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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   February 2017

Lending's Perfect Storm

Mortgage brokers can navigate the rough waters facing the commercial mortgage market this year

Lending's Perfect Storm

With new regulations taking effect and interest rates on the rise, commercial lenders and brokers can sense a storm on the horizon. The path to success in the coming year is sure to be paved with new and frustrating obstacles.

But there’s hope for those willing to work through the obstacles. As the storm clouds descend, it will take competent navigation to pass through these straits unscathed.

The commercial lending market may face some headwinds this year, thanks to new regulations on commercial mortgage-backed securities (CMBS) and construction lending markets, a rising interest rate environment, and more than $100 billion of CMBS loans scheduled to mature in 2017. Concern regarding CMBS loan maturities in 2016 and 2017 — the result of peak volume in CMBS financing from 2005 to 2007 — has been well-documented.

Fortunately, the commercial lending market has worked through these maturities so far with limited impact to the commercial market. This is due, in large part, to banks and insurance companies picking up the slack while interest rates were near all-time lows. The year ahead, however, may prove a bigger test as new regulations, combined with rising interest rates, add to an already cresting tidal wave of maturities.

Regulatory waves

At the end of 2016, all financial institutions were required to comply with new regulatory capital rules related to High Volatility Commercial Real Estate (HVCRE). The new regulations related to HVCRE were part of the Basel III banking regulations adopted between 2010 and 2011. The most notable change requires that banks and all savings and loan institutions set aside 50 percent more capital against certain construction and development loans that either exceed the standard now in place for a loan-to-completed-value ratio or do not meet the cash-equity requirement of 15 percent of the appraised “as-completed” value.

Last year, large banks began pulling back on construction financing because of tighter regulatory requirements and concerns about exposure in some property sectors and geographic regions. As a result of the new regulatory capital rules now in effect, a borrower without a solid project and cash equity of at least 15 percent of the appraised “as-completed” value who seeks a construction loan likely will have to consider alternative sources of capital (e.g., smaller regional and community banks, life companies, debt funds and family offices). At a minimum, borrowers should expect higher financing costs for construction projects.

The year ahead may prove a bigger test as new regulations, combined with rising interest rates, add to an already cresting tidal wave of maturities.

In addition to the HVCRE regulatory capital rules, new risk-retention rules under the Dodd-Frank Wall Street Reform and Consumer Protection Act regulatory overhaul went into effect, requiring issuers of CMBS to retain at least 5 percent of the securities they create. Until the dust settles and issuers figure out how to address the risk-retention requirements, CMBS loan originations likely will continue to decline.

In the near term, this new regulation will drive up financing costs and reduce the number of CMBS players. As such, CMBS lenders will continue to lose market share, which has already declined from 27 percent in 2014, to 16 percent in 2015, to 7 percent midway through 2016.

Alternative sources of refinancing CMBS loans with higher LTVs may be limited to regional and local banks, insurance companies, debt funds, private lenders and family offices as larger banks may not be as active because of bank regulators’ concerns about the market. Thomas Curry, head of the Office of the Comptroller of the Currency (OCC), expressed concern about the commercial lending market in a media statement issued after the release of OCC’s Spring 2016 Semiannual Risk Perspective report, saying, “With commercial real estate lending, we are signaling a flashing yellow or a caution light.”

CMBS maturities

Combined with the recent regulatory changes in the bank market, a wave of loan maturities is coming due this year. In 2017, more than $100 billion of CMBS loans are expected to mature. Compare that to the approximately $50 billion of CMBS loans originated in 2016 through Sept. 30, and it’s apparent that significantly fewer loans are being originated than are maturing, even on an annualized basis.

Capital markets are active, and many financing sources in today’s market provide brokers with the opportunity to be the life raft for borrowers.

Last year, a similarly large volume of CMBS loans came due while the CMBS market was dead. Alternative sources of funding, primarily by banks and insurance companies, stepped up and filled the demand gap. This trend of alternative sources filling the void will likely continue.

The added challenges in 2017, however, are the rising interest rate environment and the higher cost of financing due to new regulations and increasing default rates in the CMBS market. Morningstar Credit Ratings LLC predicts that borrowers won’t be able to pay off roughly 40 percent of the CMBS loans coming due this year. Unlike 2016, when banks filled most of the gap, nonbank lenders may now need to fill the void as banks become more conservative.

Navigate the waters

While these challenges may seem daunting, there is good news. Capital markets are active, and many financing sources in today’s market provide brokers the opportunity to be the life raft for borrowers. Brokers and borrowers can navigate this challenging environment in the following ways: 

Develop relationships with as many different capital sources as possible: insurance companies, debt funds, private lenders and family offices.

Provide succinct executive summaries to lenders to help them quickly evaluate each deal. The executive summary should provide information about the borrower, details about the property, the loan amount requested and the use of loan proceeds. Underwriters are busy, so providing an effective loan-submission summary might mean the difference between approval or denial. 

Consider short-term bridge or mezzanine financing to pay off commercial loans on properties with temporarily depressed values resulting in an artificially inflated loan-to-value ratio. With the stringent prepayment penalties typically attached to CMBS loans, many of these loans may be coming due at a time when the value of the underlying asset may be temporarily depressed. That could be the result of the loss of a significant tenant; a slowdown in the local market as a result of the decline in energy prices; a sizeable portion of leases expiring in the current year; new inventory coming online, etc. Once the property is stabilized, the broker can then refinance the borrower into a more permanent loan. As such, brokers can add tremendous value for their borrowers during this process. 

Expect increased costs for HVCRE construction loans because of the additional capital-reserve requirement and more conservative loan-to-cost and loan-to-value ratios.

Be prepared to have alternative sources of financing for your construction-loan request. Insurance companies, private lenders and family offices will continue to fill the void. But not all construction lenders are created equal. Make sure you understand the lender’s experience and how construction funds and draws are handled.

 Be proactive. Don’t wait until just before the loan’s maturity date to explore options.

•  •  •

While President Donald Trump promised during his campaign to repeal Dodd-Frank, analysts say this could take a long time and certain provisions could remain on the books regardless. So, don’t expect these challenges to be resolved quickly. Take this opportunity to become familiar with the financing sources available to you. 


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