The Weakening State of Underwriting
Sam Chandan March 4, 2014, 12:15 p.m.
The commercial real estate finance industry has entered 2014 with a renewed sense of confidence. The incautious tone at the first quarter’s outlook conferences belies the industry’s recent history and the losses incurred on precrisis lending activities. Instead, heady predictions of higher lending volumes are being proffered as unequivocally positive signs of better days ahead. More is better in the mundane calculus, and the next year will undoubtedly see more lenders in more places enabling investment by a wider range of borrowers. We are hard-pressed to show serious evolution in our approaches to credit risk measurement. But as long as we ignore that capital flows and the cost and capacity for leverage influence prices and risk-taking, there is no cause for a more prudent analysis.
Depending on your vantage point, reengaged lenders and easier access to financing may not be such novelties. For commercial borrowers in New York and its peer markets, and for multifamily borrowers across a much broader market landscape, the recovery in capital flows is well established. In these settings, strong sponsors with high-quality assets are not crippled by shortfalls in equity and debt to any significant degree. Instead, saturation with artificially subsidized capital has contributed to prices that have trended higher in anticipation of stronger fundamentals. More recently, it has allowed for narrower spreads, as underlying risk-free yields have climbed from their lows.
Capital abundance is not a universal condition. In contrast with the most privileged, secondary and tertiary markets and markets for value-add investments have been relatively underserved. For both debt and equity, uncertainties related to the underlying economics of property performance matter more in these markets. Their smaller scale entails more limited liquidity and a stronger anchoring to income. The secondary-market lag has widened sufficiently over the last year such that investors and lenders have inevitably come in search of yield.
Whether in primary or secondary markets, there is room for debate about the quality of current vintage loans. Standards tightened inordinately during the depths of the financial crisis and remained conservative in its immediate aftermath. From this perspective, standards have not deteriorated so much as normalized. On the other side, standards are adjusting faster than the outlook for property income warrants. Because the quality of today’s loans is only proven out in the future, assessments of loan quality contemporaneous with origination can never be substantiated unequivocally. It is invariably an exercise in forecasting. Worse yet, the market demonstrates little ex post interest in differentiating who forecasted well and who forecasted poorly.
What might lead us to believe that loan quality is deteriorating, especially if confidence about the direction of the market is firming? History gives us a hint in that loan quality is countercyclical in lending volume. We lend more—and more aggressively—when we are more confident about momentum in the asset price trajectory. Down the road, the vintage analysis will show that loans made in 2007 experience higher default and loss rates than loans made in 2009 under more conservative assumptions. That should inform our thinking now, as exuberance threatens to run ahead of meaningful improvements in how we measure, manage and mitigate risk. If the industry consensus is right, lending is poised to grow faster than the pool of well-qualified borrowers. That can only square if standards loosen.
Apart from competition to fund deals, other forces are working to influence loan quality. The belabored wave of CMBS maturities is seen as both an opportunity for high-yield-seeking distress investors and a challenge for the industry as a whole. Upon closer examination, it is readily apparent that precrisis CMBS loans scheduled to mature over the next several years are a mixed bunch. The pools are dominated by relatively small retail properties, including neighborhood and community shopping centers and unanchored strip malls. Hedge funds are emerging as prospective sources of refinancing for lower quality, illiquid assets, but their ability to differentiate risky from very risky is often untested.
What’s a lender to do as risk-taking reasserts itself? As permanent financing opportunities become more competitive, some banks are returning to construction lending sooner than planned. Absent the conduit, this is a relatively uncontested segment of the commercial real estate capital market. During the second quarter of 2013, banks’ net construction lending increased for the first time since before the financial crisis. Walking away from lending opportunities is easier proposed than done if it amounts to shuttering the store or willfully ceding market share. In the best scenario, a well-informed lender will be able to gauge risks and returns with greater precision, pricing more efficiently as a result. In practice, that is unlikely to result in market share growth until after the market has peaked and competitors have been waylaid by their own balance sheets.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School. The views expressed here are his own. He can be reached at email@example.com