Lending Tightens in Small Cap Commercial Markets
Changes in the Commercial Landscape
Commercial real estate is at the crossroads of major global changes. A variety of factors are impacting the industry, from moderate macroeconomic growth and space utilization shifts to changing interest rates and record pricing. Global economies have experienced noticeable slowdowns over the past couple of years, leading many central banks to resort to easing monetary policies, which put interest rates at or near zero. The United States economy, while also moderate, has maintained an upwards growth trajectory, which has cast it as a comparative bright spot in the gloomy global economic landscape.
Commercial real estate investment trends mirrored the global economic slowdown and broader uncertainty over the past year and a half. Investors took a pause from the strong pace of investments recorded in 2015 as they weighed the impact of economic and geopolitical changes upon markets. Commercial investments in the U.S. echoed the global trends, with sales volume in large cap[i] markets closing the year at $488.6 billion, an 11 percent decline on a yearly basis, according to Real Capital Analytics. The first quarter 2017 sales volume came in at $94.8 billion, an 18 percent drop year-over-year.
In comparison to deals in large cap markets, 83 percent of REALTORS® who specialize in commercial investments reported transactions below the $2.0 million threshold in 2016. Although many REALTORS® participate in transactions above $2.0 million per deal, they serve a segment of the CRE market for which data are generally not as widely reported: small cap investments.
The silver lining for U.S. commercial properties came from the comparative strength of these smaller markets, such as Nashville, Tennessee; Charlotte, North Carolina; Jacksonville, Florida; Denver and Austin, Texas. These metros have been experiencing growing economies, rising employment and a diversifying corporate base. With demand for commercial spaces outpacing supply in these markets, vacancies have been declining and pushing cash flows up. In addition, for investors looking for higher yields, even with the change in monetary policy and the Federal Reserve’s moves to increase short-term interest rates, the long-term rates remained low.
Based on data from the National Association of REALTORS® (NAR), CRE in small cap markets continued on a divergent path from the large cap counterparts, with sales volume accelerating during 2016. REALTORS® reported continued improvement in fundamentals and investment sales. The investment volume accelerated throughout 2016, with the latter half of the year posting double-digit yearly gains.
As domestic and international investors across the value spectrum broadened their search for yield into small cap markets, increasing demand coupled with a shortage of inventory drove property prices higher by an average of 5.9 percent during 2016. During the first quarter of 2017, prices gained an additional 7.2 percent compared with the prior year.
Long Shadow of Financial Regulations
While accelerating prices offered good news for landlords and owners looking to sell, it also signaled concern for banking regulators. As commercial asset prices reached new highs in large cap markets, federal regulators voiced concerns about the trend’s sustainability and overall sector performance. Against this backdrop, bank examiners — working within the framework of the Dodd-Frank Act — have been scrutinizing banks’ balance sheets more closely and questioning more strongly allocations to CRE loans. In addition, the past two years also witnessed the implementation of the Basel III Capital Accords’ requirement on High Volatility Commercial Real Estate (HVCRE). The regulation assigned a 150 percent risk weight to capital deployed for acquisition, development and construction loans if the borrowers did not meet certain equity and leverage thresholds, essentially making certain commercial loans more expensive.
The NAR Commercial Real Estate Lending Trends 2017 report highlights the noticeable differences between the large cap and small cap commercial markets. Debt financing represents a much larger portion of capital in small cap markets, whereas large cap deals benefit from significant equity contributions. For regional and community banks, which accounted for 58 percent of all capital in REALTOR® commercial markets, compliance costs stemming from financial regulations have made a stronger impact on available capital for deals. With higher costs of compliance and higher capital reserve requirements for commercial loans, regional and community banks became more cautious in their lending during 2016, resulting in tightening of capital. In 2016, 37 percent of REALTORS® reported tightening lending conditions, compared with 33 percent in 2015. The tightening in lending conditions for the second consecutive year came as a noticeable reversal of a multiyear trend.
Moreover, 51 percent of REALTORS® reported that insufficient bank capital remains an obstacle to commercial sales in small cap markets. When asked about the main reasons for lending difficulties, REALTORS® indicated uncertainty for financial institutions as the main reason for the banks’ restrictive approach to commercial lending, followed by proposed legislative and regulatory initiatives.
On the macroeconomic front, activity is expected to pick up the pace, both globally and in the U.S. The uptick in gross domestic product and employment will maintain leasing fundamentals on an upward trajectory. However, concern in the capital markets over asset pricing, rising interest rates and current regulations are likely to weigh on transaction volume. The sales data for small cap CRE markets in the first quarter of 2017 showed a 4 percent yearly decline, a clear shift in the trend line.
With the presidential administration and Congress looking at initiatives to change the regulatory and tax landscape, investors remain wary of the impact upon commercial markets. In June of this year, the House of Representative passed a bill — The Financial Choice Act — aimed at repealing many of the Dodd-Frank Act’s regulations. While the House bill passed along party lines, the Senate’s composition would require several Democrats to cross party lines to agree on the current or a similar bill. Given the atmosphere in Washington, the likelihood of a bipartisan agreement is up in the air. Meanwhile, buyers and sellers in the small cap space are watching to see whether the quarterly drop becomes a trend or represents a temporary blip.
[i] Large cap markets defined as those with transactions aggregated at $2.5 million and above.
George Ratiu is Director of Quantitative & Commercial Research for National Association of REALTORS®