Summer Street Advisors


       


Tuesday
Aug232016

U.S. Banks Shy Away from Risk, Settle for Lower Yields

Banks have taken a decidedly more cautious stance on commercial real estate lending this year. They’ve pulled back from construction lending, except in cases where developers have capital at risk. Borrowers seeking to refinance can expect to find loan-to-value ratios in the range of 65 to 70 percent, maybe higher for pristine deals with no complications—“no hair on them,” in industry parlance.

The real estate market is in good shape, with low vacancies and rising rents across all property types. In the industrial and apartment sectors, development has barely kept up with demand. And the U.S. economy shows no signs of an imminent downturn. Normally, banks would be lending aggressively at this stage of the cycle. But this time around, they’re still smarting from the impact of the last down cycle, and they’re facing greater regulatory scrutiny than ever before.

One new rule under Dodd-Frank requires banks to reserve more capital for highly volatile commercial real estate (HVCRE) loans on their books, which effectively reduces their profitability by limiting their deal flow. Banks that issue commercial mortgage-backed securities (CMBS) must also name a senior officer accountable for true reporting of loan information, opening the door to personal exposure to fraud charges. These two rules send the message loud and clear: banks must not stray from prudent loan practices again.

One result is that U.S. banks are in a good position to withstand an economic downturn. An International Monetary Fund report in April noted that U.S. banks are more profitable than European banks with lower levels of nonperforming assets, and have limited exposure to riskier loan categories such as emerging market economies and energy-related credits. And the results of the Federal Reserve Board’s supervisory stress test in June showed that the 33 largest U.S. banks would see their aggregate common equity capital ratio fall from 12.3 percent (where it was in the fourth quarter of 2015) to 10.5 percent. In a "severely adverse" scenario that includes a deep global recession and a five-point increase in domestic unemployment, the aggregate equity ratio would still be at 8.4 percent or higher—enough to cover banks’ losses without a bailout.

So the upside is that U.S. banks are in a much more solid position than they were 10 years ago, and they’re motivated to keep it that way. The downside for borrowers is a higher cost of capital and less generous loan terms. Although that complicates refinancing for some owners, at least it will help them avoid workouts later.