The wave of lending for commercial real estate development that arose after the 2008 financial meltdown is secured by offices, shopping centers, multifamily and industrial properties all over the US. But worries about regulatory pressure intended to tamp down systemic risk — risk of the same kind that caused 2008 — are sparking concerns that a wave of refinancing made necessary by closer looks at underwriting standards could cause a new crisis in lending.
The Joint Regulatory Statement of December ’15
In December of last year, the Federal Reserve set the stage for placing CRE lending under a microscope. In a press release named “Statement on Risk Management in Commercial Real Estate Lending” (download full PDF here), federal regulators had this to say about CRE lending:
The agencies have observed that many CRE asset and lending markets are experiencing substantial growth, and that increased competitive pressures are contributing significantly to historically low capitalization rates and rising property values. [Footnote 2 – For example, between 2011 and 2015, multi-family loans at insured depository institutions increased 45 percent and comprised 17 percent of all CRE loans held by financial institutions, and prices for multi-family properties rose to record levels while capitalization rates fell to record lows. Sources: Consolidated Reports of Condition and Income, Costar Property Price Index, and CBRE. End of Footnote 2.] At the same time, other indicators of CRE market conditions (such as vacancy and absorption rates) and portfolio asset quality indicators (such as non-performing loan and charge-off rates) do not currently indicate weaknesses in the quality of CRE portfolios. Influenced in part by the continuing strong demand for such credit and the reassuring trends in asset-quality metrics, many institutions’ CRE concentration levels have been rising.
The agencies’ examination and industry outreach activities have revealed an easing of CRE underwriting standards, including less-restrictive loan covenants, extended maturities, longer interest-only payment periods, and limited guarantor requirements. The agencies also have observed certain risk management practices at some institutions that cause concern, including a greater number of underwriting policy exceptions and insufficient monitoring of market conditions to assess the risks associated with these concentrations.
Regulators advise that lenders review their portfolios and “maintain risk management practices and capital levels commensurate with the level and nature of their CRE concentration risk.”
Wave of Refi?
A topic of concern in the wake of regulatory scrutiny is the extra burden placed upon lenders causing a credit crunch as banks struggle to comply with new capital requirements and more stringent underwriting standards. Some, like Morgan Stanley’s analyst Richard Hill, quoted in Bloomberg, believe that the new standards will affect smaller banks unduly. “”Given [regulators’] increasing concern about banks with high CRE exposures and years of loosening underwriting standards, we see a scenario where the most exposed banks will be unable to satisfy the CRE market’s financing needs.” he said.
Here Hill references the smaller banks — much smaller than Morgan Stanley with its 60,000 employees operating in 42 countries — characterizing them as “stepping into the void” left by a decline in bond issuances, aka commercial mortgage backed securities, which Hill says have declined to levels not seen in a decade. The small bank’s exposure to CRE, according to Hill, places them on a collision course with imposed federal standards, leaving the smaller banks outgunned in a regulatory fight.
One Writer’s Thought
In my experience, it’s not common to find the voice of a huge bank worrying much about the fate of smaller banks, even in the wake of regulatory adjustments. Such a position suggests that reading between the lines is called for. Is Morgan’s harrumphing here about how heightened lending standards will affect smaller banks really a backdoor sales pitch to hype its own CMBS offerings or its own refi absorption potential? Is it grist for the mill against how heightened standards will burden Wall Street? Or is it what it appears: a reasoned observation of the entire sector’s capital allocation ecosystem?
Time may tell.