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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2016

Regulations, Prices and Competition Shape Bank Lending in 2016

The financial sector is buffeted by credit markets, overseas investment and demographic trends

Key Points

Lending landscape

  • New rules are affecting capital and risk-retention standards.
  • Credit source are proliferating.
  • Recruiting young talent is a priority.
  • The urban-rural disconnect is intensifying.
  • International investment remains significant.
 

The financial services sector is positioned for some potentially large transformations this year that will affect the commercial real estate industry. Regulatory matters, increased competition and changing demographics are among the top issues that will alter the state of the market. The sector also will be affected by interest-rate policy, volatility in the global economy and the outcome of the U.S. presidential election.

The impact of this year’s changes will be influenced by government and nongovernment entities, factors outside of the banking business, and internal industry challenges. To ensure institutions are properly prepared to navigate these transformations, commercial real estate professionals should be aware of some key themes that will shape commercial real estate this year and beyond.

Regulatory issues

Regulation continues to be a top concern among lenders and could fundamentally reshape commercial real estate. This past December, federal banking agencies issued a Statement on Prudent Risk Management for Commercial Real Estate Lending, which warned about loosening of commercial real estate loan-underwriting standards. The agencies added that supervisors will continue to pay special attention to commercial real estate lending in exams in 2016.

Additionally, new regulations on capital requirements for high-volatility commercial real estate (HVCRE), the Dodd-Frank Wall Street Reform and Consumer Protection Act credit-risk retention rule, and impairment accounting will be implemented over the course of the year. Overall, the 2016 regulatory environment will make commercial lending activities increasingly challenging as additional rules are approved by regulatory agencies and implemented throughout the industry.

This year, industry leaders hope to seek additional clarity from the regulators regarding HVCRE classifications, which went into effect in January 2015. Although FAQ guidance was released in April, many questions remain unanswered, and banks and developers are still confused by many aspects of the rule.

The Dodd-Frank credit-risk retention rule for commercial securities, which goes into effect in December, is another area of confusion. Although the rule primarily affects the commercial mortgage-backed securities (CMBS) market, it has the potential to have an impact on credit availability across all sectors of commercial real estate. Various trade associations in Washington continue to press for rule changes and guidance, in hopes of streamlining the implementation and market’s digestion of the rule.

Changes to impairment accounting under the Financial Accounting Standards Board standards, which are set to be released in the first quarter of this year, will require significant operational adjustments throughout the banking industry. Regulators are working on the final credit-loss model, which will likely be implemented in 2018, and may have significant effects on real estate loss-reserve accounting that would affect credit availability.

As lending rules shift and proliferate, the professional examinations associated with financial regulations continue to be extensive, time-consuming and cumbersome processes for banks. Current inconsistencies in analysis and interpretation will only intensify through the year, as more rules are implemented, potentially causing further headaches in the closely monitored examination process.

Interest rate uncertainty

In December, the Federal Reserve approved the first increase in short-term interest rates in almost a decade. Although the increase was widely anticipated, there is some concern in the industry about how the market will absorb rate hikes.

As baby boomers retire, having well-trained young professionals already
in place will be vital to the stability of the financial-services industry.

Eric Rosengren, president of the Federal Reserve Bank of Boston, spoke to these fears in a speech late last year, in which he said he was worried about the rapid rise in commercial real estate prices — echoing similar comments made by John Williams, president of the San Francisco Fed.

With low rates, there are worries among bankers that investors are seeking higher returns without properly analyzing the risk and preparing for the effects of rate hikes. Consequently, lenders are apprehensive, particularly with regard to runoff risk, credit spreads and borrowing costs.

Competitive environment

The interest-rate risk is only amplified by the increased competition among lenders. Borrowers are finding more sources of alternative lending, such as credit unions, marketplace lenders, insurance companies, government agencies and real estate investment trusts, which has been accompanied by a trend of eased underwriting standards for commercial real estate loans.

This competition also extends to the CMBS market. Currently, at least 40 CMBS lenders  are active in the industry, according to market experts. With so many players, the smaller shops issue overly competitive quotes in hopes of increasing their market share, forcing the larger lenders to become more competitive in order to keep the business they already have. This market environment has led to thinning profit margins and could result in poor deal execution. Given these market conditions, there are legitimate questions about the market’s stability and excess credit supply.

As credit standards have eased, some market experts have opined that the commercial real estate  market is becoming frothy, and that prices may have reached their peak. When coupled with declining capitalization rates, which are back to prerecession levels, and predictions of continued rising interest rates, lenders believe these market dynamics may lead to another commercial real estate bubble. The increasing rates will compete against the rental yield on commercial real estate properties, which could negatively  impact prices and result in disastrous declines in property values.

Urban-rural divide

Commercial real estate is affected by a distinct dichotomy between urban and rural areas. Commercial real estate lending has grown sharply in metropolitan regions of the U.S., at same time that lending in rural areas remains steady, or sluggish. The divide seems to be a direct result of the lack of job growth in rural areas, compared to urban areas.

The U.S. population is moving to the areas of employment that are largely concentrated in metropolitan cities, such as San Francisco, Houston and Charlotte, where there has been an uptick in job growth in recent years. This segregation will likely have a direct  impact on economic growth, and some are concerned about the long-term effects of this disconnect.

Property values in metropolitan U.S. cities also have benefited from the influx of foreign capital generated by overseas investors’ belief that their assets are better protected in the U.S. than in their home countries. Although initially this trend was most prevalent in gateway cities like New York and  Miami, other cities have also started to see an increase in foreign investment.

In New York City, Chinese investors have become the biggest private buyers of real estate. With the Chinese stock market declining sharply this past year, and Chinese authorities loosening some restrictions on overseas investments, China remains an important source of capital in the U.S. commercial market.

Demographics drivers

Commercial real estate will be affected by changing demographics in the workforce as baby boomers retire and millennials gradually begin to replace them. The decisions boomers make about where to retire, as well as the uncertainty around many millennials’ housing and work choices, will be significant in the industry.

Demographics also raise important questions for lenders, who are finding it harder to recruit and retain young staff members. As baby boomers retire, having well-trained young professionals already in place will be vital to the stability of the financial services industry.

Those effects are particularly evident in the appraisal industry. Appraisal companies are attempting to combat a projected shortfall of qualified appraisers as the industry’s workforce rapidly ages — posing a major near-term challenge for commercial real estate lenders, especially in rural areas with fewer appraisers.

Overall, 2016 will be pivotal for commercial real estate. Lenders should keep a watchful eye on the issues most likely to affect the industry, in order to properly prepare for a successful year. 


 
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