The Tightening Up of Lending

As Lending Standards Tighten, Relationships Matter More Than Ever

By: Michael Hoban, featured in SIOR Magazine

With most banks maintaining a conservative approach to lending and the Fed continuing to hold back on interest rate cuts, what’s it like trying to get a CRE deal financed in this environment?

For Gabriel Silverstein, SIOR, national chair of institutional capital markets for SVN | Angelic and a former Grand Prix sailboat racing enthusiast, the answer is the same as when he was asked what it was like to race across the North Atlantic: “Imagine standing outside on the bed of a pickup going 50 miles an hour, with people throwing ice water on you constantly, for weeks at a time,” he laughs. “That's kind of what it feels like trying to do loans these days. It's just brutal.”

Banks reported a tightening of their commercial real estate lending policies during the first quarter of 2024, according to the Federal Reserve’s senior loan officer opinion survey released in May. The quarterly survey noted that banks reported tighter standards and weaker demand for all types of commercial and industrial loans during the first three months of the year, including maximum loan sizes and interest-only payment periods. Banks also reported weaker demand for construction and land development loans.

IT'S ABOUT RELATIONSHIPS

Silverstein says the decrease in lending has more to do with who lenders are choosing to lend to rather than wholesale changes in lending parameters and requirements. “It doesn't mean that it's harder to get a loan because the standards are higher,” he contends. “It means it's harder to get a loan because there are fewer people willing to look at anyone that they aren't already lending to. At least that’s what I’ve seen over the past nine-plus months.”

The brokers interviewed for this article universally confirmed that assessment. “The lenders that I speak with regularly only want to lend to proven sponsors – people they know, who in many cases have skin in the game, meaning that they have deposits that will go along with the loan for the bank,” says Mike White, SIOR, broker-in-charge for Charleston Industrial in South Carolina. “It’s a change that has occurred over the last 18 months since interest rates started escalating.”

Landon Williams, SIOR, senior vice president for Cushman & Wakefield in Memphis, Tenn., also stressed the importance of not only having a pre-existing lending relationship with the bank but also an active business relationship. “Banks right now are mostly concerned about deposits and working through potentially distressed loans coming down the pike,” says Williams. “For an investor to get a CRE loan from a bank, the bank will almost certainly require the borrower to move deposits to the bank if the borrower isn’t already a tenured customer.”

According to a report by Northmarq, the deposit requests generally amount to 10% of the loan amount. Not so coincidently, the standard risk-based capital requirement for commercial loans at banks is 8%. By requesting the extra deposits, the banks are effectively asking the borrowers to self-fund the risk-based capital requirement for the loan.

Imagine standing outside on the bed of a pickup going 50 miles an hour, with people throwing ice water on you constantly, for weeks at a time. That's kind of what it feels like trying to do loans these days.

OTHER LENDING HURDLES

Another largely overlooked obstacle to financing, says White, is that in addition to raising interest rates, the Federal Reserve has restricted the amount of construction lending banks can hold on their balance sheets to reduce risk. “That's really constrained the ability of smaller banks and regional lenders – which are obviously more active in smaller tertiary markets like mine – to provide financing for CRE loans, whether it's new construction, new development, refinancing, or purchasing distressed assets. So I think the supply constraint of available funds is having as much if not more of an impact than the interest rates.”

Banks have also curtailed lending for speculative projects across all asset classes in his market. “I would tell you that ‘speculative’ is still a bit of a dirty word right now, and it's probably a nonstarter for most of the smaller lenders in this marketplace,” says White. “They want to see SBA, they want to see user-occupier loans or other forms of collateral to reduce their overall risk.” That also means an end to the market practice of opportunistic investors purchasing land parcels adjacent to proposed development projects or new interchanges in anticipation of flipping the land. “That lending has absolutely disappeared,” concludes White.

DECREASE IN LTV RATIOS

Another contributing factor to the slowdown in lending is the decrease in loan-to-value (LTV) ratios. According to the CBRE Lending Momentum Index, which tracks the pace of CBRE-originated commercial loan closings in the U.S., the average LTV ratio increased by 80 bps to 62.3% from Q4 2023 to Q1 2024.

White says that LTVs in his market have shrunk from what had been 80-20 18 months ago to 50-50. “The banks want a lot more equity provided by the sponsor in the specific loan transaction to lessen the perceived risk. And I think this ties back to the increase in regulation in lowering risk in the balance sheets.”

“The LTV requirements have certainly been reduced since the good old days of 2021 and early 2022,” says Williams. “For many deals, the LTV has been dictated more by the requirement to meet a higher minimum debt service coverage ratio, and the higher DSCR minimum has resulted in a reduced LTV in many deals.” Williams adds that in addition to the decrease in LTV, many lenders in his market that previously offered loan terms of seven to ten years have reduced loan terms to five years.

VALUATIONS

The level of uncertainty in property valuations is also impeding deals, as lenders hesitate to take on additional risk. According to the June Green Street Commercial Property Price Index (CPPI), which measures pricing for institutional-quality commercial real estate, property prices increased by 1% through May 2024 but are still 21% below their March 2022 peak. Distressed properties have lost even more value. According to a Q1 article by Trepp, office properties financed by CMBS loans transferred to special servicers were found to have experienced staggering value losses – exceeding 50% in 2023. And the distress may continue. In their Q1 report, Moody’s Analytics forecast that valuations across all CRE property types will probably drop 10% peak-to-trough during the next 18 months, with office plunging 26% by the end of next year.

“There's a huge chasm between the buyers and the sellers right now,” says Arlon Brown, SIOR, an senior vice president and broker/investor with the Boston-based Parsons Commercial Group. “The sellers think that it's 2022, and the buyers are looking at the reality of 2024 where the rates have ticked up, and the debt coverage ratio has also increased.”

Brown cited the difficult task that appraisers face in today’s climate. Comps from 18 months ago are no longer relevant, and he is seeing a flattening or decrease in pricing in some sectors with more current comps. “It’s all over the board, and appraisers are concerned about potential legal action because the values can change so rapidly,” says Brown.

Williams concurs that appraisers are in a difficult position because the system uses recent sale comps to establish current value. “And when you don't have many data points, you have to really get creative or use outlier sales, and that creates challenges when you're trying to figure out what an asset is worth today,” he explains.

There are still lenders out there. You might have to make a lot more calls to get a lender who makes sense for any given deal, but the good news is that you don’t need a dozen lenders to get a deal done. You only need one.

ALTERNATIVE LENDERS EMERGE

As commercial banks reduce their presence in the market, alternative lenders are stepping up to fill the void. According to a Q1 report by the Mortgage Bankers Association, the dollar volume of loans originated by traditional banks decreased by 41% year-over-year, and a 17% decrease for GSEs, but a 35% increase in life insurance company loans, a 41% increase for investor-driven lender loans, and a 93% increase in the dollar volume of commercial mortgage-backed securities (CMBS) loans.

Silverstein expects private debt funds to play a larger role in 2024. “In this challenging lending environment, the private debt funds have continued to grow and are filling more and more of that space left by traditional lenders,” says Silverstein. “I think we’re going to continue to see more non-regulated lenders, not just lending on bridge transitional properties, but even lending on stable properties.”

U.S. fund firms PGIM, LaSalle, and Nuveen appear poised to jump into the fray, telling Reuters in May that they plan to increase their credit exposure to property in 2024, focusing on lending to stable asset classes like logistics, data centers, multi-family, and high-end office. After sitting on the sidelines following the interest rate hikes, the real estate private equity funds and others believe that asset valuations may have hit bottom and real estate debt can offer attractive returns.

RESERVING IN ROUGH

While securing financing for deals may be like navigating rough seas for the foreseeable future, deals will still get done ­­— it will just take a lot more work for the broker and their clients. “It’s not like some of the earlier cycles where there's just no money,” says Williams. “There are still lenders out there. You might have to make a lot more calls to get a lender who makes sense for any given deal, but the good news is that you don’t need a dozen lenders to get a deal done. You only need one, and you’ve just got to figure out who that is.”