Commercial Real Estate (CRE) asset quality deteriorated between 2007 and 2012 on the heels of the global financial crisis (GFC). As a result, not only did the total CRE debt outstanding fall as a whole, so did banks’ proportion of that total fall from 50.2% in 2008 to 47.5% in 2007 – a $229 billion drop. That was then, the situation is different now. Average CRE loans on bank balance sheets reached $1.63 trillion at the end of 2016, according to S&P Global Ratings, $0.11 trillion over the previous high. At the same time, asset quality steadily improved quarter-over-quarter, with the proportion of CRE loans 90 days or more past due dropping to roughly 0.05% in the first quarter of 2017.
The favorable environment for CRE, including rising property values and low vacancy rates, increased demand by real estate investors for financing. Attractive interest rates, sound asset quality, and intense competition for other asset classes spurred banks to pick up CRE lending in response. With commercial mortgage-backed securities (CMBS) playing a lesser role, this led to strong growth of CRE bank lending, especially with regional and community banks where localized expertise gives these institutions a competitive edge.
Banks Dominate CRE Loan Origination
Given CRE’s higher asset quality, there was an increase in tolerance for looser underwriting standards, moving from more conservative to more aggressive origination practices in a trend consistent with past credit cycles, according to the OCC. But the situation could quickly change. An unexpected market shock could raise borrowing costs and slow or reverse property price growth. In addition, there are other reasons to be concerned that CRE credit quality could deteriorate and underwriting standards tighten:
- Multi-family markets are overheated, and new apartment construction, most of which has been at the luxury end of the market, will likely outpace demand.
- CRE in energy-producing states will be impacted by the direct and indirect job losses associated with oil price volatility.
- Retail real estate is facing challenges from e-commerce.
- Hotels are particularly susceptible to intense competition and cyclical economic weakness.
- Natural disasters, as recently experienced during this 2017 hurricane season, can impact default and recovery assets.
It’s essential that lenders stay on top of market developments and be ready when changes happen. S&P Global Market Intelligence’s Credit Assessment Scorecards can provide a thorough view of credit risk by combining point-in-time factors with forward-looking qualitative factors, converging industry trends and relationships between key drivers.
Drawing on our August 2017 webinar, 7 Key Drivers of Credit Risk and Top Trends in U.S. Commercial Loan Portfolios, we outline a few factors to consider as you assess credit risk of CRE transactions. Our approach suggests that banks:
- Start by first understanding the transaction type, with recourse transactions emphasizing the sponsor risk and non-recourse transactions focusing on the structure of the transaction.
- Consider property type-specific financial benchmarks, particularly for the five most common types: industrial, retail, office, multi-family, and lodging.
- Look at market risks by incorporating an analysis of the timeframe of leases and the credit strength of tenants, property location, and competitive landscape.
- Finally, determine whether it’s necessary to assess specific risk factors for both the construction phase and operations phase.
S&P Global Market Intelligence’s CRE Credit Assessment Scorecard Analytic Scope and Framework
Source: S&P Global Market Intelligence. For Illustrative Purposes Only.
For more information on how you can leverage this scoring methodology and workflow tools, please request a demo.
S&P Global Market Intelligence. Pressman, R. (2017, May 5). U.S. Banks Are Increasing Their Commercial Real Estate Lending--But At What Risk? (Rep.).
“2016 Survey of Credit Underwriting Practices Office of the Comptroller of the Currency,” Washington, D.C., December 2016.