An MBA CREF 2017 Panel Summary: Concentration, Construction and Competition: Banks and Their Evolving Market Role
The commercial real estate lending business is rocking—in more ways than one. By many measures, business has never been better, and the outlook for 2017 is strong. But banks have also had their world rocked by a new, and still evolving, set of regulatory requirements. And many require major changes to lending practices, in short order. This year, we’re all in a market characterized by equal parts opportunity and uncertainty
Contending with the changes in lending standards and practices affects not only banks, but borrowers. How to navigate these issues and serve their clients was at the center of the discussion at a lenders panel at the Mortgage Bankers Association Commercial Real Estate Finance (MBA CREF) conference titled “Concentration, Construction & Competition: Banks and Their Evolving Market Role.” Moderated by Angela Mago, Executive Vice President of KeyBank Real Estate Capital, the panel included commercial lending executives from banks ranging in size from a community bank to major institutions.
The overall view offered by these CRE finance leaders is one of optimistic caution. It’s optimistic because this year looks like a continuation of the great market seen in 2016. Yet, it’s a cautious market due to the myriad of factors that could cause the economy or the real estate lending business to suddenly take a new direction. And it’s anybody’s guess whether that direction could be up, down or sideways.
Balancing Opportunity and Risk
Using statistics presented by MBA research professionals the previous day, Mago set the stage for the discussion by providing a snapshot of the 2016 market.
“Apartment cap rates are at all-time lows and apartment values at all-time highs, multifamily mortgage originations had a record year last year, outstanding mortgage debt has never been as high–so we are setting some precedents in this market,” Mago said. “Originations in 2016 were $502 billion, not quite a record but close to the previous year,” and just a few billion dollars shy of the peak year in 2007.
Despite the brisk volume, lenders have shown much more discipline than they did a decade ago. “LTVs [loan-to-value ratios] today are similar to 2010, but on a stressed basis they’re closer to 2007, due to where yields are today and the more aggressive cap rate environment,” Mago said. Asset fundamentals are stronger today than a decade ago as well. NOIs [net operating income levels] are trending up, and are exceeding prior peaks in all asset classes, while asset prices are higher than the previous peak in all classes except suburban office.”
Banks played a larger role in CRE originations last year, with balance-sheet lending up by 6 percent compared to 2015, according to MBA numbers. CMBS lending was about 15 percent lower than in 2015, while Fannie Mae and Freddie Mac increased their volume by about 10 percent. Life companies continued their pattern of consistent annual volume.
All the panelists said they hope to do as much volume in 2017 as they did in 2016—if not more—but whether they can achieve that goal will depend on the level of demand for capital, as well as the yields they can achieve on real-world deals.
Breaching the Wall of Maturities
According to MBA statistics, about half of all originations in 2016 went to refinance maturing CMBS loans from 2006-2007, while the other half consisted of new construction and term loans. The ‘wall of maturities’ peaked last year but will still create strong demand for refi capital in 2017. It’s the other half—new transaction volume—that represents a wild card for originations.
One open question involves the impact of rising interest rates. In recent years, interest rates have been so low that investors could afford to buy properties at historically low cap rates. Now that interest rates have increased by 50 to 70 basis points, and the Federal Reserve has suggested that rates could rise more in 2017, it’s believed that cap rates may start to rise as well. Higher cap rates could increase transaction volume as owners who have been net sellers come back to the market as buyers, one panelist noted.
Meanwhile, banks’ appetite for loan volume varies significantly by property type. Panelists agreed that supply and demand factors are most favorable in the multi-family sector, followed by industrial and downtown office markets. The retail segment, however, is seen as struggling against the rising tide of e-commerce trends. Department stores and standalone “big-box” retailers face the greatest challenges, while urban centers with restaurants and “fast fashion” retailers are among the best candidates for growth in the sector.
As banks face greater scrutiny from federal regulators, their real estate lending practices can be affected in a number of ways. All banks represented on the panel conduct stress tests to determine how loans might perform under adverse economic conditions, and then make sure to set aside enough capital to cover any potential losses. Large banks are required to conduct stress tests, but some community banks that aren’t subject to the same rules perform the tests anyway, to ensure they understand their risk-adjusted returns.
For example, one bank recently adjusted its core stress rate on construction loans to 6 percent for multifamily and 6.25 percent for most other property types, which translates to initial yields of about 8 percent and overall debt yields of 9 percent or higher.
In addition, regulators may question banks that have too much of their portfolio concentrated in commercial real estate, especially construction loans. Panelists referred to the “100/300 rule”—if a bank’s total construction loans exceed 100 percent of its risk-based capital, and total CRE lending exceeds 300 percent of risk-based capital, then the bank is classified as a real estate-concentrated lender, and is subject to additional scrutiny.
Avoiding Risk Concentration
Regulators also discourage banks from having too many loans concentrated in a single asset class, or in one geographic market. One panelist noted that his bank had to pass on a good opportunity because it would have exceeded the bank’s threshold on hotel exposure; now the bank is looking to move some of its lesser-quality hotel loans off its balance sheet to make room for higher performing deals with more experienced borrowers.
The exposure profile of borrowers is an issue as well. Recently, banks have had to turn down opportunities with developers that have too much in the pipeline, compared to the size of their stabilized portfolio. And regulators tend to question loans where the interest-only period exceeds three years.
Compliance is also an area where uncertainty is ever-present in 2017. Every bank has its own method for determining when an asset can be considered stabilized, allowing distributions to be made. Some banks hold distributions until initial construction is complete, while other look for a particular debt-service coverage ratio.
“Regulators don’t prescribe what stabilization means. Each bank has to determine what it means, and be consistent across its portfolio,” Mago said. “If you look at the large banks and how they handle this, the lowest common denominator is return of capital.” Although some banks may prefer more clarity on the issue, that would require several different government agencies to “get on the same page.”
Stabilizing the Market
The rules may present new challenges for banks and new hurdles for borrowers, but they are fulfilling their intended purpose of helping banks to look at risk objectively. One panelist observed that its borrowers are also more disciplined than ever before. in fact, the interests of banks and their real estate clients are better aligned than ever, as neither side wants to see loans go into default. Whatever direction the economy or the real estate market goes, lenders and borrowers are in a good position to meet the challenges together, without the type of disruption seen a decade ago.
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