5 commercial real estate (cre) challenges in 2017

Enterprise Risk · Credit Risk · Market Risk · Operational Risk · Regulatory Compliance · Securities Lending

1

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


2

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.


3

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.


4

JOIN. ENGAGE. LEAD.

THE END OF HISTORICALLY LOW

INTEREST RATES

1


5

JOIN. ENGAGE. LEAD.


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.


6

JOIN. ENGAGE. LEAD.


INTEREST RATES (CONT.)

Sources: St. Louis Fed, CoStar


7

JOIN. ENGAGE. LEAD.



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.


8

JOIN. ENGAGE. LEAD.



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.


9

JOIN. ENGAGE. LEAD.



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.


10

JOIN. ENGAGE. LEAD.



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.


11

JOIN. ENGAGE. LEAD.



Lenders will maintain a strong position if they can:

• Charge risk adjusted spreads while

• Maintaining conservative advance rates

• And meaningful recourse structures.


12

JOIN. ENGAGE. LEAD.



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.


13

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.


14

JOIN. ENGAGE. LEAD.

RETAIL ISSUES

2


15

JOIN. ENGAGE. LEAD.

RETAIL ISSUES

So far in 2017, many major

retailers have announced store

closings, while e-commerce sales

continue to grow.


16

JOIN. ENGAGE. LEAD.

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.)


17

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.


18

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.


19

JOIN. ENGAGE. LEAD.


Of note, most retailers now

disclose the amount of sales

attributed to e-commerce on

their income statement.


20

JOIN. ENGAGE. LEAD.


Lending risk exists in

all retail store types.


21

JOIN. ENGAGE. LEAD.


Location is still of primary

importance with retail real

estate…

…but location can only

eliminate a portion of the

risk.


22

JOIN. ENGAGE. LEAD.


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.


23

JOIN. ENGAGE. LEAD.


Standalone retail buildings will

need to be designed and built so

that if the tenant vacates,

replacement tenants will be

attracted to the space.


24

JOIN. ENGAGE. LEAD.


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.


25

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.


26

JOIN. ENGAGE. LEAD.


During underwriting,

collateral-specific risks

need to be addressed including:

Location Building(s) Tenants Leases


27

JOIN. ENGAGE. LEAD.


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.


28

JOIN. ENGAGE. LEAD.

CURRENT

REGULATORY ENVIRONMENT

3


29

JOIN. ENGAGE. LEAD.

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.


30

JOIN. ENGAGE. LEAD.

517262 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

262262 banks with

C&D loans ≥100%

of risk-based

capital.


(CONT.)This consists of:


31

JOIN. ENGAGE. LEAD.

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.)


32

JOIN. ENGAGE. LEAD.


(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.


33

JOIN. ENGAGE. LEAD.


(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.


34

JOIN. ENGAGE. LEAD.


(CONT.)

Sufficient capital adequacy

and a healthy loan loss

allowance are critical.


35

JOIN. ENGAGE. LEAD.


(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.


36

JOIN. ENGAGE. LEAD.

CCAR AND CONSTRUCTION

4


37

JOIN. ENGAGE. LEAD.


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).


38

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.


39

JOIN. ENGAGE. LEAD.

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.)


40

JOIN. ENGAGE. LEAD.

CCAR AND CONSTRUCTION (CONT.)

Large banks in particular are

managing their portfolios with

the stress test results in mind.


41

JOIN. ENGAGE. LEAD.


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.


42

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%


43

JOIN. ENGAGE. LEAD.


CRE lending is a key part of most lender origination

platforms and balance sheets.


44

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.


45

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.


46

JOIN. ENGAGE. LEAD.

Growth is

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%


47

JOIN. ENGAGE. LEAD.

MULTIFAMILY VS. SINGLE FAMILY

5


48

JOIN. ENGAGE. LEAD.

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.


49

JOIN. ENGAGE. LEAD.

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.


50

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



51

JOIN. ENGAGE. LEAD.


In most U.S. markets, these

multifamily units were

absorbed.


52

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.


53

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.


54

JOIN. ENGAGE. LEAD.


Lenders need to understand

the demand for multifamily vs.

single family.


55

JOIN. ENGAGE. LEAD.


Underwriting should address

the future population needs,

preferences, and income levels

needed to qualify for rent or a

mortgage.


56

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.


57

JOIN. ENGAGE. LEAD.


As with retail,

borrower and

management capabilities

are equally important to

the success of

multifamily properties.


58

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.


59

JOIN. ENGAGE. LEAD.


If higher interest rates

are coming,

then bank balance

sheets stand to benefit

from a normalized

interest rate

environment.


60

JOIN. ENGAGE. LEAD.


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.


61

JOIN. ENGAGE. LEAD.

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


62

JOIN. ENGAGE. LEAD.

For additional information about

credit risk management,

visit

www.rmahq.org/credit-risk/

LEARN MORE

http://www.rmahq.org/credit-risk/


63

JOIN. ENGAGE. LEAD.

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.

SHARE THIS PRESENTATION

http://www.rmahq.org/

http://landing.rmahq.org/membership

5 commercial real estate (cre) challenges in 2017

Economy & Finance