Without actually using the dreaded B-word, a U.S. federal regulator warned last week of rapid commercial real estate growth accompanied by looser underwriting standards. Let’s examine what commercial real estate players can do to minimize the danger posed by a possible CRE bubble.
But first we’ll look at the problem laid out by the Office of the Comptroller of the Currency.
“It’s at this stage of the cycle that we also see strong loan growth combined with easing underwriting to result in increased credit risk,” currency comptroller Thomas Curry said in remarks accompanying the release of the OCC’s semiannual risk report. “While leveraged lending and auto lending remain concerns, CRE lending and concentration risk management has become an area of emphasis for regulators.”
Underwriting problems the OCC found include less restrictive covenants, extended maturities, longer interest-only periods, limited guarantor requirements and deficient stress-testing practices.
Low interest rates are partly to blame, since borrowers can be expected to take more money as long as it is cheap. Banks, for their part, can end up in a bidding war of sorts as they compete for borrowers by offering more attractive conditions that contribute to looser underwriting standards. Last month’s Brexit vote, meanwhile, appears set to contribute to the Fed’s decision to keep interest rates low for the time being.
It may be too late to bring bubble-type lending to a halt, but there are some things that individual commercial real estate players can do to protect themselves:
Practice safe lending
One of the problems the banking regulator cited was looser underwriting standards. In the short term, borrowers may seek extended maturity dates or limited guarantor requirements, and providing such perks can make a bank more appealing to a borrower. Though such tactics may be aimed at wooing more borrowers, they can ultimately backfire in the case of a popped bubble.
Get direct access to data
In Curry’s remarks, the currency comptroller indicated that banks’ assumption of “unfamiliar risks, including expanded reliance on third-party relationships” contributed to the problem.
How do you develop your own information and your own relationships, so as to minimize reliance on another party? By having alternate sources of data independently accessible.
A lender that wants to find information about a property owner might want to know about other properties belonging to the same owner; borrowers may want to find out if their real estate needs fit in with a lender’s strategy; and banks may want to find out more about each other’s real estate record before joining forces to syndicate a loan. In addition, lenders and borrowers alike may want to know more about a given market before sinking money into a property.
Having direct access to data can help lenders keep up (or raise) their underwriting standards by giving them the tools to find the information that can minimize their risks.
Keep default at bay
For borrowers who can’t make the mortgage payment or fail to keep a property to an acceptable standard (both financially and operationally), defaulting might seem like a quick fix. But just as lenders use stress tests to reduce risk, borrowers can perform their own internal stress tests, with the aim of avoiding overleveraging and a hiking interest-rate environment, which can then lead to higher monthly debt payments and unfavorable loan performance metrics.
Look at the big picture
In addition to the type of lender and the underwriting standards, other variables in commercial real estate deals include property type and market type.
For instance, the OCC report flags multifamily as having higher vacancy rates than other commercial property types, saying markets with the most new construction “will likely see apartment vacancy rates rise by more than 1 percent and will experience slower rent and net operating income growth.” By contrast, the report notes, more limited construction for other property types has contributed to national vacancy rates for office, industrial and retail properties that have declined over the past two years and are expected to continue to decline.
Lenders and borrowers alike, then, would do well to carefully consider property type in a given market, as well as the wisdom of new construction at the moment.
Reconsider running with the giants
The OCC found high growth concentrated in the commercial real estate portfolios of banks, especially small banks. By late 2015, the banking regulator found, over 180 banks had more than doubled their commercial real estate portfolios in the previous three years, and over 200 more had CRE portfolios that grew more than 50% in that period.
The credit crisis and stock market flux of the 2008 recession pushed many smaller investors into putting their funds into real estate. Small banks got into the picture and ended up competing with big banks. But one of the problems is that when small-capitalization banks put a lot of funds into commercial real estate, they are more likely to have concentration problems than larger lenders, which have more financial resources and are better able to diversify.
It would be prudent for small banks to assess whether it makes sense to continue to have such a large proportion of financial resources in CRE.
The report issued by the Office of the Comptroller of the Currency is a wake-up call for commercial real estate finance. Rather than signaling undue alarm, however, the report should be seen as “a flashing yellow or a caution light,” as Comptroller Curry said in a recent interview.
Now is the time for commercial real estate players to recognize that there is still plenty they can do to minimize risk.
Ely Razin is CEO of CrediFi, a big data platform serving the commercial real estate finance market. He can be reached at ceo@credifi.com.
