Don’t Count Banks Out of Filling CRE Debt Void Just Yet

Posted on July 14, 2016

With CMBS issuance down by half over the first half of this year, banks have largely stepped in to meet the strong demand for CRE debt financing. However, analysts are beginning to raise questions on the impact regulatory and pricing issues may have on bankers’ ability to continue providing borrowers with funds in the second half.

Private CMBS issuance totaled just $25.2 billion in the first half of the year, projecting annualized deal flow of $50 billion — which is 46% lower than last year’s total.

Meanwhile, banks’ share of CRE debt has risen to record levels. In the first quarter of this year, bank market share of total CRE loan originations across all lender types rose to a record 52%.

Bank CRE loan assets increased 3.1% in the first quarter on a seasonally adjusted basis, according to Federal Reserve numbers. And they went up another 3% through June 29 of this year. Multifamily lending continued leading the charge increasing 4.1% in the second quarter, up from 3.7% in the first quarter.

That spurt has caught the attention of the Comptroller of the Currency (OCC), which cited CRE lending among the host of strategic, credit, operational and compliance risks it reported this week.

“CRE lending and concentration risk management has become an area of emphasis for regulators,” said Thomas J. Curry, Comptroller of the Currency, in his remarks accompanying the release of the OCC’s semi-annual risk perspective.

“CRE portfolios have seen rapid growth, particularly among small banks,” Curry noted, while pointing out that 406 banks had CRE portfolios that had grown more than 50% in the prior three years by the end of 2015. More than 180 of those banks more than doubled their CRE portfolios during the past three years.

“At the same time (that) we are seeing this high growth, our exams found looser underwriting standards with less-restrictive covenants, extended maturities, longer interest-only periods, limited guarantor requirements and deficient-stress testing practices,” said Curry.

Can Banks Keep Satisfying Strong Demand?

Given regulators’ increasing concern over banks with high commercial real estate exposures and loosening underwriting standards, Morgan Stanley Research posed a scenario in which the most-exposed banks may be unable to satisfy their CRE market’s financing needs.

According to Morgan Stanley’s analysis, small banks (defined as those with $1 billion to $10 billion in assets) represent 23% of all CRE loans outstanding. Of concern though is that this group has accelerated originations relative to its market share, originating 38% of nonfarm nonresidential CRE and 47% of multifamily loans across all banks in the first quarter.

Morgan Stanley data also found that small banks have been far less aggressive in tightening underwriting standards than larger banks.

“CRE valuations could suffer in secondary and tertiary markets where small banks have filled the void, notably for multifamily properties that aren’t eligible for GSE [government sponsored enterprise] financing and lower quality malls,” wrote Morgan Stanley Research analysts Richard Hill and Ken Zerbe. The analysts also noted that CMBS defaults could rise if banks pull back from filling the void left by the shrinking CMBS market.

It’s Not Just Regulators Urging Lender Caution

“I would say that any slowdown in lending activity, particularly on the multifamily construction side, is not specific to a bank’s portfolio size; it is due to concern (in multifamily) about asking rent growth outpacing wage growth and oversupply on Class A properties in “hot” markets, along with whether or not there is any “juice” left in the value-add segment,” said Cal Evans, CRE market intelligence director, with Synovus Financial, a Southeast-based mid-size bank with a strong presence in CRE lending in secondary and tertiary markets.

Evans said he is seeing a divergence in class performance among multifamily properties. For instance in Charleston, SC, Class A apartment occupancy is coming in at sub 90%, while Class B/C occupancy is at 98%. Both are respectively below and above the natural rates of occupancy for those classes, he said.

“The first quarter was when I heard all groups — bankers, developers, investors, regulators, and appraisers raise concerns about changing fortunes in all CRE sectors,” Evans said.

Even if Bank Lending Plateaus, CRE Lending Still Running Strong

Overall, originations of commercial and multifamily mortgages are expected to total $500 billion in 2016, down just slightly from the $504 billion originated in 2015 and also less than the record of $508 billion originated in 2007, according to The Mortgage Bankers Association.

“The year has started off with more than its fair share of twists and turns,” said Jamie Woodwell, MBA’s vice president of commercial real estate research, adding that global economic uncertainty still remain wildcards in how the second half plays out.

But on the supply side, Woodwell said, life insurance companies, Fannie Mae and Freddie Mac are expected to make-up for some – but not all – of the slowdown in the CMBS market this year. The net result will likely be 2016 originations coming in just a shade lower than 2015 levels.

And don’t count banks out of the mix just yet, said Jeffrey Weidell, president of NorthMarq Capital, a San Francisco-based CRE financial intermediary. Although caution is the message everyone is hearing, it’s not what Weidell is experiencing.

“If one lender is reluctant there is another behind it (who is) willing,” Weidell said. “We have found that the smaller lenders are more focused on the quality of the deal and the sponsor relationship than the property type. If they become overweight in one area – say retail – they become less aggressive but there is another bank without a similar concern.”

“For existing and leased properties we are not experiencing negative impacts,” he said.