The past 18 months have seen a surge in commercial real estate (CRE) lending as banks, in response to America’s 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 in commercial mortgages – a post-crisis record representing 22 percent growth for the quarter, according to data from the Mortgage Bankers Association.
Unfortunately for borrowers and lenders alike, getting banks to lend on real estate may become much more difficult in the 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 in the global 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 currently lead in terms of lending and origination, but that trend is beginning 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 a greater necessity for more competitive terms, and the impending regulated lending environment to be brought on by such legislation as the Dodd-Frank Act and the Basel Committee on Banking Supervision’s Basel III. As a result, it remains to be seen what will happen when these two forces collide.
Now that banks once again have become more comfortable with real estate financing, competition is getting stiffer and deals are getting riskier. In order to win more business, banks have been loosening their lending standards and have become more willing to lend against riskier strategies.
“Many more banks are open to construction loans and loans to developers that are doing ground-up projects, whereas it was very challenging to find that kind of financing a couple of years ago,” says Ronald Kaplan, Northeast leader of CohnReznick’s CRE industry practice. He cites the New York condominium market as one example, noting that only one or two banks were active in that market just two to three years ago, but that has “changed quite a bit now” as more players are getting in the game.
Commercial banks that securitize their loans also have been a part of this greater tendency towards risk. In results from a 2014 outlook survey by the Commercial Real Estate Finance Council (CREFC), members cited a predicted increase in the volume of interest-only loans as the “most concerning trend in new commercial mortgage-backed securities (CMBS) issuance.” Apart from its prevalence within CMBS, an overall increase in interest-only mortgages shows the propensity of lenders to take greater risks in a more competitive environment.
CREFC president and chief executive Steve Renna, however, points out that an increase in interest-only loans is proportional to the overall increase in CMBS volume. “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.”
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 they go into effect.
“Regulators are trying to ring 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 a bank needs to have behind that loan, and for how long,” says Renna. “They are making it harder for the banks to remain in the business.”
One big area of concern for banks involves Dodd-Frank’s impact on construction lending. The regulation restricts ‘high volatility commercial real estate’ (HVCRE) loans, with banks ultimately required to hold 12 percent instead of 8 percent in capital reserves for each loan they issue. The regulation also 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 effectively could 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 still are 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 shrink the banks’ portion of the pie 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.
The latest version of Basel III also addresses HVCRE loans, which applies to certain acquisition, development and construction loans. Each HVCRE loan in a bank’s portfolio that meets the definition would be assigned a 150 percent risk weighting under the proposed rule, as opposed to a 100 percent risk weighting under current rules. 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 maintain more capital on hand, or the cost of lending has to increase so much more so they can generate the profit needed to meet the capital requirements,” reasons 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. “Lending will become more expensive for banks, and that will create openings for other capital providers in the CRE lending space,” says Renna.
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 the Urban Land Institute and PwC’s Emerging Trends in Real Estate 2014 survey correspond with Kessler’s prediction. “Financial organizations that are not traditional banks are starting to make loans again in a significant way,” one real estate adviser stated 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 likely will lose their hold on the market. Kaplan adds that debt funds also have other advantages, including the ability to close faster.
Still, Renna hesitates to say that private equity funds will take the place of banks in certain areas of the debt market. He agrees that private equity will take over some loan origination when the regulations come into effect, but he believes their true role in the market remains to be seen.
“It depends on whether those loans are the types of loans private equity funds want to make,” Renna says. “If banks retreat in the marketplace, it doesn’t necessarily mean other lenders can and will move into that space. Private equity funds have to evaluate whether there’s enough yield for them because their capital is more expensive than that of banks.”
Beyond just debt funds, banks have more competition to worry about as other less-regulated entities, such as conduit lenders that contribute to CMBS deals, also are becoming more active in the lending space and getting a bigger piece of the pie when it comes to loan origination. Indeed, the CMBS market is gaining a lot of momentum as a competitor, compared to when it essentially was shut down following the onset of the financial crisis, and Kessler sees a projected increase in CMBS activity again this year.
The CMBS market has a decided advantage over the regulations that banks must contend with when it comes to certain deals. “There are some very large single-asset CMBS trans-actions that banks wouldn’t touch because the concentration is just so large,” says Kessler.
An uncertain future
Notwithstanding 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, and higher interest rates may incentivize banks to pursue more loans in the expectation that lending could become more profitable. In addition, in their rush to finance real estate transactions, banks could tighten spreads on loans to become more competitive.
Jones Lang LaSalle’s 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 pending regulatory changes, the question now is not whether or not debt will be favorable, but in whose favor – banks’ or alternative lenders’ – the market will move.
On the increase
Responses to a recent survey reflect commercial banks’ growing presence in real estate lending
Banks’ increased activity in loan origination has shown that they once again are getting comfortable with commercial real estate (CRE) lending in a way they have not been since before 2007. Respondents to the Urban Land Institute and PwC’s Emerging Trends in Real Estate 2014 survey made note of that increased comfort, adding that they expect an increase in the availability of debt capital in 2014 from five main sources: the commercial mortgage-backed securities (CMBS) market, commercial banks, insurance companies, mezzanine lenders and non-bank financial institutions. Within those responses, commercial banks rose to second place, up from fourth place last year. The survey also notes that, despite the expected increase in interest rates as the Federal Reserve tapers its quantitative easing initiatives, commercial banks should retain their ability to be “very competitive” in 2014.