Federal regulators are urging banks to exercise caution to avoid getting burned as the commercial real estate lending market heats up.
As values have skyrocketed and lenders have crowded in, regulators are growing more concerned that loan terms are becoming too loose. They have issued guidance to banks that they will be paying closer attention to commercial real estate lending and checking to see if banks follow previously announced guidelines.
At the same time, however, conditions for lending are strong and incidents of defaults are few.
“The bank regulators are trying to get ahead of this given past bubbles,” said Ronald R. Glancz, a partner in the financial institutions practice at Venable LLP in Washington, D.C., and a former assistant counsel of the Federal Deposit Insurance Corp. “While real estate valuations in some markets have become quite high, that view has to be balanced by a couple of other factors, namely the low vacancy levels in multifamily housing and the considerable amount of equity (i.e., down payments) that investors need to put down to get commercial loans these days.”
Bright spot
Coming out of the financial crisis, multifamily housing has been a bright spot in the U.S. economy. Low interest rates and strong demand for rentals have translated into a boom in commercial real estate construction and lending. Global investors have eagerly poured money into office buildings and apartment complexes.
In the view of some market participants, banks in general are adequately protected on the downside but a bubble has indeed inflated for rental apartment buildings in urban markets such as New York, San Francisco, Dallas and Los Angeles.
“Out of commercial real estate, the most over-priced of all asset classes — stocks, bonds and alternatives — are apartments, and especially new, urban high-rise apartments,” said Joseph J. Ori, executive managing director and founder of Paramount Capital Corp., a San Francisco Bay area real estate investment, financing and advisory firm that serves investors, developers, institutions, financial organizations and owners nationwide.
New apartment buildings in core urban markets are trading at 3.5 to 4% capitalization rates, “which makes no sense,” Ori said. A property’s capitalization rate is defined as its net operating income divided by its sale price.
Even secondary markets like Atlanta have seen an influx of foreign money, which has helped to force up real estate values. The percentage of foreign buyers in Atlanta commercial real estate shot up from 4% in 2014 to 18% in 2015, according to analysts with the Federal Reserve Bank of Atlanta, who noted, “Anecdotal reports from bankers across the country suggest that increased foreign investment is distorting property values and introducing additional risk to the marketplace.”
Lowering of standards
The boom in commercial real estate has caused some banks to lower their standards, according to a statement of the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency.
”The agencies’ examination and industry outreach activities have revealed an easing of CRE (commercial real estate) underwriting standards, including less-restrictive loan covenants, extended maturities, longer interest-only payment periods, and limited guarantor requirements,” the statement said.
More than one third of community banks exceed 2006 regulatory guidance for what constitutes a concentrated position in commercial real estate, according to a report by Ron Feldman, executive vice president and senior policy adviser at the Federal Reserve Bank of Minneapolis. The banks in question either have construction and development loans that exceed their total capital, or commercial real estate loans comprising more than three times their capital (along with 50% growth of such over three years).
“The pain will come to the community banks and the local banks that have a higher percentage of their portfolios in commercial real estate because that is a lot of what they see,” Ori said.
While the voluntary thresholds set by regulators may provide a broad brush view of the industry, banks defend the safety of their actual commercial real estate loans.
Take for example Independent Bank Group Inc. of McKinney, Tex., which was flagged by industry data provider SNL Financial as being one of the 31 banks with assets totaling more than $500 million that exceeded regulatory guidelines for commercial real estate concentration.
In discussing fourth quarter 2015 results with Wall Street analysts, David Brooks, chairman and CEO of Independent Bank, argued that the portfolio was sound: “I think our loan-to-values tend to be in the 50% to 65% range on those credits typically. A lot of them are seasoned credits. They are to family offices, they are to small businesses, they are to doctor practices — doctor groups that have been in practice for 10, 20-plus years.”
When it comes to commercial real estate, Ori said “the banks are in pretty good shape.”
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