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As Economic Indicators Worsen, Lenders Say They're Still Not Worried About Their Leverage

The current economic cycle soldiers on, but enough warning signs have begun to flash that a crucial question bears revisiting: Is the commercial real estate industry better off than it was before the last recession?


From banks to debt funds to mortgage brokers, the real estate finance industry believes it has overall held steady on risk factors such as loan-to-cost or loan-to-value ratios. Capital One Senior Vice President Sadhvi Subramanian said her department does not go beyond 65% leverage, which is what brokers from CBRE and JLL say is virtually an industry standard for banks today.

“I would say on the banking side, they’ve been pretty consistently disciplined because they have the Great Recession in their memory,” CBRE Vice President Bill Leffler said.

Some recent research flies in the face of those accounts. University of Alabama real estate professor K.C. Conway told National Real Estate Investor in early June that banks are actually underwriting construction loans at 75% to 80% loan-to-cost ratios, and may push to 90% in the next 24 months or so.

“I have definitely not seen any banks going to 75-80% [loan-to-cost], unless they get more recourse in the deal,” JLL Managing Director of Finance Chad Orcutt told Bisnow, though he clarified that such a tradeoff is much less common than lower-leverage loans right now.

Debt funds have been willing to push to 80% leverage since they became a force in the market a few years ago, accepting greater risk for better yield. Such funds also do not have federal regulators discouraging them from taking ownership of defaulted properties and attempting to recoup value through direct management.

Madison Realty Capital Managing Director Josh Zegen said he hasn’t changed his standards — loans up to, but not exceeding, 80% — since he co-founded his firm in 2004.

Research firm CrediFi released a report this month that found CRE loans make up a larger portion of banks' balance sheets than had been publicly disclosed. Beyond that, fewer banks are packaging those loans into commercial mortgage-backed securities since the CMBS market was rocked by the Great Recession.

Combined, those two factors add up to lenders having more risk exposure than they are perhaps willing to admit, according to CrediFi CEO Ely Razin.

“The optimists are missing data,” Razin told Bisnow. “A lot of what you hear in the marketplace is sentiment based on gut feeling and deal flow, and as long as they keep flowing, the dance keeps going. And that’s true until the music stops.”

The Federal Reserve

The music certainly hasn’t stopped, and Razin said there is substantial liquidity in the market keeping transactions moving at a healthy pace. But at least in industrial and retail, the beat is slowing down — loan originations dropped by nearly $10B in the U.S. from 2017 to 2018 in retail, and nearly $15B in industrial, CrediFi found.

Slowing transaction volume is not nearly enough to indicate the beginning of a recession. That would take an event at a level that affects either the national and global real estate markets or the overall economy, a moment rather than the culmination of slow-developing trends, multiple sources told Bisnow.

“Cycles don’t die of old age,” Leffler said.

It has only been a month since President Donald Trump first announced the substantial increase of tariffs on $200B worth of Chinese imports — not enough time to determine whether the trade war between the governments of the U.S. and China will be the event that triggers the next recession, as every source surveyed for this story agreed.

Still, the trade war shows no signs of abating, and potential new tariffs on Mexican imports would only compound the issues that the American supply chain has already been having with volatility. The general anxiety that a diplomatic conflict between the two biggest world powers invites has caused investor confidence to plummet recently, and warning signs are showing in the economy.

The U.S. Federal Reserve dropped interest rates among the general climate of uncertainty in early June, a clear sign that Chairman Jerome Powell is now more concerned about sustaining economic growth than keeping it under control. The U.S. Bureau of Labor Statistics' most recent report found that job growth slowed dramatically in May, to 75,000 jobs created, and the previously reported figures in March and April were revised down. 

"You can’t read too much into one jobs report, but [Friday]'s weak jobs number adds to a growing set of indicators that point to a weakening economy," tweeted Betsey Stevenson, a former member of the Council of Economic Advisers.

Whether leverage in the market is at healthy levels or not, a spike in construction prices due to the trade war will put pressure on contractors, developers and their equity partners to make good on construction loans, since lenders don't take responsibility for cost increases after terms are signed.

Whether borrowers have the extra capital needed to keep construction projects ongoing depends on the project and owners in question, but if buildings can't produce the return needed for any type of loan to be paid back, the added exposure CrediFi claims that banks have would make for a sharper downturn.

“If you have enough [loans] starting to weaken, then landlords might see significant problems, then lenders would see more significant problems,” Razin said.

For now and for the most part, the real estate industry seems confident that the next economic contraction will be a softer landing than the Great Recession. Only time will tell if borrowers and lenders have been as prudent as they think.