The past eighteen months saw a surge in commercial real estate (CRE) lending, as banks, in response to economic recovery, have become more comfortable with providing debt and more willing to take risks. In fact, in the third quarter of 2013, commercial banks across the US originated $257 billion of commercial and multifamily mortgages, according to data from the Mortgage Bankers Association, marking a post-crisis record and a 22 percent growth year-to-date.
Unluckily for borrowers and lenders alike, however, persuading banks to lend against real estate assets may become much more difficult in coming years. Regulatory authorities in the US and globally are working to put a stop to risky financing in an attempt to prevent the reoccurrence of bank activity that played a part the financial crisis. “There are a couple of different dynamics going on,” says David Kessler, national director of the CRE industry practice at CohnReznick. “Banks still lead in lending and origination currently, but stage is being set for a trend to move in a different direction.”
The CRE lending landscape is under the influence of two divergent forces—a market in recovery with increasing competition and an increased necessity for risk, and the impending strictly regulated lending environment to be brought on by such legislation as the US financial regulation overhaul the Dodd-Frank Act and the Basel Committee on Banking Supervision’s Basel III. It remains to be seen in 2014: what will happen when these two forces collide?
Back in the game
Banks’ increased activity in loan origination has shown that they are getting more comfortable with CRE lending in a way they have not been since before 2007. Respondents to the Urban Land Institute’s Emerging Trends in Real Estate 2014 survey made note of the increased comfort banks felt in 2013, saying they expected an increase in the availability of debt capital this year from five main sources: the commercial mortgage-backed securities (CMBS) market, commercial banks, insurance companies, mezzanine lenders and nonbank financial institutions. Within those responses, commercial banks rose to second place in the survey in terms of expected availability of debt capital, up from fourth place a year earlier.
“Of the 2.5 trillion of outstanding commercial real estate debt, banks hold 35 percent currently, with CMBS and asset-backed securities at 23 percent, agencies and GSEs at 16 percent and life companies at 14 percent,” explains Kessler. “In the third quarter of 2013, banks originated more than anyone else.”
It seems commercial property lenders have a new attitude, and are almost as confident as peak market days. “If you ask banks about commercial real estate lending, they’ll say they are getting back into the market pretty aggressively because it’s where they want to lend,” comments Steve Renna, president and chief executive officer of the Commercial Real Estate Finance Council (CREFC). “Real estate provides a good return for them and it’s good on a risk-adjusted basis.”
Now that banks have become more comfortable with real estate financing, competition is getting stiffer and deals are getting riskier. One of the easiest ways to see how banks are upping their risk strategies is to note the kinds of real estate projects to which they are willing to lend.
“Many more banks are open to construction loans and loans to developers that are doing ground-up, whereas a couple of years ago it was very challenging to find that kind of financing,” says Ronald Kaplan, Northeast leader at CohnReznick’s CRE industry practice. Kaplan pinpoints the New York condominium market as one example, adding that only one or two banks were active in that market only two to three years ago, but that has “changed quite a bit” now as more players are getting in the game.
Commercial banks with loans in the CMBS market have also been a part of this greater tendency for risk. In the results from the CREFC 2014 Outlook Survey, CREFC members named the predicted increase in the volume of interest-only loans as the “most concerning trend in new CMBS issuances.” Apart from its prevalence with CMBS, the overall increase in the interest-only loan model shows the propensity for lenders to take greater risks in a more competitive environment. Renna adds that an increase in interest-only loans is likely just proportional to the overall increase in volume of CMBS issuances, given the level of activity. “The market is just getting a little more aggressive,” he says. “It may not be so good when it comes to refinancing later on, but that doesn’t mean interest-only is all bad. It’s just a tool, and it depends on how you apply it.”
Regulation on the rise
Just as time is bringing economic recovery and making banks more active and more aggressive lenders, regulators are beginning to implement their post-crisis financial legislation, threatening to restrict just how risky banks can be. Certain provisions in Dodd-Frank and Basel III will make it much more difficult for banks to lend once the regulations go into effect.
“Regulators are trying to wring risk out of the banking system with all these various requirements on how a certain loan will affect the type and the amount of capital you have to have behind that loan, and for how long,” says Renna. “They are making it harder for the banks to remain in the business.”
A big area of concern for banks involves Dodd Frank’s impact on construction lending. Dodd Frank restricts “high volatility commercial real estate” (HVCRE) loans, and reserve banks will ultimately be required to hold 12 percent instead of 8 percent on their books for each loan that they issue. The regulation will require mortgage originators to retain 5 percent of any loans they repackage and sell off. Such restrictions would certainly change banks’ approaches to lending and could effectively knock them out of the CMBS game. However, with such a complex and comprehensive regulation as Dodd-Frank, certain provisions are continuing to unfold and banks are still fighting for changes. As the regulation continues to develop and roll out, the ability to access liquidity for CRE projects and the legislation’s complete impact on the market cannot be fully known.
Kessler argues that changing legislation will lead banks away from their current position as top loan originators. The more stringent the requirements become, the more expensive it will become to lend, and the less likely banks will be to put their capital into CRE financing, depending on the types of loans. “If they can put out the money for something other can construction and development, they’ll make more money because their reserve requirements would be less,” says Kessler.
The latest version of the global Basel standards, Basel III, also addresses HVCRE loans, which applies to certain acquisition, development and construction loans. Each HVCRE loan meeting the definition in a bank’s portfolio would be assigned a 150 percent risk weight under the proposed rule. Under current rules, these loans are risk-weighted at 100 percent. This increased risk weighting goes into effect on January 1, 2015.
“Either banks are not going to be lending as much because they have to have more capital on hand, or it means that the cost of lending has to go up so much more so they can generate the profit needed to make the capital requirements,” comments Kessler on the provisions of Basel III.
Opening the debt door
With banks becoming subject to more severe regulations, there will be an opening in the lending landscape and the need for other capital providers to fill it. Kessler predicts that real estate debt funds will be the ones to step in when banks are forced out of certain types of financing. Debt funds have become a dominant force as lenders, as they have greater investor interest and do not face the threat of public regulation.
Responses from ULI’s Emerging Trends survey correspond with Kessler’s prediction. “Financial organizations that are not traditional banks are starting to make loans again in a significant way,” a real estate adviser responds in the survey. “Private equity funds are pooling capital from pension funds. They are making the case that they can get yields from CRE debt lending at rates that are more competitive with Treasuries and bonds.” This rise of debt funds provides banks with even more competition, and if regulations restrict banks from making more aggressive deals, they will likely lose their hold on the market. Kaplan adds that debt funds also have other advantages, including the ability to close faster and provide a higher rate of return to investors.
Even beyond debt funds, banks have more competition to worry about as other less-regulated entities, such as life insurance companies and CMBS, are becoming more active in the lending space and getting a bigger piece of the pie when it comes to loan origination. The CMBS market is gaining a lot of momentum as a competitor, compared to when it essentially was shut down following the financial crisis. Kessler states that he has seen a continued increase in the market, as well as a projected increase for 2014, and CMBS have an advantage over the regulated banks when it comes to some deals. “There are some very large single asset CMBS transactions that banks wouldn’t touch because the concentration is just so large,” notes Kessler.
An uncertain future
Notwithstanding the impending regulatory restrictions, the expectation in the current market is for banks to continue to be very competitive with their lending activity in 2014. Interest rates are expected to rise, especially with the Federal Reserve’s tapering of quantitative easing that began in January. Higher interest rates may incentivize banks to pursue more loans in the expectation that lending could become more profitable. “They still have loans on their books that they have not written down. Their balance sheets have started to improve. They have had some gains, so they will be able to take some losses,” says one real estate investment adviser in response to ULI’s survey. In their rush to finance real estate transactions, banks could tighten spreads on loans to become more competitive.
The Jones Lang LaSalle Cost of Debt Changes report released in January ends on a positive note, stating, “In spite of market fluctuations, some of which is expected to be Fed related, the cost and availability of debt shall remain favorable.” Of course, with the pending regulatory changes, the question now is not whether or not debt will be favorable, but in whose favor. The answer remains to be seen, whether banks will keep their hold on the market or if alternative lenders, including private equity funds, will find a way to rise to the top.