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How a lack of CRE standardization is threatening bank valuations

In spite of the ongoing economic uncertainty triggered by the pandemic, the residential real estate market has performed extraordinarily well over the past year. This is largely due to the fact that, under the influence of the industry’s large, government-sponsored investors, the residential mortgage market has been standardized. Today, there is a high degree of certainty as to the underwriting requirements for the transactions, the data collection requirements, the structure and makeup of securitized pools and, most recently, the Federal Reserve’s appetite for mortgage-backed assets.

The result of this level of standardization is a residential mortgage market that has become highly efficient and a growing source of supply for asset growth that investors are seeking, including banks.

Unfortunately, things are quite different on the CRE side of a bank’s lending business. There has been no similar stabilizing force in the commercial real estate mortgage business, a gap that is now creating one of the most significant threats the lending industry faces.

The fractured nature of CRE
Commercial real estate loans now comprise a quarter of U.S. commercial banks’ loan portfolios. These loans are “Level 3” assets, meaning they are both the most illiquid and the most difficult to value.

CRE loans are not easy to originate, are often difficult to price and sell afterward, and often very challenging to resolve in the event of default. Unlike residential mortgage assets which can be segregated into granular pools and priced in seconds, every CRE asset is unique, and each bank tends to treat this business differently while using highly inefficient, labor intensive manual processes.

Much of the difference between these two businesses can be traced to the application (or lack thereof) of technology. Past efforts to create CRE lending and servicing platforms have focused on tools to support internally focused tasks such as risk analytics and accounting. And while there are currently efforts in the works to change all of this — with the GSEs playing a larger role in the multifamily business and senior living; and MISMO working to standardize the dataset required to model rent rolls — CRE is still far from realizing the efficiencies enjoyed in the residential real estate market.

The colorful cast of regulatory bodies only exacerbates this challenge, as bankers learned through the adoption of the Basel HVCRE rules in the aftermath of the Great Recession. Borrowers were offered wildly different financing structures driven by diverging interpretations of HVCRE, which in turn depended upon the identity of their bank’s primary regulator.

For now, each bank’s approach to its CRE business looks proprietary and opaque from the outside. Past experience proves that opacity means bank valuations will suffer dramatically in the next downturn.

The risk banks face now
The pandemic’s impact on commercial real estate has been devastating. Thousands across the country have discontinued their businesses, leaving office space vacant. Others have found a safe harbor in forbearance and relief programs that will soon end (or already have), bringing with them an inevitable second wave of defaults.

Meanwhile, new entrants are targeting banks’ lucrative CRE portfolios by specializing in specific property types that allow them to underwrite, close, and service loans much more efficiently than ever before. Smaller institutions are capitalizing on new technology platforms, leveling the playing field, and subsequently taking business from larger, slower competitors.

At the same time, the higher risks involved have caused some banks to simply back away from CRE. A successful lending program often leads to overweight exposure, causing a well-managed bank to appear inconsistent as it withdraws from successful verticals in order to balance its risk weightings. Selling off risk to a third party is problematic because asymmetric information may result in a discount, even for performing loans. And in a distressed scenario, what used to be a coveted pool of large, richly priced loans can quickly become a large, poorly priced millstone — and a serious threat to stock prices.

The CRE industry needs standardization more than ever and technology exists today that can streamline and standardize much of the commercial lending process, across loan and property types for institutions of any size.

However, adopting it will require bankers to give up their unique, outdated approaches to the business in favor of a process that provides more transparency to investors and regulators and more certainty to the market in general. The industry would do well to make this change before investors realize that banks are ill-equipped to manage the largest assets on their balance sheets and divest.

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