How a scarcity of CRE standardization threatens financial institution valuations

Despite the ongoing economic uncertainty triggered by the pandemic, the residential real estate market performed exceptionally well over the past year. This is mainly due to the fact that under the influence of the industry's large, government-sponsored investors, the residential mortgage market was standardized. Today, there is a high level of security around the underwriting requirements for the transactions, the data collection requirements, the structure and composition of securitized pools, and lastly, the Federal Reserve's demand for mortgage-backed assets.

The result of this standardization is a highly efficient residential real estate mortgage market that has become a growing source of supply for asset growth that investors, including banks, are looking for.

Unfortunately, things look very different on the CRE side of a bank's lending business. There was no similar stabilizing force in the commercial real estate mortgage business, a void that is now one of the greatest threats to the lending industry.

The broken nature of CRE
Commercial real estate loans now make up a quarter of US commercial banks' loan portfolios. These loans are “Level 3” assets. H. they are both the most illiquid and the most difficult to evaluate.

Commercial real estate loans are not easy to grant, often difficult to price and sell afterwards, and often very difficult to resolve in the event of default. Unlike residential real estate mortgages, which can be split into granular pools and priced in seconds, every commercial real estate asset is unique and every bank tends to treat this business differently while employing very inefficient, labor-intensive manual processes.

Much of the differences between these two companies can be attributed to the application (or lack of) technology. Previous efforts to create credit and service platforms for commercial real estate have focused on tools to support internally focused tasks such as risk analysis and accounting. And while efforts are being made to change all of that – with GSEs playing a bigger role in multi-family business and senior living; and MISMO are working on standardizing the data set required to model rental price trends – CRE is still a long way from realizing the efficiency gains in the residential real estate market.

The colorful composition of the supervisory authorities only exacerbates this challenge, as bankers have learned from the adoption of the Basel HVCRE rules after the Great Recession. Borrowers were offered very different funding structures due to different interpretations of HVCRE, which in turn depended on the identity of their bank's primary regulator.

Right now, every bank's approach to their CRE business looks proprietary and opaque from the outside. Past experience has shown that bank valuations will suffer dramatically in the next downturn.

The risk banks are facing now
The effects of the pandemic on commercial real estate are devastating. Thousands across the country have ceased business and freed up office space. Others have found a safe haven in forbearance and relief programs that are about to end (or have already completed), bringing with it an inevitable second wave of defaults.

Meanwhile, new entrants are targeting the banks' lucrative commercial real estate portfolios by specializing in certain types of real estate that allow them to write, take out and service loans much more efficiently than ever before. Smaller institutes use new technology platforms, level the playing field and consequently take business away from larger, slower competitors.

At the same time, the higher risks have led some banks to simply pull out of CRE. A successful loan program often results in an overweight exposure, which causes a well-run bank to appear inconsistent as it pulls out of successful verticals to offset its risk weights. Selling risks to third parties is problematic, since asymmetrical information can lead to a discount even with fulfilling loans. And in a crisis scenario, a once-coveted pool of large, high-priced loans can quickly become a large, cheap millstone – and a serious threat to stock prices.

The commercial real estate industry needs standardization more than ever, and technologies exist today that can streamline and standardize much of the commercial lending process across loan and property types for institutions of all sizes.

However, adoption will require bankers to abandon their unique, outdated approaches to business in favor of a process that provides greater transparency for investors and regulators and more security for the market in general. The industry would do well to make this change before investors realize that banks are ill-equipped to manage and dispose of the biggest assets on their balance sheets.

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