Lending Restrictions, Looming Regulation For Banks Cast 'Long Shadow' On CRE

Banks across the country are tightening their lending standards at the same time regulators are considering ratcheting up their liquidity expectations, further stunting loan dollars directed toward commercial real estate as the impact of heightened interest rates persists.

During the second quarter, between 60% and 70% of senior loan officers at 85 banks surveyed by the Federal Reserve reported having tightened standards on all categories of CRE loans. Except for a brief moment at the beginning of the pandemic, capital for CRE deals is now harder to obtain than at any time since the Global Financial Crisis.

Fifty percent of respondents to the Fed's survey expect either somewhat tighter or considerably tighter lending standards later this year, while the other half expect standards to remain unchanged.

“Banks tightening their lending standards on CRE casts a long shadow on the sector,” LH Meyer economist Derek Tang said. “The effect is likely to last for quite some time. Banks are hitting the pause button on CRE borrowing, and no one is sure when to start again.”

It isn't unusual to see bank lending contract or lending standards tighten during a down economic cycle. Those actions impact all kinds of lending, Tang said.

“But for real estate, the issue is especially acute because there are certain secular dynamics that are affecting commercial real estate in particular in very different ways this time,” Tang said, especially in the office sector, which hasn't recovered from the pandemic.

Banks aren't just tightening their standards, but they are also telling customers, particularly new ones, that they aren't lending, Tang said.

“They're looking at existing or future borrowers and saying, ‘You know, you might be able to service your loans right now. But is that going to be true in a few years’ time?’” Tang said.

“Whether it's the borrower or their guarantor, or their assets or liquidity or the overall trajectory of a project, all those things are being looked at harder,” said Obermayer Rebmann Maxwell & Hippel attorney Michael Thom, who focuses on financing and real estate transactions.

Tighter lending standards impact each segment of CRE differently. For the office sector, it represents yet another in a heap of woes.

“The cost of debt for office properties has also increased, both due to the interest rate environment as well as a reduction in the pool of potential lenders for office,” Newmark Global Head of Research David Bitner said.

“Maturities in this sector are more front-loaded than other property types. Moreover, office values have been severely impacted over the last several years, with substantial portions of loans having fallen in value since they were first originated.”

Since banks aren't the only source of real estate capital, tighter lending standards will represent opportunities for nonbank lenders.

“Closed-end funds have raised record quantities of dry powder,” Bitner said. “Recently, there’s been strong fundraising for opportunistic vehicles, which are positioned to deploy into repriced assets and are showing discipline in waiting for further price reductions.”

There are also indications that insurance lenders are becoming more active on the margin — particularly as CRE debt yields on low-leverage, stabilized product have risen, he said.

Tightening of lending standards by banks isn't the only concern for CRE borrowers going forward. Regulatory reform that requires banks with over $100B in assets to increase their effective reserves might also represent a lending headwind.

In August, bank regulators, including the Federal Deposit Insurance Corp. and the Fed, proposed new rules for larger banks aimed at preventing the sort of cash flow issues that helped touch off this spring's banking crisis. Banks with more than $100B in assets would be required to issue $70B in long-term debt, which would raise capital by an average of 16%, according to estimates by Fed Vice Chairman for Supervision Michael Barr.

“Even though those proposals aren't yet law, banks are anticipating them,” Tang said. “They're going to say, ‘We're going to make sure that we're ready for that if it does happen.’ And that's going to generally further the climate of caution for lending.”

The comment period for the proposed new capital requirements ends on Nov. 30.

The financial industry is pushing back on the proposed regulations. Last week, a group of industry organizations including the Bank Policy Institute, the American Bankers Association and the Financial Services Forum sent an open letter to regulators, asserting that the approval process for the regulations is fatally flawed.

“The proposed rule violates these basic legal obligations,” the letter says. “Key elements of the proposed rule rely on a wide variety of data, analyses and methodologies that have been withheld from public view and comment.”

Others within the industry are worried that while the new rules don't specifically apply to smaller banks, the upshot might still be pressure to merge in order to better compete with larger entities. Bank consolidation, even among smaller community banks, stands to have a longer-term impact on the kinds of local lending they do, including real estate deals that would be too small for larger banks to bother with.

“Community banks have traditionally made the unique loan, done the unique transaction,” Seattle-based Sound Community Bank Laurie Stewart told Marketplace.

“As you get bigger, in order to get through this cycle, you’re not going to be as creative a lender because it’s not scalable,” she said. “As community banks continue to consolidate and they become bigger regionals, our communities will suffer.”

Tougher conditions for bank lending also mean an extra layer of difficulty for borrowers as they try to get out from under loans that need to be refinanced in the coming quarters and years, Tang said.

“There are a lot of loans out there with special terms,” Tang said. “They might have a low rate that resets in the next few years, and so the effect of tighter standards lags even though interest rates have gone up 500 basis points this year. So the damage hasn't already been done. This might take awhile to work through, and as it works through, things will slow down even more.”