5 Commercial Real Estate (CRE) Challenges in 2017

Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending
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JOIN. ENGAGE. LEAD.
5 COMMERCIAL REAL ESTATE (CRE)
CHALLENGES IN 2017
An Excerpt from “2017 Industry Insights:
Perspectives from the Front Line”
by RMA’s Credit Risk Council

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JOIN. ENGAGE. LEAD.
HOW WE GOT HERE
Lenders still face historical
challenges of additional regulation
and emerging risks from a
strengthening economy and
higher interest rates.
2017
Regulators issued joint statement
on prudent CRE lending that
reminded financial institutions of
existing regulatory guidance for
CRE lending activity through
economic cycles.
2015 2017
With a historic recession in the rear
view mirror, we are now in the
fourth longest economic expansion
cycle in U.S. history, and caution is
warranted.
2017
Expect additional
expansion as identified
by increased stock prices
and higher interest rates.
Lending strategies will need to account for CRE risks that result from both an
expanding economy and recession.

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JOIN. ENGAGE. LEAD.
THE 5 CHALLENGES
1. The end of
historically low
interest rates.
2. Retail issues.
3. Current
regulatory
environment.
4. CCAR and
construction.
5. Multifamily vs.
single family.

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THE END OF HISTORICALLY LOW
INTEREST RATES
1

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INTEREST RATES
• A historically low interest rate environment appears
to be ending. In Q1 2017, CRE faced the end of a
near eight-year cycle with:
See the graph on the following slide.
600+ bps
400+ bps
A greater than 600+ bps spread
between LIBOR and cap rates.
And a greater than 400+ bps spread
between the 10-year Treasury and cap rates.

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INTEREST RATES (CONT.)
Sources: St. Louis Fed, CoStar

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Borrowers have benefitted
greatly from strong project-
level cash flow that allowed
them to earn back their initial
capital and provide a return to
equity investors.

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Rising interest
rates on floating
rate loans may
negatively impact
borrower cash
flow and result in
lower debt
service
coverages
(DSC).
If the rate is
fixed, then the
borrower (at
refinance) will
likely not receive
either the same
free cash flow or
loan proceeds
that were
available during
the previous
cycle.
Higher borrowing
rates will result in
fewer loan
dollars, assuming
advance rates
hold steady.

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As a response, borrowers will need to
increase rental rates and aggressively
manage operating expenses to
generate cash flow that will ultimately
support a refinance.

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In a refinance, bank advance rates,
spreads, and covenants will ultimately
determine if borrowers can pull equity out
or if it must be maintained in the property.

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Lenders will maintain a strong position if they can:
• Charge risk adjusted spreads while
• Maintaining conservative advance rates
• And meaningful recourse structures.

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It is now even more important for
lenders to fully understand the
cash equity that borrowers either
have remaining in the project or
the amount of initial cash equity
invested for construction or
acquisition.

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JOIN. ENGAGE. LEAD.
If lenders provide non-recourse financing and all invested equity has
been repaid, then they will have only themselves to blame if the
borrower returns the keys when the loan goes into default.

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RETAIL ISSUES
2

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RETAIL ISSUES
So far in 2017, many major
retailers have announced store
closings, while e-commerce sales
continue to grow.

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8.1%15.1%
2.9%
Total retail sales
in 2016
increased 2.9%
(±0.5%) from
2015.
Total e-commerce
sales for 2016:
estimated at $394.9
billion, an increase of
15.1% (±1.8%)
from 2015.
Source: U.S. Census Bureau.
E-commerce sales
in 2016 accounted
for 8.1% of total
sales; e-commerce
sales in 2015
accounted for 7.3%
of total sales.
RETAIL ISSUES (CONT.)

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JOIN. ENGAGE. LEAD.
Lenders need to
understand the risks
of their existing retail
portfolio and
determine how to
best manage their
balance sheet going
forward by:
• Closely monitoring existing
loan covenants.
• And identifying loans secured
by collateral that will be
attractive through the next
real estate cycle.

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JOIN. ENGAGE. LEAD.
Some retailers and
retail industries will be
successful with the
traditional retail model
of a brick and mortar
location.
While other retailers
will likely continue to
suffer from decreased
sales and will continue
to vacate or not renew
leases.

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JOIN. ENGAGE. LEAD.
Of note, most retailers now
disclose the amount of sales
attributed to e-commerce on
their income statement.

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JOIN. ENGAGE. LEAD.
Lending risk exists in
all retail store types.

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Location is still of primary
importance with retail real
estate…
…but location can only
eliminate a portion of the
risk.

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New retail loan originations will
need to be sized and structured
based on the future success of
the tenants and not solely based
on the current rent roll and
economics.

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Standalone retail buildings will
need to be designed and built so
that if the tenant vacates,
replacement tenants will be
attracted to the space.

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Additionally,
regional malls and
power centers may
need to be
underwritten for
future real estate
use, which may
include:
• Storage
• Grocery stores
• Gyms
• Entertainment
• And even residential.

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JOIN. ENGAGE. LEAD.
Concentration levels and
limits on retail property should
be established or modified,
and strategy should clearly
outline a lender’s appetite to
originate new retail secured
loans.

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During underwriting,
collateral-specific risks
need to be addressed including:
Location Building(s) Tenants Leases

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Full
underwriting
must also
address the
borrower’s
ability to:
Own and manage a retail property through
a volatile macro economy.
Address specific risks created via e-
commerce.
Improve the collateral to enhance leasing
interest.
And repay the loan in full given any other
borrower global recourse obligations.

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CURRENT
REGULATORY ENVIRONMENT
3

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CURRENT REGULATORY ENVIRONMENT
The December 2015 Statement on Prudent Lending
reiterated regulator concerns over financial institutions with
weak risk management and high CRE credit
concentrations.
It stated that agencies will focus on:
• Financial institutions that have recently experienced weak risk
management and high CRE credit concentrations.
• Or those with lending strategy plans for substantial growth in CRE
lending activity.
• Or those that operate in markets or loan segments with increasing
growth or risk fundamentals.

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517
262 banks with CRE loans
≥300% of risk-based capital
and growth in CRE loans
≥50% over the last 36
months.
Based on call report findings
as of December 31, 2016,
517 banks and thrifts
exceeded regulators’ 2006
guidance on CRE loan
concentrations.
262
262
262 banks with
C&D loans ≥100%
of risk-based
capital.
(CONT.)
This consists of:

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343 In 2016, the number
of banks violating
the guidance
represents a 51%
increase over three
years.
In Q1 2014,
there were 343
total banks that
violated the
guidance.
51%
(CONT.)

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(CONT.)
With a Republican-elected president and with the House
and Senate in Republican control, regulations on banks are
expected to decrease.
Although the systemically important financial institution
(SIFI) threshold is in line to be raised from the current $50B
amount, and some aspects of Dodd-Frank are likely to be
repealed, banks should not expect less agency scrutiny on
prudent lending practices, strategy, and concentrations.

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(CONT.)
Keys to being prepared for regulatory
review include maintaining appropriate
loan policies, underwriting standards,
and concentration limits, combined with
lending strategies that are responsive
to the local and macroeconomic forces.

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(CONT.)
Sufficient capital adequacy
and a healthy loan loss
allowance are critical.

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(CONT.)
Proving a full understanding of
credit risk to regulators may also
require banks to subscribe to
third-party data sources that will
help them to better understand
property level and macro forces
that impact specific collateral
locations.

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CCAR AND CONSTRUCTION
4

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Since 2009, large banks have been
facing annual stress testing required by
the Dodd-Frank Act (DFAST) and the
results are then addressed in the bank’s
Comprehensive Capital Analysis and
Review (CCAR).

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JOIN. ENGAGE. LEAD.
The Fed publishes economic
scenarios and requires the largest
banks to stress test their loan
portfolios and disclose the
resulting capital levels under the
scenarios.

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150%
Basel III requires banks and thrifts to
disclose their high volatility commercial
real estate (HVCRE) and must assign a
150% risk weight to any HVCRE
exposure.
(CONT.)

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CCAR AND CONSTRUCTION (CONT.)
Large banks in particular are
managing their portfolios with
the stress test results in mind.

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After the Fed publishes stress test results,
banks then analyze the results to discover the loan types
causing the highest capital charge.
One of the worst
performing loan groups in
the stress test is
construction lending.
A possible outcome of the
stress test is lower
construction and more
cautious CRE lending at
large banks in particular.

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JOIN. ENGAGE. LEAD.
Recent data support
this possibility:
Based on call
report data, as
of mid-2016,
construction
lending
represented
less than 20%
of bank CRE
lending.
Historically, it has been as
high as 40% of bank CRE
portfolios, but has averaged
25% since the 1980s.
Banks have pulled back
slightly on CRE
originations in the last 12
months ended Oct. 31,
2016; $1.137 trillion in
CRE loans were
originated, down 5.1%
compared to the prior
year period.
20%
25%
5.1%

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JOIN. ENGAGE. LEAD.
CRE lending is a key part of most lender origination
platforms and balance sheets.

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JOIN. ENGAGE. LEAD.
As banks continue to analyze and respond
to the relatively new stress testing
environment…
the analysis of a risk-adjusted return will
become common as banks better
understand the cost of capital related to
their lending activities.

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JOIN. ENGAGE. LEAD.
It will not be a surprise if construction
lending continues to be de-
emphasized by large banks and
replaced by smaller bank originations
and non-regulated debt funds.

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JOIN. ENGAGE. LEAD.
Growthis
striking
CRE loans account for around
21% of all banks’ loan portfolios.
The growth in CRE
lending by small- and
medium-sized banks
has been particularly
striking.
21%
40%
But in the past 20 years, they
have risen from 15% to 30%
of midsize bank portfolios.
(CONT.)
And from 20% to over
40% of small bank
loan portfolios.
30%

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MULTIFAMILY VS. SINGLE FAMILY
5

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MULTIFAMILY VS. SINGLE FAMILY
The homeownership rate in the U.S.
is now 63.7%, a rapid decline from its
2004 peak of 69.2%.
63.7%
7%
Meanwhile the U.S. rental vacancy
rate remains near 7%, near its
thirty-year low.

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MULTIFAMILY VS. SINGLE FAMILY (CONT.)
• The decreased ownership rate indicates increased
demand for rental units.
– Developers responded to the demand by delivering
315,000 multifamily units in 2016, consistent with
deliveries since 2013 of at or above 300,000, all near
peak levels last seen in the late 1980s.
• Of particular concern are the 378,000 units set to be
delivered in 2017.

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JOIN. ENGAGE. LEAD.
The decreased
ownership rate
indicates
increased demand
for rental units.
Developers responded to the
demand by delivering 315,000
multifamily units in 2016, consistent
with deliveries since 2013 of at or
above 300,000—all near peak
levels last seen in the late 1980s.
Of particular concern are the
378,000 units set to be delivered in
2017.
315,000
378,000

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In most U.S. markets, these
multifamily units were
absorbed.

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JOIN. ENGAGE. LEAD.
In many major
metropolitan
areas, rent per
square foot levels
have reached
all-time highs and
are now falling
slightly from peak
levels.
Of additional concern:
Net rents trail
underwritten
rents due to
concessions in
markets where
supply exceeds
demand.
Class A
deliveries are
about 85% of
new multifamily
deliveries in
major
metropolitan
areas over the
past five years.

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JOIN. ENGAGE. LEAD.
Most single family
residential values now
exceed pre-recession
values, primarily benefitting
the asset owner’s balance
sheet, but also resulting in
fewer people who can
qualify for a mortgage.

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JOIN. ENGAGE. LEAD.
Lenders need to understand
the demand for multifamily vs.
single family.

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JOIN. ENGAGE. LEAD.
Underwriting should address
the future population needs,
preferences, and income levels
needed to qualify for rent or a
mortgage.

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JOIN. ENGAGE. LEAD.
Additionally,
banks will
need to
manage
existing
exposure to
multifamily by:
• Monitoring loan covenants.
• Passing on future lending
opportunities if supply/demand
is out of balance.

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JOIN. ENGAGE. LEAD.
As with retail,
borrower and
management capabilities
are equally important to
the success of
multifamily properties.

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JOIN. ENGAGE. LEAD.
Lenders have an opportunity in the
next cycle to reduce their balance
sheet risk by pursuing lending
strategies that address future risk.

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JOIN. ENGAGE. LEAD.
If higher interest rates
are coming,
then bank balance
sheets stand to benefit
from a normalized
interest rate
environment.

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Specific risks may upset those benefits if
lenders have a myopic view of CRE lending.
Retail
shopping
habits.
Banking
regulation.
Borrowers'
preference to
own or rent.

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The Credit Risk Council supports
professionals who are responsible for
establishing, maintaining, or carrying
out credit risk management policies.
The council focuses on funded and
off-balance-sheet risk management,
including capital markets activity, and
other forms of credit intermediation
and risk mitigation.
ABOUT RMA’S CREDIT RISK COUNCIL

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For additional information about
credit risk management,
visit
www.rmahq.org/credit-risk/
LEARN MORE

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Visit http://www.rmahq.org for information on risk management.
RMA is a member-driven professional association whose sole
purpose is to advance sound risk principles in the financial services
industry.
RMA helps its members use sound risk principles to improve
institutional performance and financial stability, and enhance the risk
competency of individuals through information, education, peer
sharing, and networking.
Become a member today.
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5 Commercial Real Estate (CRE) Challenges in 2017

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