By David L. Dubrow, Esq. and Michael Lengel, Esq. of Arent Fox LLP
In the 1993 movie Groundhog Day, Bill Murray’s character Phil Connors mysteriously relives the same February 2 over and over again, until, using his accumulated experiences, pre-knowledge of events, and a change of heart, he finally gets it right and the Universe permits him to move on.
On February 2, 2016, the Wall Street Journal reported that “low-doc” mortgage loans are making a comeback, the same non-income verifying process that, when abused, “helped fuel a tidal wave of defaults”in the 2008 crisis.
Is this déjà vu all over again?
The real estate market has grown considerably during our otherwise tepid economic recovery since the Great Recession. Banks, insurance companies, the GSE’s, private funds, mutual funds, and CDFI’s are quite active in real estate lending. The CMBS market, CDO’s and credit default swaps are back.
In our view, the balance has tipped towards the market being more of a borrower’s market than a lender’s market.
A borrower’s market historically results in greater price competition, a lowering of credit standards and increasingly greater risk taking. It also increasingly aligns with a market peak.
Simultaneously, we see banks facing phased-in regulations from the Collins Amendment and Basel 3 guidelines.
This includes changes to Tier 1 capital (now to be risk-assessed, purged of hybrid securities and hidden off-balance sheet liabilities), stricter capital requirements, phased-in reserves for a supplemental capital conservation buffer3 and even a proposed, incremental counter-cyclical buffer.4
An example of Basel 3 capital risk assessment: loans for commercial real estate are risked at 100%; high volatility commercial real estate loans for construction, acquisition and development are risked at 150% .
As these regulations continue to phase-in over the coming years, the probable result will be that the volume of bank lending will decline. Such a decline will likely lead banks to focus on safer core customers. In turn, such a decline will also create greater opportunities for non-bank lenders.
A collateral impact of these regulations is an emerging trend for banks to avoid the 150% capital requirements for development/construction loans.
To avoid classification as a development/construction loan, a borrower must contribute 15% of the “as completed” value of the project prior to the advancement of the loan and may not withdraw this capital or any other capital generated by the project until the loan is refinanced with permanent financing.
This new bank requirement is impacting returns on equity and posing new challenges for developers in successfully raising equity to finance projects. This emerging trend will counter undue bank risk but may also undermine the pace of development projects.
The combination of a growing borrower’s market, increased capital requirements for banks resulting in a trend towards safe core client lending and an active unregulated shadow banking sector creates tremendous opportunities for real estate funds and poses potential risks for lending standards.
The opportunities will arise from competitive advantages for funds over the regulated banks and from increasing demand for real estate loans. However, as funds chase greater returns, the potential for a material decline in credit standards arises.
For example, as reported by WSJ, some private equity funds, with hopes of achieving greater returns, “are planning to roll out new private funds that invest in Alt-A mortgages” (currently just 2.5 percent of the mortgage market) provided they find lenders with the willingness to make these riskier loans, that will emphasize the use of proper underwriting criterion (with realistic LTV ratios), and lenders that will provide “the right set of borrowers.”
Others have gone back to “tweaking” formerly-rejected applicants, sometimes lowering underwriting standards to find borrowers that may “have high debt-to-income but strong cash flow.”
Unless handled very carefully, Alt-A mortgages could be quite risky.
It appears that an array of lending opportunities await in 2016 for lenders. The question is — will market participants avoid the errors that led to the financial crisis or will history repeat itself?
We expect in the main that the lessons from the Great Recession will not be so soon forgotten.
While risk taking will likely increase, and while on the margins undue risk will be taken, we do not believe real estate risk will be the driver of the next recession.
However, the 2016 real estate market will unfold in the context of great uncertainty caused by world-wide economic stagnation, the presidential election, the Federal Reserve’s efforts to raise interest rates and the growing impact of bank regulatory requirements.