Commercial real estate lending is starting to pick up, even though the property market has suffered historic collapses in value. Hammered by defaults and delinquencies, and criticized for pretend-and-extend accounting, the banking industry is nonetheless pursuing this business with such vigor that some executives complained on their fourth-quarter conference calls about how competitive the loan pricing has become already.
But in so doing, are banks preparing the next asset bubble by re-opening the commercial property loan window? After all, office vacancy rates are in the upper teens, retailers are still shuttering stores, unemployment is at 9 percent, and indexes of consumer and small business confidence are weak. How can banks entertain new loans under such circumstances? Should they not focus instead on clearing the massive amounts of suspect loans already on their books?
For at least three economic reasons, I think the resumption of commercial property lending is no reason to indulge in 'bank-bashing' in early 2011.
First, this is the very best time to be a lender if safety and soundness is the decisioning standard. A long-term study of commercial mortgage loan defaults and delinquency looked at the performance of 18,000 loans over 30 years of history, and concluded the origination years of the loans with the lowest cumulative default rate were 1991 and 1992.
Like today, it was a time following a massive banking crisis. It was marked by constricted liquidity, depressed property values, and a market characterized by low rent and high vacancy. Values underwritten during such a period have relatively low downside cyclical risk remaining.
Second, a business strategy to refrain from lending, in favor of pursuing an aggressive foreclosure and write-down approach to the real estate loan portfolio, further damages bank balance sheets. Insisting on tighter credit availability has the unintended consequence of weakening all commercial property collateral. I think this is unnecessarily self-punitive.
In the Panic of 2008 and its aftermath, commercial property values over-corrected in the face of abnormally low transaction volumes and the flight of capital to the safe harbor of Treasuries. That capital is returning in a disciplined way to so-called risky assets, including real estate. Witness the reduction since March 2009 in capital held by institutional money market funds from $2.5 trillion to under $1.8 trillion, as reported in the Fed's H.6 Money Supply reports.
This has sparked, among other effects, a return of equity capital flows into commercial real estate, with an easing of capitalization rates in the context of double-digit equity risk premiums—even at low loan-to-value ratios. Banks need not presume that the depressed values of late 2008 to early 2010 were the "new normal" for the market. That period was the aberration, not the norm.
A related third point is this: the classical virtues of patience and prudence can be well respected in the resumption of lending. Current underwriting standards are understandably rigorous and the judgments made by investment committees are, in the main, quite sober. Bankers earn their money not by the application of supposedly objective mathematical formulas or by responding to market pressures to grow (or shrink) the book of business.
As imprudent lending undoubtedly occurred in the midst of the bubble by the implicit "mark to market" of considering the inflated price of the last deal as a reflection of value, so too the "mark to market" of valuing assets based upon the scant evidence of depressed prices in a thinly traded market shows poor judgment on the part of lending institutions.
Ironically, sound economics teaches that banking discipline means tightening standards on risk when real estate markets are strong, and keeping the lending window open when markets are weaker. It is not an easy or uncomplicated business. However, those bashing banks for returning to the market, saying "there you go again," are neither being accurate in their assessment in the risk of new loans nor are they thinking through the economic consequences of keeping liquidity from the commercial property markets as they recover in 2011 and beyond.