The commercial real estate debt landscape has become considerably more crowded of late. The resulting contest to fund deals, along with historically low cost of capital, has contributed to higher real estate prices and taken an inevitable toll on underwriting standards.
The latter trend is most easily observable in the information-rich CMBS market, but is also present in the competitive overlaps between lenders. A range of indicators, from historically low debt yields to falling amortization, shows us the direction of understanding standards even if it does not tell us our exact position in the risk cycle.
For life companies and other lenders of a conservative ilk, prevailing conditions are in contrast with the tighter standards enforced in the initial reaction to the financial crisis. In that environment, life companies were able to grow their share of the lending pie judiciously while still adhering to the standards reflected in their enviable default and loss experience. The lion’s share of new commitments went to a highly privileged class of well-heeled borrowers. Looking forward, however, some life companies risk compromising that discipline as they increase allocations and work to maintain or improve upon their strong market standing in an environment of heightened competition.
Commercial real estate’s rising tally of lenders is also increasingly diverse, supporting borrowing against a wider array of small and large properties, primary and secondary markets, urban and suburban locales, and investment strategies.
Both in principal and in practice, that is it to the market’s benefit, helping to even out an otherwise lopsided recovery. Central to the rebound of secondary and tertiary markets, which otherwise have lagged, a relative surfeit of conduit lenders has joined life companies and banks to reengage with borrowers across a more complete range of the investment spectrum. Corners of the market that are still suffering persistent shortfalls in access to debt are now scarce rather than common. If the menacing wall of CMBS maturities presents a considerable challenge, it is in part because of the underlying mix of properties, and not just because of sheer volume.
The headline numbers on lending activity support the anecdotal assessment and show a market reclaiming its former vigor. After declining for four consecutive years, commercial real estate loans outstanding increased in 2013 and 2014. Pending the release of fourth quarter data by the Federal Reserve, Chandan Economics estimates that net lending against commercial properties climbed more than $140 billion over the last two years. Multifamily mortgages are estimated to have increased by more than $85 billion over the same period. Demand for mezzanine loans reflects senior lenders’ readiness to accept a fuller capital stack, as well as the pervasiveness of the hunt for yield.
While the conduit lenders may consolidate their numbers over the next year, the outlook for aggregate lending points to continued momentum across almost all capital sources. Lenders and their borrowers are not necessarily moving in lockstep, however. Notwithstanding broader improvements in fundamentals, lending volume will increase at a more rapid clip than borrower quality if lenders’ own prognostications are to be taken seriously. Making the rounds of the New Year symposia and surmising from a quick read of the industry surveys, borrowers can expect to see an increase in deal flow from virtually every major lender class. This market prediction holds for life companies as much as any group. The most recent Real Estate Lenders Association-Chandan Economics Survey of Commercial Real Estate Lender Sentiment shows life companies outpaced only by CMBS in terms of volume growth in 2015.
As the real estate recovery has turned to expansion and the expansion has in turn matured, the lending environment has changed—and not always to the advantage of the life companies. The larger number of banks and conduit lenders quoting loans is certainly not a problem in itself; the next few years’ schedule of maturities point to ample lending opportunities for risk-seeking sources of capital. Life companies are not among the deliberate risk seekers, but the participation of other lenders does spill over into their preferred turf. Even if the lending profiles of the different classes of institutions vary dramatically, overlap has increased as lenders of all stripes have gravitated to the higher-quality borrowers that comprise the life companies’ wheelhouse.
Looking forward, life companies are better equipped to walk away from aggressive underwriting scenarios than most of their peers. That will serve them well over the next several years. Like other lenders, they are faced with a changing interest rate environment that will bear on pending refinancing, as well as the exit performance of current originations. Distinguishing them from other lenders, their favorable track record over the last cycle has the potential to fuel overconfidence. It bears reminding that, as an industry, we make the worst performing loans when we are most confident of the outlook.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School, University of Pennsylvania. The views expressed here are his own. He can be reached at email@example.com.