How US regional banks are winning the greatest share of US CRE originations as CMBS falters. Justin Slaughter reports.
Associated Bank is part of a long and growing list of US regional banks that have become the willing beneficiaries of the decline in CMBS volume this year.
“Banks are filling a gap left by the CMBS market,” Paul Schmidt, EVP and head of commercial real estate at the Wisconsin-based bank, tells Real Estate Capital.
Schmidt says many borrowers with mid-sized loans on properties across Wisconsin, Illinois, Michigan, and Ohio, especially office and retail, have CMBS loans coming due. But instead of re-upping with CMBS, they are choosing three-to-seven year loans from their local bank instead.
“We are seeing banks coming in to reposition or put more capital into these assets,” he says.
Schmidt has focused on borrowers “who got burned” by the 10-year CMBS conduit deals executed during the crisis for quite some time, but business has picked up in 2016 as old selling points take on new meaning.
The borrowers who secured CMBS deals in the past typically had very little flexibility, and if they decided to sell the property they often signed prepayment agreements and paid high penalties for working around strict deadlines, he says.
To the contrary, there are no prepayment penalties with a regional bank loan, even if it’s floating rate, because the bank intends to keep the loans on its books rather than selling them off to investors, he adds.
The approach is working. The bank said its loan balance was $4.7 billion at the end of second quarter this year. And Real Capital Analytics (RCA) ranked it the 11th top regional bank through the first half of 2016.
And the approach is also working broadly for regional banks across the country. Dozens of regional and local banks like Associated have swept up exactly the type of borrowers that were flocking to CMBS before the most recent financial crisis, with these banks now representing the largest share of commercial real estate originations in the US.
Of the $183 billion in first mortgage US originations during the first two quarters of the year, regional and local banks took the largest share with 21 percent, or $38.43 billion, up from 16 percent in 2015, according to data from Real Capital Analytics (RCA).
Their share edged out the national banks, which took 20 percent, followed by international banks, government agencies, life insurance companies, and private funds. (RCA defines “regional/local bank” as any banking institution not subject to the Federal Reserve Comprehensive Capital Analysis and Review, or CCAR, ‘stress tests,’ which typically includes institutions with less than $50 billion in assets.)
Meanwhile, CMBS captured just 9 percent ($16.47 billion), representing a significant role reversal for the two lending groups. In 2012, CMBS lenders captured 23 percent of the market for financing commercial properties while regional and local banks captured just 9 percent.
Total CMBS issuance this year has only reached $44.8 billion through the end of September, according to Trepp, while it predicted that total issuance will not even reach $65 billion by the end of the year – a 30 percent drop from last year’s total of $95.1 billion – based on the 15 deals still in the pipeline for the final quarter of the year.
Jim Costello, SVP and analyst at RCA, says the pullback in CMBS lending has opened opportunities for smaller banks in secondary and tertiary markets where CMBS was traditionally their strongest competitor.
“People hear ‘CMBS’ and they think ‘Wall Street,’” says Costello, “but CMBS is ‘main street’ lending, it’s typically packaging ‘main street’ loans, taking on the risk of loans on properties in secondary markets like Jacksonville, Florida and Topeka, Kansas and other areas.”
As CMBS lenders have become more cautious this year, due to widening spreads and new risk retention regulations set to take effect, they have pulled back, leaving these smaller markets of the US in need of other types of lenders to step in.
While the RCA data shows that regional banks have increased their share of the market in all regions, they have done so at a greater pace in the Southeast and the Midwest.
Several commercial real estate debt teams at regional and local banks across the country told Real Estate Capital that their increase in market share is due to the fact that they provide the $5-50 million loans that CMBS lenders have retrenched from, and which are often smaller than the deals that larger banks, life companies, and private firms target.
Dan Easley, head of all commercial real estate business for the Bank of Texas parent company, says his commercial real estate lending has grown steadily over the last five years, from a gross loan balance of $1.7 billion in 2012 to $4 billion today, in part due to the recent decline in CMBS lending.
“A fair amount of business that we have done in the last three years, including value-add and bridge loans, might have otherwise been done by CMBS,” says Easley. “Particularly on non-multifamily deals, banks have stepped in to finance acquisitions on existing property with cash flow, whereas in the past, you’d see CMBS lenders have the A and the B notes on those deals.”
The bank’s “bread and butter” loan range is $5-20 million, and the loan average is closer to $7-10 million, Easley says.
Easley’s 63-employee commercial real estate group, with offices in Dallas and Houston, Texas; Albuquerque, New Mexico; Tulsa, Oklahoma; Kansas City, Kansas; Denver, Colorado; and Phoenix, Arizona (which does deals in Salt Lake City and California too) is on track to do $1.5 billion in volume this year.
Lea Overby, managing director of research at Morningstar Credit Ratings, agrees that the gap in CMBS lending in secondary and tertiary markets is due to the decline in CMBS lending across the board, rather than CMBS lenders pulling back from these markets to focus on larger markets.
“Conduit lenders are flat out having a difficult time,” she says. “So yes, they are lending less in those markets, but they are also lending less in the big markets too.”
At the peak of the market in 2007, $230 billion of CMBS was issued. After the financial crash, issuance collapsed to essentially zero by 2009; but the CMBS market rebounded in the years since, with $90 billion issued in 2014 and $94 billion issued in 2015.
But spreads widened for new-issue AAA 10-year bonds from 82 basis points in June 2015 to more than 150 basis points this March, according to a Mortgage Bankers Association report, which marked the beginning of a rocky 2016.
Costello says regional banks are stepping up to fill a critical gap because the structures of their deals are similar to those that CMBS once provided, typically three- to 10-year senior mortgages.
Despite the similarities between the financing, many borrowers are also seeking out regional bank loans because they can also provide a more flexible structure than CMBS.
Easley says that CMBS can undercut banks on pricing, but what gives banks the advantage over CMBS is the leeway in documentation. To give one example, a bank may offer a default provision that allows for 90-day cure, whereas in the CMBS shop, they only allow only for 30- or 60-day cures. (A cure indicates the period of time during which a borrower is allowed to resolve a default with make-up payments).
“To a customer, that’s more meaningful than paying 15 [basis points] less in spread,” says Easley. “The flexibility is our best weapon against CMBS shops.”
Private debt funds typically seek deals with heavier transitional elements, designed to reap higher returns, while the large insurance companies and institutional lenders are interested in larger, primary market loans.
“These banks are in a position where they need to be making loans and they have the expertise of the local markets that have very attractive yielding loans for them,” he says.
New York Community Bank was the top regional lender in the first half of 2016 with nearly $2.5 billion in originations. But the New York-based firm only ranked #18 compared to the top lenders overall, showing that a wealth of these smaller banks have boosted lending. By comparison, Wells Fargo topped that list with $19.5 billion in originations.
Kenneth Keiser, EVP and director of multifamily and investment CRE lending at Customers Bank, says his regional bank is no longer undercut by the CMBS lenders.
“CMBS was cheaper than the banks eight years ago and customers were flocking to them,” says Keiser, “but they found out afterwards that there is no flexibility.”
For instance, many multi-generational owners in secondary or tertiary markets jumped on the CMBS bandwagon during its heyday, leading up to the financial crash of 2008, often receiving financings with one full percentage point lower interest.
But many of these CMBS borrowers found out that their 10-year CMBS deals were riddled with prepayment and yield maintenance provisions that stopped them from cashing out their equity to invest in other properties, as property values crept upwards again after the Great Recession, says Keiser.
What’s the catch?
Are there dangers involved with the relatively rapid ramp up from the regional banks?
“This growing pace of lending by the regional/local banks has been looked at with some concern on the part of regulators,” read an RCA report. “There are concerns with respect to reserves held by regional/local banks for potential losses and a worry that they are simply stretching for yield.”
This August, the president of the Federal Reserve Bank of Boston, Eric Rosengren, voiced concern that the commercial real estate market was growing too rapidly, while in September he argued publicly that the Federal Reserve should raise interest rates to prevent an overheating.
But, more specifically, Costello says that regional and local banks “are not cutting standards to gain market share,” but consistently seeking opportunities as they arise.
The average loan-to-value (LTV) ratio for regional and local banks in H1 stood at 71 percent versus 73 percent in H1’15, and average occupancies have increased from 95 percent to 96.4 percent.
However, Richard Ehst, president and COO at Customers Bank, argues that his team’s real estate lending remains conservatively focused on “high value, low risk” credit opportunities like multifamily, which constitutes roughly 85 percent of its $3.7 billion CRE loan balance.
“Multifamily is extremely low risk, high value, so we chose to move in that direction,” says Ehst. “Basically, in today’s rate environment you can’t afford to take risk, bottom line.”