BLOG VIEW: Against a backdrop of a strong and growing economy and despite confusion over recent tax changes, commercial real estate lending continues to grow and lenders are seeing increased demand for capital as developers respond to positive financial trends.
Deloitte reported rising CRE investments on a global scale earlier this year, with U.S. CRE investments growing 11% year-over-year to $122 billion in 2018. What’s more, CRE lending volume increased 3.9% in the first quarter compared to the first quarter of 2018, according to Federal Reserve data.
These deals tend to be lucrative for lenders and represent a fixed portion of their overall lending portfolio. Increased competition for this business (from other lenders, insurance companies, pension funds, the bond market, new marketplace lenders, private investors and even the U.S. Small Business Administration’s 504 Loan program) is forcing many lenders to choose between either pulling back on CRE lending or loosening their credit standards to get more business – something that is anathema to their chief credit officers’ instincts.
The key to gaining market share in CRE lending is tied to a lender’s ability to better manage and mitigate risk. Chief credit officers are very good at underwriting credit risk in the deals they approve for their institutions. Unlike residential mortgage lenders, however, who can pass some of the risk to private mortgage insurance (PMI) companies, CRE lenders tend to hold all of the risk within their own portfolios.
In response, the only option for reducing risk and protecting the institution from default is to demand what is known as a personal guarantee from the individuals behind the company or borrower requesting the loan.
The hard truth is that in a case of default, personal guarantees are rarely collected, and the debt often ends up being negotiated as part of a settlement.
In response, more CRE lenders are adopting a commercial property loan insurance (CPLI) strategy to help manage risk. Just as PMI has enabled residential lenders to transfer risk away from their institutions and free up capital to make more loans, CPLI functions similarly for the commercial real estate lending market.
As a point of comparison, every residential mortgage loan with a loan-to-value (LTV) above 80% carries private mortgage insurance. Residential lenders are operating in an $11 trillion market and have used this model successfully for decades. The commercial real estate market is significantly smaller, representing a $3.5 trillion business. CRE lenders can benefit from the same insurance infrastructure that makes most residential loans work.
In essence, CPLI policies cover the top, or riskiest, 25% to 40% of qualified commercial real estate loan amounts, significantly reducing lender exposure to foreclosure losses. Just as PMI has done in the residential market, this frees up chief credit officers to underwrite and approve commercial real estate loans without the need for onerous personal guarantees that render them less competitive without providing adequate protection for the lender.
Over time, this improves the overall risk position for the institution’s portfolio and generates capital relief – providing additional funding to support future CRE lending growth and improved return on equity.
While this provides value in the form of increased lending capacity in strong economic markets, there is perhaps an even greater benefit for lenders who are factoring the impact of a potential end-of-cycle event on their loan portfolios.
For example, if underwriting tightens in anticipation of a future 5% to 10% value decrease and the market undergoes a 25% to 35% decrease in response to a “black swan event” instead, CPLI provides lenders with protection against this unanticipated event.
The residential mortgage industry has experienced a continuum of evolution for decades and has seen a sea change in how it markets to borrowers and originates and closes loans. The same should be reflected in lenders’ CRE lending programs.
Adopting mortgage insurance for the commercial lending industry is just one part of modernizing the business to lower the cost of borrowing and make lenders more competitive in the marketplace.
David Eichenblatt is owner of LGIS Group. He has more than three decades of experience as a commercial real estate investor and developer.
