originations as for the last 12 months ended Oct. 31, 2016, $1.137 trillion in CRE loans were originated, down 5.1% compared to the prior year period.   

CRE lending is a key part of most lender origination platforms and balance sheets. As banks continue to analyze and respond to the relatively new stress testing environment, the analysis of a “risk adjusted return” will become common as banks better understand the cost of capital related to their lending activities. It will not be a surprise if construction lending continues to be de-emphasized by large banks and replaced by smaller bank originations and non-regulated debt funds. The growth in CRE lending by small- and medium-sized banks has been particularly striking. CRE loans account for around 21% of all banks’ loan portfolios, but in the past 20 years, they have risen from 15% to 30% of midsize bank portfolios and from around 20% to over 40% of small bank loan portfolios.  

Multifamily vs. Single Family

The homeownership rate in the U.S. is now 63.7%, a rapid decline from its 2004 peak of 69.2%. Meanwhile the U.S. rental vacancy rate remains near 7%, near its thirty-year low. The decreased ownership rate indicates increased demand for rental units. Developers responded to the demand by delivering 315,000 multifamily units in 2016, consistent with deliveries since 2013 of at or above 300,000, all near peak levels last seen in the late 1980s. Of particular concern are the 378,000 units set to be delivered in 2017.  

In most U.S. markets, these multifamily units were absorbed. In many major metropolitan areas, rent per square foot levels have reached all-time highs and are now falling slightly from peak levels. Of additional concern, net rents trail underwritten rents due to concessions in markets where supply exceeds demand, and Class A deliveries are about 85% of new multifamily deliveries in major metropolitan areas over the past five years.

Most single family residential values now exceed pre-recession values, primarily benefitting the asset owner’s balance sheet, but also resulting in fewer people who can qualify for a mortgage.  Lender understanding of the demand for multifamily vs. single family is needed. Underwriting should address the future population needs, preferences, and income levels needed to qualify for rent or a mortgage. Additionally, banks will need to manage existing exposure to multifamily by monitoring loan covenants and passing on future lending opportunities if supply/demand is out of balance. As with retail, borrower and management capabilities are equally important to the success of multifamily properties.

Lenders have an opportunity in the next cycle to reduce their balance sheet risk by pursuing lending strategies that address future risk. If higher interest rates are coming, then bank balance sheets stand to benefit from a normalized interest rate environment. However, specific risks like retail shopping habits, banking regulation, and borrowers' preference to own or rent may upset those benefits if lenders have a myopic view of CRE lending.    

Hear more on this timely topic during an informative session, Five Reasons Why Development Projects Lose Money, at this year’s Annual Risk Management Conference on November 12–14 in Boston, MA.

Please look for the next Industry Insight on Tuesday, September 12, How to Stay Balanced as Risk Managers in Today's Benign Environment.

RMA Provides Education, Tools, and Community for Financial Institutions of All Sizes

Read More

How nCino Enables Bankers to Perform Better Industry Analysis with Annual Statement Studies Data

Read More

5 Reasons to Upgrade Your Risk Rating System in 2021

Read More

comments powered by Disqus