Wells Fargo Securities: Potential CRE Lending Risks

Despite low delinquencies, steady increases in bank commercial real estate lending is beginning to spark questions about whether CRE could repeat the 1980s, said Wells Fargo Securities, Charlotte, N.C.

CRE loans tripled in value between 1980 and 1990, but then commercial property values plummeted between 30 and 50 percent over a two-year period. By the early 1990s, a significant share of bank CRE loans was either non-performing or foreclosed and thousands of lending institutions failed.

“Today, the lending environment is a long way from the banking and thrift crisis of the 1980s,” said Wells Fargo Securities Senior Economist Anika Khan. “That said, there is heightened sensitivity given the sharp downturn during the Great Recession, with market participants wondering if new risks are looming, especially as valuations have nearly doubled off their lows over the past five years or so.”

Mortgage Bankers Association data show that banks and thrifts held the largest share of commercial mortgages outstanding in the second quarter, accounting for nearly 38 percent of outstanding loans. Commercial and multifamily mortgage debt held by banks and thrifts increased 7.8 percent over the past year to reach the $1 trillion mark.

Khan said because the Federal Reserve has held interest rates low, bank net interest margin reached its lowest level on record. “To help offset some of the decline in net interest margins, mid- and large-size banks are increasing their concentrations of so-called ‘riskier assets,’ including income-producing and multifamily loans, while small banks remain largely capital-constrained,” she said. “For mid- and large-size banks, real estate loans as a percentage of risk-weighted assets are the highest on record, with the pace gradually accelerating for both mid- and large-size banks.”

Khan cited anecdotal reports of fierce competition for real estate loans and relaxed underwriting standards–especially for mid-size banks eager to gain market share. “However, much of the uptick in lending for mid- and large-size banks is due to the increased appetite in the multifamily sector, as operating fundamentals have outperformed during the recovery,” she noted.

As to whether credit risks for mid-size banks are mounting, Khan said the Office of the Comptroller of the Currency’s 2014 Survey of Underwriting Practices showed easing of underwriting standards within commercial and retail products for the third consecutive year. The report noted that although loan quality remains sound, competitive pressures, abundant liquidity and desire for yield have resulted in eased underwriting standards and increasing credit-risk concerns.

“In particular, bank examiners found that exposure to all types of CRE and construction loans pose the greatest credit risk for community and mid-size banks, while commercial lending and leveraged and large corporate lending are the primary concern for large banks,” Khan said.

Khan noted that the OCCs findings remind her of the previous cycle, with the survey first citing similar concerns back in 2004. “[But] at present, CRE loan performance remains strong with noncurrent CRE loans and net charge-offs also at historically low levels,” she said. “However, as we found in the previous cycle, delinquencies and defaults tend to lag in the cycle and ratchet up fairly quickly when the cycle turns.”