Commercial Development: Seizing the Opportunity in Growth Markets

While the industry ails, some commercial real-estate lenders thrive.

October 2015 | by Robert Harris

The contagion that started in homes in 2007 has spread to offices and shops. Commercial real estate (CRE)—one of several asset classes severely affected by the global crisis—has seen property values decline by over 25 percent in many markets, with some experts predicting an eventual drop of more than 50 percent for the worst affected regions. Most banks are deleveraging significantly, some to ensure their own survival; for many, this deleveraging includes a sharp curtailment of CRE lending. As a result, financing for CRE has dried up significantly. Some large property groups, unable to refinance as balloon payments come due, have already defaulted. A few have even filed for bankruptcy. In short, the commercial property industry and its lenders find themselves in the midst of a downward spiral.

Given this bleak outlook, there is perhaps no better time for a look inside the opaque CRE finance industry. Many CRE lenders find it difficult to understand how their performance stacks up against that of their peers. And few can say with any certainty how top performance is achieved. These gaps in understanding put banks at risk; if they misunderstand their economic performance, they will also likely miss critical opportunities to improve their business models. Such an opportunity might well be at hand as the financial crisis passes and the new reality sets in.

Our research has produced two key findings. First, the industry as a whole does not return its cost of capital (defined as equity) even in the best of times, let alone over the business cycle. Put another way, the “profits” recorded in good times are in fact economic losses to equity holders; worse, they fail to provide a cushion for the significant losses that come in industry downturns. In our view, as we will explain, the primary culprit is poor deal selection and, more specifically, a failure to adequately price the underlying risks. Other factors include a lack of revenue diversification and cost inefficiency. Because of these dynamics, we expect that even after the current crisis has faded, the CRE finance industry will continue to destroy value.

That said, some CRE lenders do in fact generate returns exceeding their cost of capital—our second finding. Top-performing lenders have developed a thoughtful approach to their business, choosing their customers with care, concentrating on the markets they know best, and taking a deliberate view of the many risks inherent in property markets. Furthermore, they have kept their businesses at a manageable size, moving countercyclically to reduce volumes.

These top performers have exercised admirable prudence, and many are now reaping the benefits of a seller’s (i.e., a lender’s) market. The rest are struggling. Troubled lenders should not let a good crisis go to waste. They can take advantage of the lull in their business to enrich their understanding of the ways top performance is achieved and build the capabilities such performance requires. Banks that can establish these skills and processes soon will be well placed to capture an outsize share of the economic profits of this important market once the crisis has passed.

 

Executive Editor

 Ms Anna Sullivan

Ms Anna Sullivan