To borrow a phrase, here we go again.
According to a report Monday from Fitch Ratings, U.S. banks have record exposures to commercial real estate (CRE) loans but valuation and lending trends are not sustainable in the medium term. Indeed, Fitch projects a softening of the CRE market in the coming months.
In December 2015, the Federal Reserve, Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency issued a joint statement warning about the potential risks to the banking system from CRE lending, just as they did prior to the financial crisis. The statement noted an “easing of CRE underwriting standards, including less-restrictive loan covenants, extended maturities, longer interest-only payment periods, and limited guarantor requirements.”
U.S. banks, especially smaller ones, have kept on lending since the warning. CRE loans have increased at a cumulative annual growth rate of 3.7% the last five years, says Fitch. The main driver has been multifamily property lending, which is expanding faster than any other major bank loan class. It has posted a CAGR of 10.7% in the last five years.
“Falling homeownership rates have helped drive U.S. banks’ commercial real estate lending to record levels as property valuations also approach or exceed pre-2008 peaks,” says Fitch in its report.
In addition, says Fitch, “a $205 billion wall of maturing loans from CMBS conduits originated in 2006 and 2007 creates the potential for further CRE lending growth through 2017.”
The Green Street U.S. Commercial Property Price Index (CPPI) has more than doubled since May 2009, and recent data show the CPPI rising at a robust 7.5% rate.
The good news the past five years, though, has been the slowdown in lending for hotel, industrial, retail, and office space, as well as the fall in construction loan balances, “which experienced the highest loss severity in the last banking crisis.”
Fitch says banks have “tightened their lending standards for construction, driven by their experience in the last crisis and by subsequent regulations that require them to hold additional capital on loans to highly leveraged construction projects.” But, recently, some banks have expanded their construction lending, which Fitch considers an unwise move given current CRE market conditions. Fitch expects losses similar to the last crisis in construction lending when the next downturn occurs.
The credit profiles of smaller banks are the most at risk, says Fitch, because “they generally have the highest concentration of CRE exposure.” Those banks with more than 300% of risk-based capital in CRE “have less than $50 billion in assets and most have assets below $10 billion,” according to Fitch.
The timing and severity of the CRE market’s softening “is uncertain and depends on factors including interest rates and overall economic conditions,” Fitch says, and it admits that “some asset quality mean-reversion is factored into our ratings.”
Negative rating actions for banks is “only likely when banks’ losses and nonperforming asset ratios exceed our expectations and those of similarly rated peers,” says Fitch.
But Fitch clearly believes some of that is coming.