Reports in the US suggest that the commercial real estate lending market is getting very competitive with an increase in loss rates in the final quarter of 2015. While net charge-offs as a percentage of average loan balances still equate to just 0.14% this is a significant increase from 0.02% in the previous quarter. There is nothing to worry about at the moment but is this increase in loss rates a sign of things to come or just a quirk which seems to occur in the fourth quarter?
Competition is intense
Competition in the commercial real estate market is very intense with lenders working on relatively small margins to attract business. While we are unlikely to see a significant increase in the cost of finance in the short to medium term we could see yet more margin pressure in the weeks and months ahead. This reduction in profit margin effectively reduces the safety headroom built into many mortgage arrangements to protect the lender.
Sometimes it can be difficult to relate ongoing demand for both domestic and commercial real estate in the US to the struggling economy. Indeed the recent rise in US base rates has received much criticism with many experts believing the authorities acted too quickly and will eventually be forced to reverse this.
Are banks loosening their criteria?
There is evidence to suggest US banks are loosening the criteria attached to the growing number of commercial real estate mortgage arrangements. We have an increase in the number of extended maturities as well as interest only periods. When you also throw in limited guarantor requirements than less restrictive covenants it does in some ways begin to feel like 2008 all over again. Are the banks so desperate for business that yet again they seem prepared to gamble the house?
Is it time for the regulators to step in?
It will be interesting to see how the regulators react to this apparent loosening of mortgage criteria across the commercial real estate sector. When you bear in mind that worldwide interest rates are still near record lows and unlikely to increase in the short to medium term it seems that many banks are prepared to work on tighter profit margins. If they are also prepared to reduce previously tightened covenants then perhaps we have the makings of a problem in the medium term when interest rates finally rise?
While some would suggest there are reasons to be concerned today it is also dangerous to take one quarter in isolation. We need to see a pattern of increasing write-offs to confirm the emergence of a new trend which would then likely catch the eye of regulators. In the meantime it does look as though money market rates will remain relatively low for the foreseeable future but competition in the real estate market is certainly intense.
Conclusion
While sceptics might suggest that a loosening of covenants and restrictive details on new mortgage arrangements, together with an increase in write-offs, is worrying, it is dangerous to take figures from one quarter in isolation. Surely it would be inconceivable to suggest that the banking community has learned nothing from the 2008 collapse – an impact which is still being felt worldwide today.