How Lack of CRE Standardization Threatens Bank Valuation


Despite the continued economic uncertainty caused by the pandemic, residential real estate market has shown unusually good results over the past year. This is largely due to the fact that under the influence of large investors financed by the state, the mortgage market was standardized. Today there is a high degree of confidence that underwriting transaction requirements, data collection requirements, structure and composition of securitized pools and, more recently, the Federal Reserve’s appetite for mortgage-backed assets.

The result of this level of standardization is the residential mortgage market, which has become a highly efficient and growing source of supply for asset growth sought by investors, including banks.

Unfortunately, on the part of CRE, the situation is different in the bank’s lending business. There has been no similar stabilizing force in the commercial real estate mortgage industry, and this gap is currently creating one of the most serious threats in the face of the lending industry.

Broken character CRE
Commercial real estate loans now include a quarter of the USA loan portfolios of commercial banks. These loans are classified as “Tier 3” assets, which means that they are the most illiquid and difficult to measure.

CRE loans are difficult to obtain, often difficult to value and sell subsequently, and are often very difficult to resolve in the event of a default. Unlike residential mortgage assets, which can be split into granular pools and valued in seconds, each CRE asset is unique and each bank tends to treat this business differently, using highly inefficient and time-consuming manual processes.

Much of the difference between the two has to do with technology use (or lack thereof). In the past, efforts to build CRE’s lending and service platforms have focused on tools to support internal tasks such as risk analytics and accounting. And while work is underway to change all of this – GSEs are playing a more important role in multi-family business and the lives of older people; and MISMO is working to standardize the dataset needed to model rents – CRE is still far from understanding the efficiency of the residential real estate market.

The colorful composition of the regulators only exacerbates this problem, as bankers learned by adopting the Basel HVCRE rules after the Great Recession. Borrowers were offered completely different financing structures, driven by different interpretations of the HVCRE, which in turn depended on the identity of their bank’s main regulator.

At the moment, the approach of each bank to its CRE business from the outside looks proprietary and opaque. Past experience shows that opacity means banks’ valuation will hit sharply in the next downturn.

Risks currently facing banks
The impact of the pandemic on commercial real estate has been devastating. Thousands of people across the country have stopped their businesses, leaving office space empty. Others have found a safe haven in abstinence and relief programs that will soon end (or have already ended), leading to an inevitable second wave of defaults.

Meanwhile, new entrants are targeting lucrative portfolios of CRE banks, specializing in specific types of property that enable them to sign, close and service loans much more efficiently than ever before. Smaller organizations are capitalizing on new technology platforms, leveling the playing field, and subsequently taking business away from larger, slower competitors.

At the same time, the higher risks led to the fact that some banks simply abandoned the CRE. A successful lending program often leads to excessive risk taking, making a well-run bank appear inconsistent as it moves out of successful verticals to balance its risk weights. Selling risk to a third party is problematic because asymmetric information can lead to discounts even on existing loans. And in an unfavorable scenario, what used to be a coveted pool of large loans with high prices could quickly turn into a large millstone with low prices – and a serious threat to stock prices.

The CRE industry needs standardization more than ever, and technology exists today that can simplify and standardize much of the commercial lending process by loan and property type for institutions of all sizes.

However, its 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 greater certainty for the market as a whole. The industry will do the right thing if it makes this change before investors realize that banks are ill-prepared to manage and sell the largest assets on their balance sheets.

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