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Banks Cut Back on Commercial Real Estate Lending

Signs of Preparation for Next Downturn Emerge as Loan Loss Allowances Grow

Photo Courtesy of CoStar.

Banks are cutting back on commercial real estate lending, reflecting moderating property value growth and rising construction costs, while loan loss allowances grow. Both moves signal preparations for a potential economic downturn.

Loan growth slowed to 4.2 percent last year from 5.6 percent in 2017, according to bank call reports and Federal Deposit Insurance Corp. data. Many banks noted the trend in their fourth-quarter earnings calls.

"It is interesting to see a slowdown in bank commercial real estate mortgage growth. I think there is certainly heightened competition in the lending market, but I believe the slowdown to be intentional," said Jack Mulcahy, senior financial analyst for CoStar. "Banks may be preparing for the end of the bull market by cutting back on lending goals."

Mulcahy also pointed out that changes in how financial institutions, including banks, will account for loan loss reserves will take effect this coming December and could be attributing to the slowdown.

Current accounting rules call for measuring "incurred loss." The new methodology, referred to as "current expected credit losses," or CECL, calls for recognizing "expected losses," a forward-looking approach that incorporates the probability of future losses.

The change has sparked criticism, with some banks suggesting it will discourage them from originating long-term loans, such as commercial real estate mortgages.

Banks are analyzing the potential effects, but to some extent have already begun to put capital aside that might have been used for additional lending. Even though the amount of noncurrent loans has been shrinking, the amount being set aside for potential loan losses increased last year.

The amount banks have in reserve for losses increased to $124.7 billion at year end. That amount is 124 percent more than the value of loans 90 days or more delinquent and is up from a ratio of 106 percent at the end of 2017.

"Banks deployed a large percentage of their capital to use between 2014 through 2017," Mulcahy added. "Based upon industry financials, banks are now enjoying higher returns and padding their balance sheets for the next downturn."

Big Bank Curtailment

The nation's largest banks lead the reduction in lending. Of the 10 banks that reported the largest decrease for loans on their books at year end, six had total assets of more than $100 billion.

Wells Fargo, the nation's third-largest bank by total assets, shrank its commercial real estate loan holdings by about $8.8 billion, or 6 percent, for the largest decline.

"Large banks -- $250 billion or more -- have taken their foot off the pedal when it comes to lending," Mulcahy said. "Total commercial real estate holdings fell by 0.41 percent in 2018 -- the last time there has not been positive growth was in 2011."

Much of the slowdown can be attributed to construction loan volume totals. Big banks reduced their exposure by 5.96 percent, and the overall construction amount among banks of all sizes started shrinking in the fourth quarter.

The rising pace of construction costs has created "a shrinking pool of projects that make economic sense," according to statements in the Federal Reserve's latest Beige Book. The Beige Book is a Federal Reserve System survey on current economic conditions, which it uses to assess the outlook for the national economy.

2019 CoStar.

Written by Mark Heschmeyer.

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