The readiness of US banks to participate in the commercial  real estate lending market improved in 2015. Healthier  balance sheet positions, rising asset prices, and a  brightening outlook for fundamentals all contributed to  swifter matchmaking between lenders and their borrowers.  This progress did not occur in isolation, however. Lenders of all  stripes, including conduit participants and non-bank financial
institutions, were also more vigorous in their engagement with  borrowers. The result was observably higher risk-taking for banks  that, competing with other classes of lenders as well as with each  other, faced a practical choice of pushing the underwriting envelope or ceding opportunities and market share.

In contrast with stabilized property lending, small- and medium-balance construction financing remained a weakly contested segment of the market in 2015, largely free of competitive  pressures from geographically remote balance sheet lenders and from the conduit. That continues to suit regional and community banks perfectly well. Following the post-crisis drought in building activity, opportunity knocks once again. As of Q3 2015, banks have increased net construction lending for ten consecutive quarters. The magnitude of the increases is measured however. As compared to historic norms, subdued expansion in construction lending reflects plodding improvements in the number of viable small- and mid-cap development projects. The impact of higher
risk weights on the banking system’s construction lending capacity is almost certainly a factor as well. The extent of its drag should become clearer in 2016.

Cyclical Attention to Risk Fades

Data from the most recent slate of bank call reports and from Chandan Economics’ independent mortgage data collection show sustained trends in bank lending heading into the new year: both small and large banks are growing their positions in commercial real estate and construction; the lending market is increasingly crowded and many banks are losing market share; to stave off that competition, the risk profile of recently originated loans is often markedly higher than for loans made just a few years ago; and, in contrast with CMBS, drags from banks’ legacy debt are now a de
minimis consideration.

As in past cycles, the medium-term implications of banks’ increasing risk tolerance are not perfectly observable—or heeded—at the time of loan-making. Quite the opposite, the current profile of bank activity suggests they are discounting their own stress testing regimes in an unsurprising effort to remain competitive. Uneven regulation across classes of lenders is a complicating factor in that competitive landscape. Even as our risk models show deterioration in marginal loan quality, improving property fundamentals and the shrinking pool of legacy loans are supporting favorable inferences about the future performance of today’s new exposures.

Bank Delinquency and Default Trends

The blended default rate on commercial and multifamily mortgages held by banks—including loans 90 days or more delinquent and loans in non-accrual—declined to just 0.8% in the third quarter of 2015, the lowest level since before the financial crisis. Excluding apartments, the commercial property default rate fell to 1.0%, its lowest level in more than seven years. The apartment default rate is now just 0.3%. That is well below Chandan Economics’ estimate of the long-term structural non-performance rate, centered around 0.5%. Five years earlier, banks’ multifamily default rate had peaked at 4.7%, higher than for their commercial mortgages. At that time, banks’ multifamily default rate was also significantly higher than roughly comparable agency measures of distress, a difference we attribute principally to selection bias in the apartment sector’s lender-borrower relationships.

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Bank New Lending Trends

Higher lending volumes have been an important contributor to lower
default rates, which reflect the near-complete dilution of legacy
pre-crisis bank loans as well as the cumulative impact of writedowns
and troubled debt restructurings. Exclusive of multifamily
lending, the balance of commercial mortgages held by banks
increased to $1.2 trillion in the third quarter of 2015, its highest
level on record. The $23.8 billion quarter-to-quarter increase was the
largest in seven years. Multifamily lending also posted its largest
quarterly net increase of the post-crisis era, rising $13.9 billion.
Across both commercial and multifamily mortgages, net lending
has increased by $106.4 billion from a year earlier, a 7.5% expansion
in banks’ exposure to the sector.

Bank Construction Financing

As of the third quarter, small residential properties accounted for
just under 22% of banks’ outstanding construction loans. Across
all projects, including multifamily and commercial real estate development, net lending has increased for ten consecutive quarters, by
$64.6 billion over the two and half years since construction financing’s
nadir. Loan-to-cost ratios have trended slightly higher but understate the risk profile of banks’ exposure because of leverage measured against rising construction costs.

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While the pace of construction lending is increasing, it continues
to lag historical recoveries. Banks’ total construction exposure was
$266.1 billion in the third quarter, still a far cry from the 2008 peak
of $626.5 billion. In the years after the dot-com recession, growth
in year-over-year construction lending peaked at well above 30%.
Reflecting an ambiguous balance of regulatory pressures and limited
need for additional inventory, construction lending is growing
at half its former record-setting pace. There are exceptions, most
notably New York City’s office building boom, but smaller banks
play a limited role in this segment of the market.

Bank Real Estate Owned and Restructuring

Distress investors with capital to deploy will do better with pending
CMBS maturities, where persistent concerns about pending legacy
maturities are a direct rather than indirect driver of the analysis. As
of the third quarter, commercial and multifamily other real-estate owned
(REO) had fallen to $4.2 billion, roughly one quarter of its
peak level in 2010. Whether through write-downs or modifications
or improvements in market conditions, the bulk of moderate quality
and high quality properties have found their way out of distress.
Exceptionally high recovery rates on early REO sales reflect that
better quality investments were jettisoned early by banks. Little of
what now remains holds institutional appeal.

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The rate of recidivism amongst delinquent borrowers is declining,
signaling further that many the headwinds facing banks are distinct
from those encountering the conduit. Where banks have modified
non-performing loans, their track record had been mixed but is
improving as the last vestiges of the crisis are wiped away. Lenders
are at risk of treating improvements in their legacy positions as
proxies for new loan quality. As they distance themselves further
from the crisis and competition intensifies, cyclical conservatism is
waning, introducing loans to the bank balance sheet that show a
clear move to renewed risk-taking.