With a goal of the improving long-term stability of the financial system, new regulatory initiatives have emerged as defining features of today’s marketplace. In the spring of 2015, CREFC undertook a study to broadly assess the qualitative and quantitative impacts of regulation on the commercial real estate sector specifically. CREFC conducted more than two dozen interviews with industry leaders representing the full range of real estate capital sources and with regulatory professionals. Financial and economic analyses complemented the interviews with quantitative evaluations of regulatory costs.
The scope of the Commercial Real Estate Regulatory Impact (CRERI) study encompassed a wide range of post-financial crisis banking and securities regulations that impact the CRE sector, including provisions of the new Basel Capital Accords (Basel III) and the Dodd-Frank Wall Street Reform and Consumer Protection Act. Assessments were conducted on the bank and non-bank markets and the quantitative impacts are meant to apply starting in July 2015.
While the interviews yielded a range of views on the magnitude of regulatory costs, key themes did emerge. At the highest level, CREFC members believed that new regulations had the effect of reducing leverage in the system, albeit on the margins, but that low interest rates and the cyclical expansion were masking the effects. In turn, the tightening of capital availability could support better credit decisions.
However, the majority of interviewees converged on the view that regulations were unlikely to achieve better underwriting outcomes due largely to poor design. Several study participants from banks and nonbanks cited specific instances where a new regulatory standard had or was likely to drive adverse selection in lending or a degradation of prevailing underwriting standards for one or more capital sources.
Amongst the key themes emerging from interviews with CREFC members, the cost and uncertainty of a mutable regulatory environment, reduced leverage and liquidity, unevenness in the regulatory burden across capital sources, and an ambiguous impact on overall loan quality and systemic risk all featured prominently:
- Cost of Regulatory Burden and Uncertainty
Now six years after the G20 regulatory agenda was articulated and five years since the Dodd-Frank Act became law, implementation details of key regulatory initiatives are still being designed. With major changes awaiting the financial services industry, CREFC members note that regulatory burden and uncertainty have become features of the marketplace. Fragmentation of regulatory authority across a large number of domestic and international agencies has allowed for parallel—and sometimes overlapping—regulatory initiatives, which has added to the overall burden and time horizon of uncertainty. For the largest global banks facing the highest regulatory burden, satisfying new rules related to capital and liquidity may require an additional 300 bps or more of capital and adjustments to the risk profile of debt held on balance sheet. For large banks, CREFC estimated additional and ongoing regulatory costs for commercial mortgage loans averaging roughly 46 bps. While other classes of financial institutions will likely bear fewer regulatory costs on an absolute basis, smaller banks in particular are feeling a greater relative burden.
2. New Regulation Raises Borrowing Costs and Reduces Lending Volume
Recently implemented and pending regulatory reforms raise banks’ and other lenders’ costs for making CRE and construction loans, reducing their incentives to lend to the sector. Since allocations to CRE will place greater demands on finite capital reserves, CREFC members noted that bank lending in other sectors will be negatively impacted as well. From the perspective of the borrower facing higher relative costs of financing, levered returns on investment will be lower, thereby reducing the incentive to borrow.
3. Cyclical Trends Mask the Full Impact of New Regulation
CRE investment and property performance trends have improved markedly since the economy’s financial crisis-era nadir. With respect to asset prices, these improvements reflect the strong relationships between capital markets and CRE investment. There is a similar relationship between macroeconomic conditions and property fundamentals, which have lagged capital during the recovery. With investment and fundamentals now both improving, CREFC members observe that strong cyclical trends are masking the drags on commercial real estate finance resulting from current and pending regulatory reforms. The full cost of reform, and its impact on real estate market liquidity, may be more readily observable during phases of the cycle characterized by economic and financial stress and reduced liquidity.
4. New Regulation Can Reduce Higher-Regulated Institutions’ Competitiveness
As the cost of financing increases for prudentially regulated institutions, the relative cost of financing declines for non-bank financial institutions (NBFIs). Reflecting this relative change, many CREFC members expressed concern that large, low-risk borrowers may migrate from banks to other, more competitive sources of capital, thereby reducing the average quality of banks’ mortgage portfolios.
While lower aggregate lending by banks and SIFIs will reduce their risk profile, this adverse selection works in the other direction, increasing the average risk profile. The impact on the total risk in the market is ambiguous, contrary to the original policy goal.
5. New Regulation Imposes Greater Costs on Small and Medium-Size Borrowers
The incidence of higher regulatory cost—who ultimately bears the cost of regulation—will fall to both lenders and borrowers. In secondary and tertiary markets, small regional and community banks are often the only consistent sources of construction and shorter-term financing. Even as smaller banks bear a relatively higher regulatory burden than larger banks and NBFIs, several CREFC members observe that smaller borrowers will internalize a larger share of those increased borrowing costs.
The large drop in secondary market liquidity that coincides with and follows a downturn places stress on asset values and slows price discovery. Contrary to policy goals, constraints on smaller lenders that reduce market liquidity may exacerbate loss rates and severities for investors and lenders alike.
6. Ambiguous Link to Loan Quality
CREFC members and researchers are divided on the question of whether current regulatory initiatives will induce higher average loan quality. Several CREFC members expressed that with greater demands on finite balance sheets, banks and other regulated entities will make better lending decisions.
Others market participants observed that when lenders internalize the costs of regulation, they will need to meet higher return requirements, which in turn will drive riskier behavior. Alternatively, if lenders push costs to the borrower, i.e. the incidence of the lending costs falls to the borrower, better borrowers can substitute into another financing source. Either way, the regulated loan pool can deteriorate given higher costs.
7. Impacting the Economy through CRE
The overall impact of new regulation on the CRE industry and its adjacencies—including construction activity, construction employment and the broader economy—is significant. In the median scenario tested by CREFC, the model estimates show a cumulative subtraction from economic output of $209 billion over 10 years. Across scenarios, the estimated ten-year cost ranges from $168 billion in the low impact scenario to $936 billion in the extreme downside case where construction activity declines by more than 5 percent from baseline projections. The primary channels of spillovers from regulatory reform are distortions to asset prices in the presence of costlier leverage and, over the medium- and long-term, a reduced supply of real property. Apart from reduced construction activity, a lower inventory of real property implies that firms will face higher costs in the space market.