Lending Legislation CCIM Feature

The People in Your Neighborhood

The growth of community banks has lagged since the Great Recession. What impact does this have on commercial real estate?

Mark Twain is credited with the saying, “History doesn’t repeat itself, but it does rhyme” — though there’s no concrete evidence he came up with it. Regardless, this aphorism holds true when it’s applied to economic and business cycles. As the commercial real estate community has learned time and again, understanding the market’s position in a given cycle is critically important. The availability of funds, which relies on economic forecasts, powers real estate activity — and a hefty chunk of these funds comes from community banks as loans and mortgages.

The United States is currently enjoying its longest economic expansion in history. This growth, which began in June 2009 according to the National Bureau of Economic Research, has shattered the previous record of 10 years of sustained growth from March 1991 to March 2001.

Understanding that a cycle, by definition, is a “group of events that happen in a particular order, one following the other, and are often repeated,” Twain’s quote about rhymes is inherently true in the bull-bear economic markets. The Great Recession was the worst economic downturn in nearly 80 years, with economic contraction hitting a peak of 2.5 percent of gross domestic product from 2008 to 2009. The economy, as it has done in previous cycles, rebounded — growing steadily, if unspectacularly, through the early 2010s. But why didn’t this recovery extend to community bank loans and assets, whose proportional growth fell behind the rest of the economy over this decade-long expansion? Why, after bottoming out in 2008, didn’t economic growth extend fully into smaller lending institutions?

Historically, approximately 75 percent of all community bank loans and mortgages have been secured by real estate, with a large amount of those loans and mortgages tied to commercial projects. The failure of total community bank loan growth to minimally match the growth of GDP affects commercial real estate lending as a whole. Financing is available; however, loan terms are more restrictive than in the past. A few of the more restrictive changes include:

  • Construction loans typically require higher levels of preleasing for non-residential rental properties and higher levels of presales for residential “for sale” projects.
  • Upfront equity requirements of 30 to 40 percent are not unusual.
  • Amortization periods for term loans are shorter.

Obviously, these changes make it more challenging to obtain project financing from a community bank.

Consolidation is a generational trend in banking, with the number of U.S. banks declining by approximately 41 percent in the last three decades, from 12,615 in 1991 to 5,162 in the third quarter of 2019. Of these, approximately 92 percent were community banks, which regulators often define as banks with $10 billion or less in total assets, meaning thousands of smaller operations have shuttered in the last 30 years. Growth is equally dismal, with 2018’s 14 new community banks being the high-water mark since the Great Recession. During 2Q2019, only five new community banks opened.

Community Bank Loan Growth Compared to Growth in GDP

Between 2017 and 2019, community bank loan growth dipped into the red. These declines were caused by community banks with thinner capital ratios hoarding cash to increase their capital ratios, loan securitization, and increased competition from regional banks and non-bank lenders, leading to fewer opportunities for community banks.

In our extended economic recovery, the total loans of community banks grew approximately 1.46 percent on average. During this same period, the U.S. GDP went from a valley of 2.5 percent contraction in 2009 to an estimated 2.1 percent of growth in GDP from 2018 to 2019. Overall, GDP grew on average approximately 1.96 percent, slightly outpacing the growth in community bank lending.

Macroeconomics and national financial trends rarely allow for easy answers. But when it comes to explaining why smaller banking institutions are a step behind, four primary reasons jump to mind.

Increased bank regulations. Following the financial crisis, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010. Those 2,000 pages were intended to make the banking system safer, but the unintended consequences of the legislation greatly increased compliance costs and forced community banks to be more restrictive in their lending. Increased competition for commercial real estate loans continues to force community banks to decrease pricing to maintain market share, negatively impacting their net interest margin.

Worse still, community banks may “stretch,” or be more aggressive than their underwriting policies permit in determining the loan amount in order, to retain existing customers or obtain new ones. Assuming additional credit risk at this point in the cycle is particularly dangerous. Or saying this another way, are community banks being paid enough to take on additional credit risk 11 years into an economic expansion?

Federal Reserve monetary policy. The Fed has changed how it conducts monetary policy. The most significant change affects how community banks pay interest on excess reserves. Rather than holding excess reserves, these dollars could be put to a more optimal use in higher yielding loan growth.

Increased competition from regional banks and non-bank financial institutions. It’s no secret to any community bank loan officer and senior management that these lenders are competing for business formerly dominated by community banks. Many large U.S. based investment firms have created non-bank lenders — or shadow banks, as they are often referred — a $15 trillion market. These non-bank lenders are typically either divisions or subsidiaries of large United States investment banks or entities being formed and supported by private equity firms. It is important to note that these lenders do not receive deposit funding, and they are largely unregulated. Because of this, they can make loans that are generally out of reach of community banks, giving them a significant competitive advantage in growing loans.

Decline in number of community banks. Arguably, less community banks contribute to less loans. As mentioned earlier, higher levels of preleasing and presales, greater equity contributions, and shorter amortization periods for term loans have become the norm. More restrictive lending negatively affects all commercial real estate lending. Developing a business relationship with your local community bank which has always been important, is arguably more important than ever, as the number of community banks continues to decrease. Where we’re at in the current economic cycle position and the decline in the number of community banks have had less effect on growth in community banks loans compared to the first three factors. But the commercial real estate industry is still missing the potential that could be fulfilled by smaller banking institutions.

Cycles are not static, as the pendulum continually swings from expansion to contraction and back. In time, community banks may reverse their contracting trend and begin to expand. This expansion should be accompanied by more loan availability for commercial real estate.

Bradley Gordon, CCIM

Bradley Gordon, CCIM, is a managing member of B.D. Gordon Consulting LLC.

Contact him at bdg72854@gmail.com.

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