CRE at a Crossroads

By Phil Hall

Baseball legend Yogi Berra famously quipped, “The future ain’t what it used to be.” Commercial real estate lenders might agree.

Although most industry experts look at the sector’s future with optimism and enthusiasm, slivers of mild apprehension have slowly permeated the near-term forecast. And while this doesn’t significantly change how industry leaders perceive the coming months, it nonetheless buffers the sense of exuberance at what the future might bring.

A warning sign of apprehension came in September 2015 when the Urban Land Institute announced that its latest forecast was “slightly less bullish on its outlook” compared to its April 2015 forecast. ULI leader and survey participant William Maher, director of North American strategy for LaSalle Investment Management in Baltimore, blames potential potholes on foreign sources. “The U.S. economy and real estate markets are in much better shape than most other countries, but global economies and capital markets are increasingly interrelated,” he says.

Jason Pendergist, president of consumer and commercial banking at Laguna Hills, Calif.-based Luther Burbank Savings Bank, agrees with that diagnosis, although he notes that overseas problems could be both a negative and positive.

“It will be an interesting time in the real estate cycle,” he says. “My gut says that we have a number of years ahead of us before we see the ugly side of the cycle pop up. If there is a negative cycle event, it will be in the global economy. But until we see the global economy return to stable constant growth, we will continue to see an advance of capital in commercial real estate.”

The bigger picture

But that is not to say that the U.S. economy is without its hiccups and headaches.

“Contrary to what we’ve been told by the mainstream media, I don’t think the economy and employment numbers are as strong as we’re being led to believe,” comments Peter Doiron, SVP at Thomaston Saving Bank, which serves the central Connecticut market. “We are still looking at 8 percent unemployment in my market.”

Michelle Lucci is a risk management consultant at Bankers Toolbox, which ABA endorses for its Crest stress testing program for CRE concentrations. She points out that economic recovery is still an elusive commodity in many markets—especially in those areas carrying the brunt of the housing bubble implosion.

“I’m in the Tampa market and many foreclosures are still working their way through the system,” she says. “Apartment prices are higher now than they were in the pre-crisis period. A bubble is possible, depending on supply and demand in local markets.”

The prudential regulators are likewise concerned about CRE concentrations, issuing a statement in December expressing “concern” about excessively loose CRE underwriting and risk management practices, and noting that examiners will be paying “special attention” to CRE portfolios.

Federal Reserve Vice Chairman Stanley Fischer expressed this view when he warned earlier in December that “signs of valuation pressures are emerging in commercial real estate markets, where prices have been rising at a solid clip and lending standards have deteriorated, although debt growth has not yet accelerated notably.”

Indeed, the Fed’s agitation was so acute that it held a secret “war game” exercise in June 2015 that resulted in a grim conclusion: there was no easy solution to handle a potential collapse of the CRE sector. News of this exercise, which was not made public until a Wall Street Journal article on December 11, found the central bank leaders depressed.

“I walked away more sure about the discomfort I originally had,” Esther George, president of the Federal Reserve Bank of Kansas City, told the newspaper.

On the horizon

Yet, on the whole, the near-term future for CRE appears to be positive. The most recent ULI forecast, which polled 49 leading economists and industry analysts, predicted that commercial property transaction volume will rise before leveling off in 2017 at $500 billion; that CRE price growth will slow down from 10 percent in 2015 to 6 percent this year and 4.5 percent in 2017; and that vacancy rates will dip for office and retail properties through 2017 while apartment vacancy rates rise slightly.

Meanwhile, office rents will rise 4 percent in 2016 and 2017; apartment rents will rise 3.5 percent in 2016 and 3 percent in 2017; retail rents will tick up by 2.5 percent in 2016 and 2.8 percent in 2017; and industrial rental growth should grow by 4 percent in 2016 and 3 percent in 2017.

But what could spoil this satisfactory forecast? Bankers are more than a little annoyed by the increased regulatory burden and examination process. Most recently, the regulatory treatment of the high-volatility CRE classification under Basel III has caused concern among lenders as expressed by Greg Sims, managing director for real estate and business banking at Kansas City, Mo.-based CrossFirst Bank.

“The one word I can use in relation to HVCRE is ‘confusion.’ Every bank is trying to do its best to figure out the regulatory need while doing their reporting correctly. But there are a lot of transactions we see that do not fit neatly into the box. It is still a learning curve.”

But California’s Pendergist does not see the HVCRE treatment as a serious game changer. “When it comes to construction projects, banks are ready, willing and able to deploy capital and support construction growth,” he says. “It will just involve a little higher interest rate and a little lower return to the bank.”

Speaking of interest rates, the risk factor is another issue for bankers to address, especially as the U.S. economy is now finally moving away from years of near-zero rates. There are some industry leaders that do not feel worried about the rate hike trajectory.

“Banks, as a rule, are very conservative and have been preparing for the interest rate increase for a long time,” says Julia Anne Slom, SVP and CRE team leader at Washington Trust in Providence, R.I. “This was built into their analysis for structuring deals. For the first time in ages, this actually will be needed.”

Yet not everyone is sanguine on the subject.

“We see a lot of banks stretching terms, going to seven or as far as 10 years,” says Sims. “From the borrower perspective, the cover ratios are going to diminish. But the lending fundamentals are strong enough—even if the rate escalates, no one anticipates a huge run-up in rates and it will not be a major impact.”

“That is the wild card,” adds Pendergist. “If we look at capital rates and interest rates, we would expect to see some level of increase in capital rates with some corresponding increase in interest rates. But over the past year, we’ve seen some ebb and flow with that—these rates have not fallen in lock step with each other.”

“Interest rate risk impacts the whole institution,” remarks Michelle Lucci. “Banks are reaching for yield to make earnings­—going long, but funding sources are not going long. A real problem here will be managing the risk, especially in the community bank sector.”

But Thomaston Savings Bank’s Doiron does not see his community bank suffering from interest rate risk. “It helps us,” he says. “On the commercial side, everything is variable. Things are fixed for periods of time.”

Turf rivalry

What Doiron is concerned about, however, is competition. The good news, he observed, was that many potential customers go out of their way to connect with banks like his. “The whole commercial area is driving our loan amounts,” he says. “Our net loan growth is about 7 percent for 2015.”

The bad news, he continues, is that while community banks are considerably different from larger rivals, they share the same regulatory burdens as the big players.

“The regulatory environment has changed so dramatically,” he explains. “It is very difficult for some customers to deal with banks. There is also the challenge of trying to sustain the volume. There is a lot of activity, but there is always so much deal stealing going on.”

Competition from nonbanks, such as credit unions and shadow lenders, is a threat to some banks, according to Slom. “They are formidable in pockets,” she warns. “It depends on the product size and deal size.”

Pendergist echoes that competition in the CRE lending is roughly divided in two somewhat unequal parts.

“On the small to moderate end, with a typical commercial real estate transaction of $10 million and less, it is very hard for a nonbank to come in with a deal that makes sense for customers,” he says. “Community banks and regional banks have a stronghold in that space. Over $10 million, however, nonbanks are the market. CMBS, GSEs or nonbanks make up the bulk of production.”

As more competitors crowd into the currently robust CRE market, Pendergist is more concerned that the sector is accelerating toward a speed bump. “The fundamentals continue to look strong, and there is still excessive demand for well-located, well-performing property,” he says. “But the question mark on the horizon is whether the fundamentals will continue to look better and better for at least five years. Yes, there will be time before we start to see that leveling out, which will be driven in large part by a slowdown and curtailment on precipitous climb in rents across the board. Rents by and large have reached their capacity. The upward slope needs to flatten out at some point.”

And Slom adds to the sense of cautious optimism that seems to reign in today’s CRE world, noting that the still-tenuous economic environment will ultimately determine the sector’s fate.

“I think we’re in a recovery, but I’m not sure if anyone would say we’re in a super robust economy,” she says. “We’re much better than where we have been. The economy is stable and improved. By not rushing upward, we will not see a momentous crashing down to earth.”

Phil Hall is a regular contributor to the ABA Banking Journal.