August 15, 2022

Square Feet: Commercial Lenders Take Step Into Riskier Deals

An increasing number of financial institutions are vying to make loans on commercial real estate now. But many buildings are still drowning under heavy debt loads, leaving few properties that can support new borrowing. This means that banks, insurance companies, hedge funds and others are competing fiercely to underwrite the few viable loans that are available. Because of the competition, some lenders have begun to compromise their underwriting standards, say ratings agencies and market professionals.

“We are deeply concerned,” said Tad Philipp, the director of commercial real estate research for Moody’s Investors Service. “Underwriting standards have gone from very good in 2010, to just O.K. this year, and we want to make sure they don’t drift into risky territory.”

Commercial loans are big business. At the peak of the market, in 2007, commercial mortgage-backed securities, which are bonds backed by pools of commercial real estate loans, were a $243 billion market, according to the research company Trepp. The market then stalled and reached a nadir in 2009 with only $2.4 billion in issuance. The market began to thaw last year and 12 deals totaling $12.6 billion were completed. Most of the loans underwritten last year consisted of top properties in prime markets, where there was very little risk of default.

This year, the deals have picked up significantly. So far, there have been 16 deals for $16.8 billion, Trepp said. Some of these deals include properties in Oklahoma and Kansas, and even hard-hit markets like Florida and California. Some of the assets are also less stable, with lenders underwriting deals for mobile home parks and self-storage units.

At the same time, metrics used to judge possible defaults are indicating more risk. Increasingly, appraisers are taking into consideration higher future rents and occupancy rates, rather than using only current figures. Inflated appraisals were common during the market peak but disappeared after the crash. There are also more interest-only loans, where the borrower pays interest on the loan but does not pay down the principal, with a large balloon payment due at the end of the term.

Appraisers say their figures are not inflated, but rather reflect the improving market in some areas of the country. “It is important to point out that commercial real estate is a two-tier market: there are distressed properties and markets and premier properties and markets,” said Leslie Sellers, the 2010 president of the Appraisal Institute, an industry group that has more than 24,000 members. Appraisers are accounting for a rosier future in only those top-tier markets, he said. “If we didn’t do that, we would be remiss.”

A sharp increase in the number of commercial real estate lenders is mostly driving the surge in mortgage-backed securities. Large banks like Bank of America, Citigroup and Goldman Sachs have resurrected their commercial mortgage-backed securities, also known as C.M.B.S., lending again after the downturn, while new players have also entered the market, like Cantor Fitzgerald and the hedge fund giant Citadel.

“Banks need to generate earnings, but they aren’t underwriting many new mortgages or other loans, so securitization is a very attractive option,” said K. C. Conway, the executive managing director of real estate analytics at Colliers International.

Insurance companies and foreign investors are also lending as they look to rotate into hard assets and out of cash and other investments that are vulnerable to inflation, Mr. Conway said. In the search for hard assets, the commercial real estate market is attractive because it is widely perceived to have bottomed out.

Yet there are only a relatively small number of properties that are not highly leveraged and in a position to borrow funds. According to Trepp, over one trillion dollars’ worth of commercial real estate loans due in the next five years are still underwater, meaning the market value of the properties is less than their debt.

“It is the classic scenario of too many dollars chasing too few deals,” said Peter J. Mignone, a partner at the New York office of the law firm SNR Denton.

With so few opportunities, lenders are facing multiple pressures. To create bonds, they must pool together several commercial loans, but with so few strong borrowers, “their only choice is to leave the primary markets and look to the secondary and even tertiary markets to fill up these loan pools,” said Lawrence J. Longua, a clinical associate professor at the Schack Institute of Real Estate at New York University.

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