Features Newswire Mann Report

Five Trends in Commercial Lending

Lending has been volatile lately, to say the least. Here are some trends we’re seeing:

Banks will scale back their lending to commercial real estate assets. Commercial real estate owners and developers depend highly on borrowing cash, as the construction of large properties requires millions of dollars of investment with no revenue being generated for years at a time while a project is being completed. Historically, banks have dominated the origination of loans to commercial real estate developers, owners and investors by lending money at lower rates than competitors on high-quality assets in prime locations.

However, in times of uncertainty such as the COVID-19 pandemic, banks tend to get more conservative and tighten their underwriting standards. For example, banks pulled back on financing many grade-A real estate projects, historically safe investments, creating an opportunity for alternative lenders such as REITs, finance companies and private equity funds to step in and lend with a higher cost of capital to account for the added risk.

Bank activity in the space came roaring back, accounting for 38.1% of commercial loan closings in Q2 2022, up from 27.5% in Q1 and 10% from a year ago, according to data from CBRE. As the economy reopened, banks regained confidence in the real estate sector. However, due to the recent 40-year high inflation, recession concerns and rising interest rates, real estate owners and developers are feeling more pressure to complete projects profitably. Consequently, lenders are beginning to tighten their underwriting standards and will more cautiously monitor their borrowers’ ability to pay off loans in a higher rate environment and slowing economy.

We predict that banks, specifically, will scale back their lending activity in the second half of 2022. Economic uncertainty and a rising cost of capital make it more difficult for banks to be competitive in the lending market. In turn, opportunities will arise for alternative lenders who can finance areas of the market where banks no longer feel comfortable. Overall, a more challenging investment environment has led to less transaction volume in 2022, yet the future holds opportunities for attractive risk-adjusted returns for non-bank lenders.

Alternative lenders that can move quickly and efficiently will succeed in today’s volatile market. Given that banks and other financial institutions continue to scale back their lending, many developers unable to secure bank financing have begun to seek alternative solutions to finance and re-finance their projects. Further, more owners are refinancing as they face the inability to bring their business plans to fruition due to rising costs and prolonged sales periods.

To fill this void, alternative lenders can move fast to provide creative and flexible financing solutions to distressed borrowers and find success in the current market. Due to the increased risks present today, it’s critical that these alternative lenders carefully assess real estate assets on a case-by-case basis to understand the true value of the collateral. Lenders across the board will become more conservative to ensure that their loan basis will be secure even in a downside scenario. However, capital necessary to acquire and construct property must be priced for developer’s profit or development will stagnate in coming years. Given the current housing shortage across the U.S., it is necessary for alternative lenders to continue to fund multifamily projects to prevent further price increases due to low supply.

Look for more office-to-residential conversions. Especially in the United States’ largest cities, office-to-residential conversions will continue to be a popular area for real estate investment. Due to the continued popularity of working from home, office vacancy remains high in cities including San Francisco and New York. Many companies have chosen to either scale back on the amount of office square footage they require or have implemented no plans to return to the office at all.

However, due to lack of supply and increased demand, condo prices and rents in multifamily buildings have skyrocketed since 2020, with less than 2% rental vacancy in New York City. Currently, the large unmet need for housing across the United States brings issues that are more intense in cities with scarce land and government regulation restricting the amount of ground-up development opportunities available. Thus, there are many opportunities for office-to-residential conversion projects.

While a good idea on paper, conversions can be very expensive and must overcome structural and financial challenges along with zoning and other regulations. Often, it’s far less expensive to build housing from scratch and only certain kinds of buildings can be converted successfully. For example, the floor plate of an existing building cannot be too large because to be converted into residential apartments, units need to be close to windows. However, for 50 years, building the largest floor plate possible was the popular design for modern office buildings. Therefore, older, run-down buildings with smaller floor plates are the best candidates for conversion.

Despite these challenges, office-to-apartment conversions created a total of more than 13,000 units nationwide from 2020 to 2021, according to data from RentCafe. While this isn’t enough to solve the housing shortage, we believe that the strategy is becoming more and more de-risked. Developers are beginning to realize that working from home is no longer a trend, but rather a lasting impact of the pandemic. Additionally, government officials are easing restrictions on these conversions. NYC Mayor Eric Adams, for example, recently tried to encourage more investment in the conversion space. Increased appetite for residential apartments coupled with a lack of demand for office space leases suggests that more real estate developers will take on these projects in the coming years.

Defaults rates by commercial lenders will rise. While the CMBS delinquency rate skyrocketed to 10.32% as a result of the COVID-19 pandemic, the CMBS default rate has dropped dramatically to all-time lows as of July 2022, according to data from Trepp. At just above 3%, the low delinquency rate suggests that commercial real estate lending is largely de-risked. However, we believe that in future months we will see the default rate tick back up.

The Federal Reserve is likely to continue to raise rates in the coming months, which will add more pressure to existing and future projects. Additionally, we believe the unprecedented amount of liquidity throughout 2020 and 2021 led to loose underwriting standards and overinvestment in some markets, but we have yet to see a correction in the real estate market in the same way that we have seen a correction in the broader market. As noted earlier, banks have become unwilling or unable to forbear notes, which will continue to cause an abundance of distressed opportunities to materialize if alternative lenders do not step in and bear the risk of these projects. Consequently, we predict that we’ll see more borrowers fail to make their mortgage payments in 2023.

Adjustable-rate mortgages will increase in popularity. According to the Mortgage Bankers Association, during the first half of 2022 the share of adjustable-rate mortgages (ARMs) nationwide rose from 3% to 10% of all mortgages, the highest percentage since before the 2008 housing crash. ARMs become more popular when interest rates rise, as homebuyers are forced to turn to cheaper alternatives than traditional fixed-rate mortgages. As the Fed has increased interest rates in 2022, mortgages have become less affordable and demand for housing across the board has fallen substantially. However, ARMs are one area in the mortgage market where activity has increased.

The rise in popularity of ARMs demonstrates that Americans are struggling to find affordable housing and are desperate for alternative ways to finance their homes during a period of rising costs and limited housing supply. When used appropriately, ARMs can serve as a useful tool to give Americans more flexibility and freedom to purchase homes. ARMs can help homebuyers save in the near term, but it’s important to note that they result in higher payments over the life of the mortgage. It is critical that homebuyers and lenders alike approach ARMs with caution.

While useful, ARMs are not a solution to the current housing shortage. Instead, they serve as a short-term fix to larger hurdles such as unsustainably low housing availability, rising interest rates, higher material and building costs and government regulation, which discourages homebuilding and multifamily investment in many cities. However, with mortgage rates rising we believe this trend will continue and it’s important that lenders carefully assess the financial stability of their \borrowers, both large and small.