Three Factors Impacting CRE Financing in 2016

By Bill Tryon, Director of Strategic Development, Partner Engineering and Science Inc.

As expected, 2015 was a strong year for the commercial real estate sector, with transaction volumes comfortably surpassing pre-financial crisis levels. According to a 2015 market survey by the National Association of Realtors, CRE sales prices increased 4.1 percent and sales volume rose by 7.4 percent, compared to 2014. Transaction values, however, declined in the fourth quarter, and a recent commentary by Morgan Stanley predicts CRE prices will remain flat throughout 2016. Interest rates are expected to be raised again, which may affect some borrowers’ ability to find favorable financing and may require owners to contribute additional equity to refinance maturing debt. What other market factors are expected to impact CRE financing in 2016?

1. Volume

A flood of maturing loans originated in 2006 and 2007 is expected to keep loan volumes high throughout 2017. However, volumes are likely to be lower than expected, since many CMBS borrowers have refinanced ahead of schedule to take advantage of low interest rates and high prices. Foreign investment should continue to bolster the market, particularly in gateway cities.

2. CMBS

CMBS has supported as much as 40 percent of all CRE lending, accounting for more than $100 billion worth of loans in 2015 alone. Recent market volatility has resulted in significant losses to some CMBS originators, however, making some lenders reluctant to originate loans for which securitization through CMBS is the sole profitable exit strategy.

To complicate matters, risk retention requirements implemented in connection with Dodd-Frank go into effect in December, requiring CMBS sponsors to retain a portion of the risk for loans they generate, the regulatory assumption being that having “skin in the game” encourages more conservative behavior. As a result, funds available to the CMBS market may be reduced, since CMBS lending will begin to impact the lender’s balance sheet. Life companies and non-regulated lenders may fill the financing gap, but increased borrowing costs appear to be inevitable.

3. Banking Regulations

Studies conducted by the Federal Deposit Insurance Corp. (FDIC) and Office of the Inspector General (OIG) showed that CRE lending played a significant role in the failure of lending institutions during the financial crisis. As a result, regulatory scrutiny of CRE portfolios has increased.

In addition, these FDIC and OIG studies revealed even greater risks associated with construction lending, particularly when lenders failed to maintain adequate controls, significantly increased the size of their construction portfolios, or expanded into unfamiliar geographic regions and types of developments. To control related risks, bank examiners have implemented increased scrutiny of construction lending practices, which translates to more stringent controls and demanding processes for borrowers.

At the same time, high-volatility commercial real estate (HVCRE) rules now require regulated banks to reserve increased capital as a hedge against potential losses associated with failed construction loans, resulting in increased borrowing costs in the range of 50 to 150 basis points. The increased reserve requirement doesn’t extend to all construction loans. For example, residential and community development loans are exempt, as are certain cases in which borrowers contribute cash equal to at least 15 percent of the as-completed property value. The rule requirements and applicability have caused some debate among banks and regulators; to play it safe, some lenders are assuming that all construction loans are subject to the rule.

Representatives from the OCC, Fannie Mae, Freddie Mac and major lenders will meet at this year’s Construction Lender Risk Management Roundtable to discuss strategies for managing risks in this changing regulatory landscape.