Financial Footing

Commercial lending institutions look to the future

The Great Recession has long been in our rearview mirror, but eight years later, that economic calamity continues to impact the commercial real estate arena—particularly commercial real estate lending. The lending industry has adapted over the past several years to a new reality: closer scrutiny on projects, waning enthusiasm within traditional banks for financing new construction, newer and more creative institutions stepping into the void and ultra-low interest rates that have persisted for so long they’ve almost become the new normal.

Into that mix arrives a new year, a new U.S. president and new federal regulations that took effect in early December. In fact, the regulatory environment will likely be the big story of 2017, with many expecting the Trump Administration to have a lighter regulatory touch—if not actually leading the charge to repeal the Dodd-Frank Act and its myriad regulations on financial institutions.

In light of all that, what should developers and investors expect to see in the coming year from the commercial real estate financing sector?

 

Risk Retention

As the new year begins, industry players have their eyes on the impact of the new Dodd-Frank regulations that went into effect in early December 2016. These new “risk retention” rules are targeted at commercial mortgage-backed securities (CMBS) issuers, requiring them to retain 5 percent of a loan’s value rather than selling 100 percent of it in the form of bonds. These rules are intended to force lenders to keep some of their skin in the game, thereby discouraging risky lending. But Adam J. Petriella, managing principal of Silverthread Capital, LLC, says those rules will also reduce profit margins for lenders and, ultimately, make credit more expensive for borrowers.

“Risk retention is a big concern this year and has caused some part of the slowing in [loan] issuance,” he says. “We are still trending below last year’s issuance by about one-third to one-half less.” He adds that specialty finance sources have proliferated due to a pull-back from big banks. “But the smaller shop is not the actual securitizing shop selling the bonds. They have to roll it up into a larger product by one of the larger banks — Wells Fargo, Bank of America,” he explains. “There’s now that added friction, where someone has to take responsibility for another’s origination, and they loathe to do that. So it’s kind of slowed the process.”

But the industry is feeling some relief in the hope that the Trump Administration will, at the very least, not implement any new regulations. “The election could play a big part in trends this year as the regs could change a great deal,” says Petriella. “The change in government policy could have a big impact and the market is split on how big this may be.”

And new “punishing” regulations are far from necessary, according to Petriella. “The market seems to have learned the lessons of 2008 without the need of new federal regulations,” he says. “Many players are developing a more realistic approach to investments in this field. The industry seemed to take the lessons from the recession and make changes on their own. Also, much of the mortgage-backed securities problems were in the residential field, not the CMBS marketplace.”

 

Interest Rates

In addition to regulations, the market has also kept a close eye on interest rates. Petriella says the rate increase in December 2015 “caused some investors to take a second look at their projects, and it has delayed some.” That’s despite the fact that 2016, in general, saw some of the lowest rates in a very long time. Because the economy has been on solid footing for the past year, and the latest employment numbers were strong, Petriella believes interest rates will hike again. And that hike will also have a dampening effect.

“If we’re talking about a 10-year loan, naturally the debt service over the term of that loan will be significant because the debt service will increase,” he says. “But more significantly in the short term will be how a loan is underwritten, and any increase in the rate will cause the size of the loan, the size of the proceeds, to go down. So if the interest rate goes up, all other things being equal, the size of the loan will decrease — it’s just math. And that will necessitate the equity owner to have to come to the table with more equity. That’s going to hurt syndicators; that will hurt folks who are raising money to buy real estate.”

A Focus on Fundamentals

Overall, a tighter regulatory environment and rising interest rates are causing lenders to approach projects with a sharp focus on the fundamentals. “We are all looking at deals on a case-by-case basis and the fundamentals of each opportunity. There is no other way to play this. There are too many variables to generalize,” says Petriella. Particularly in secondary and tertiary markets, lenders are “really digging into the fundamentals of the real estate — the tenants, the lease terms, the sponsor’s liquidity, the sponsor’s ability to pay the loan — all of these factors are being looked at pretty closely, especially compared to pre-recession.”

In particular, says Petriella, banks are leery of loans for new construction. “Construction lending by banks is really on a case-by-case basis. … The lender puts on the brakes and evaluates every construction loan. And many of the big banks are essentially out of the business — unless it’s a tier-one market. Everywhere else, it’s really a non-starter. Again, these are banks. There are plenty of non-banking institutions out there making construction bets.”

Looking at specific market segments, Petriella says that industrial projects are a strong area of investment, in large part due to the movement of e-commerce. “Multi-family is always strong. Housing sales have been mixed. The rental market is extremely strong, except within specific areas. There has been a little bit of pull-back on multi-family construction lending. The lenders are concerned that certain cities may be overbuilt on multi-family, but overall multi-family is the strongest asset there is,” he says.

 

A Strong Year Ahead

Many in the industry are hopeful about the prospects for 2017. Any shakiness or uncertainty in the economy can cause developers, investors and lenders to pull back. But as things sit in early 2017, the economy is solid, interest rates are still historically low and the Trump Administration looks to be business friendly. “Most of the folks in the business are looking at the Trump Administration and his having won the election as a positive,” Petriella explains. “His policies seem to be at least very, very aggressive, and he’s pro-business, and I think it argues well for what’s about to happen for the next two to three years.”

And even if there is any economic shakiness, the CMBS industry is well-positioned to ride out the bumps. “The market is in a different place than ’08,” Petriella says. “It’s in a very good place; it’s very strong, well-positioned. Everyone’s just a little bit more circumspect about any assignment that they’re working on in terms of financing that property. It really boils down to the fundamentals. And that’s a good thing. We’ve all learned a lesson and we’re all looking at every one of these fundamental aspects of an assignment more closely.”