Commercial lending is a crazy business right now. There is far too much capital sloshing around the economy, driving down costs to borrowers and making it hard for lenders to get paid for the riskiness of the loans they extend. Pricing is so disconnected from risk, in fact, that it’s common for bankers to refer to commercial lending as “a loss leader.” Really? All that work fielding loans, underwriting them, getting collateral, securing it, and negotiating the underlying terms for a “loss leader”? This scares me, and it should scare you too.
But commercial real estate is where things are particularly scary for me. There are four moving parts—each concerning on its own—with the potential to invoke systemic risk should they move in the wrong direction together, something that might already be happening:
- Faux diversification: In my analysis of banks’ commercial lending operations and the systems by which they are supported, diversification is something always on my mind and a part of the conversations I have with folks. And when I ask about the lending specializations into which they diversify, both system vendors and lending FIs typically say something like, “Yes, we have commercial real estate lending as a specialization.” And that’s usually it. Concerning here is that if only one lending type is your source of diversification, you’re not really diversifying. My idea of diversified commercial lending, and I’ve loaned in such operations, encompasses specializations such as high-technology companies, not-for-profit organizations, higher education institutions, professional service firms, insurance carriers, and asset-based lending.
- Systemic faux diversification: This “faux diversification” I’ve observed is quite common. It’s observed not every once in a while but rather at most lenders with which I’ve discussed the issue. Mistakes broadly made in credit markets are commonly referred to, in regulatory jargon, as sources of “systemic risk.” I know regulators are running around the economy stress-testing banks and watching concentration ratios. But from how I see it, this diversification is indeed faux in nature and is causing too much capital to flood into our commercial real estate markets.
- Excess capital: If most commercial banks are embracing commercial real estate as a diversifying lending specialization—and from where I stand, they are—among all that capital sloshing around the economy looking for a suitable borrower is a big wave headed toward commercial real estate. When supply goes up, “risk-based” borrowing costs go down and lending terms get looser; both are bad.
- The WeWork factor: Speaking of our commercial real estate markets, what exactly has been done to them by WeWork? According to real estate firm CBRE, WeWork is the number one leaser in nine of 10 cities hot in the flex-space market. Of course, we all know about this flex-space player’s ousting of its charismatic (always a troublesome thing when approaching a market top) chief executive officer and the face-losing cancellation of its planned IPO. If Wework turns out the be the Enron of this cycle, then lots of space in cities such as New York, San Francisco, and Boston will go transparent. Rent proceeds will go down, and collateral will get devalued. Do you remember what A-class commercial real estate looked like in 1989? There were entire buildings in Houston and Dallas that you could actually see through.
And here’s a bit more on WeWork as a potentially ugly moving part in this machine: According to the Wall Street Journal, banks—in a frenzy to get a part of the WeWork IPO pie, when that IPO was still a possibility—had lending operations that were extending credit to WeWork on a cash-collateralized basis. When do commercial lenders—who are terrific analysts of business models and cash flow—demand cash as collateral? When they know they’ve got a credit seeker on their hands who would never make it through a credit committee otherwise. I think I hear one of those parts moving.