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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   May 2016

Underwriting Standards Evolve

Commercial real estate lenders are adjusting risk-tolerance levels after a period of robust growth

It is no secret to anyone in the industry that since the economic recovery started, commercial real estate investment has been one of the hottest markets in the U.S. In fact, a national commercial property index from Moody’s Investors Service and Real Capital Analytics showed year-over-year price growth of 12 percent in 2015. According to the same index, commercial property prices as of year-end 2015 were at an all-time high and 11 percent greater than the prerecession high.

What has caused such a robust rebound in a relatively short period of time? A number of dynamics have contributed to the recovery, but most industry experts agree that the low-interest rate environment and availability of capital are among the key driving factors.

The consensus in the market is that underwriting standards have loosened across the board. But the amount of risk lenders have proven willing to take on varies widely among the four traditional sources of permanent financing for commercial real estate: banks, commercial mortgage-backed securities (CMBS), government-sponsored enterprises (GSEs) and life insurance companies. For loan originators, gaining a deeper understanding of the trends and traits that define these financing niches can serve as a competitive advantage when seeking to match a client’s financing needs with the right loan source.

Life companies

Traditionally, life insurance companies have been the most risk-averse sources of financing, offering lower-leverage products on high-quality, low-risk assets. There is still strong demand for financing from life companies, however, and insurance lenders hold $362 billion in commercial real estate loans, according to the Federal Reserve.

This great demand is because life companies offer extremely competitive pricing. Don’t expect much to change in this sector in the near future.

Life companies will continue to focus on high-quality assets in metropolitan locations and lend primarily on the four major CRE groups — multifamily, retail, office and industrial properties. Insurance lenders are less active in lower-quality properties or geographic markets that are most susceptible to economic slumps. Loan-to-value ratios will remain on the lower end, and these companies will pick their spots rather than stretch to win business.

CMBS

CMBS lenders have typically been the biggest risk takers in this space because they don’t hold loans on their balance sheets. CMBS loans, therefore, have been more accessible for lower-quality properties in all markets, including those considered tertiary.

Securities backed by commercial real estate loans have weakened significantly since the start of the year amid bond-market volatility. CMBS prices fell sharply in the second half of 2015, and only $9.6 billion of CMBS were issued through mid-March of this year, compared with $15.7 billion over the same period a year earlier.

As borrowers turn to banks, life companies, Fannie Mae and Freddie Mac, CMBS lenders face stiff competition. The major unknown is whether CMBS lenders will be forced to turn to higher-leveraged, riskier assets in secondary and tertiary markets to make up for the loss of business in the Class A property space.

GSEs

In 2015, Fannie Mae and Freddie Mac surpassed their respective $30 billion loan-purchase caps after the Federal Housing Finance Administration (FHFA) revised the affordable-housing loan categories that are excluded from the cap. The lending totals for the two GSEs this year are expected to remain strong.

Credit spreads — the yield difference between low-risk U.S. Treasury notes and bonds, such as mortgage-backed securities — are projected to widen in 2016. In addition, there has been no significant policy change that indicates a loosening of underwriting standards. Reforms driven by legislative action could lead to changes in the GSEs’ lending criteria, but no major shifts are expected before the November election.

Still, many believe that as commercial property prices continue to rise and investors pay for lower capitalization  rates, loan risk for the GSEs will increase in the multifamily sector — particularly for widely available high-leverage, long-term, fixed-rate loans with interest-only periods.

Banks

As commercial real estate concentrations have risen at many banks, there has been an easing in policy for making these loans. Less-restrictive loan covenants, higher loan-to-value ratios, longer-term maturities, limited recourse or nonrecourse requirements and longer interest-only periods are all increasing the risk profile of loans held on the balance sheets.

A study  conducted by the Office of the Controller of the Currency (OCC) at the end of 2015 showed that commercial underwriting standards eased at 30 percent of the 95 major banks surveyed and tightened at only 6 percent. Standards eased for stabilized assets and for construction and development loans.

Banks and savings associations in general have eased underwriting standards and increased their levels of credit risk, and large banks reported the most easing of underwriting standards. The loosening was greater in commercial real estate construction than in any other category, including leveraged loans, consumer loans, credit cards and other commercial real estate.

The OCC said  banks are increasingly making exceptions to their existing loan policies and warned that “boards of directors and senior management should carefully consider the impact of eased underwriting standards on the quality and volatility of performance in their loan portfolios, particularly for products that have already seen considerable easing over the past several years.”

The runup in commercial property prices has driven rapid growth in U.S. banks’ loan books. Regulators are now urging caution and warning banks against taking on unnecessary risk and overexposing themselves to a cyclical industry.

In fact, agencies such as the Federal Reserve, Federal Deposit Insurance Corp., and the OCC explicitly stated they will pay special attention to the allocation of funds toward investment properties this year. The banking industry’s response to this guidance could significantly affect underwriting standards for commercial real estate lending and will be an important bellwether for U.S. investment sales.


 


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