Any investor presentation or balance sheet of a community bank in Massachusetts will likely show some of the strongest credit quality since the financial crisis, or even before.
But despite strengthening asset quality, there has been repeated warnings this year – from the Federal Open Markets Committee and Boston Fed President Eric Rosengren – that smaller banks may be taking on significant risks to extend their commercial real estate portfolios.
“It’s hard to say in terms of where these banks are taking on the risk. We won’t know until the cycle has turned,” Collyn Gilbert, managing director covering community and regional banks at Keefe, Bruyette & Woods, told Banker & Tradesman. “But the reality is we have been in competitive real estate marketplace for a while; the yield curve is flattening. So, we think it’s probably safe to assume that banks are putting on credits where the risk profile is higher than the return profile.”
Gilbert said the main concern is in the luxury multifamily or luxury real estate sector, and in retail.
State-chartered banks in Massachusetts have significantly bulked up their multifamily residential real estate over the past year.
State-chartered banks have increased multifamily residential real estate loan volume by more than $817 million between the third quarter of 2016 and the third quarter of this year, reaching over $7.6 billion total as of Sept. 30, according to the FDIC.
Retail, once seen as a much safer bet, has been turned on its head due to the rise of e-commerce.
“That is where we will put a red flag up, toward retail. And even the grocery chain,” said Gilbert. “Some banks extend commercial real estate exposure to tenants that are part of a grocery anchor, or a CVS or Walgreens anchor, and yet, with what Whole Foods and Amazon and CVS and Aetna are doing, what used to be perceived as secure collateral, we may need to rethink that.”
In The Market
Opportunities in Greater Boston and within the city have led to more players in the market which, compounded with low interest rates, have increased banks’ need to be competitive.
Competing institutions are offering higher loan-to-value ratios on loans, meaning smaller down payments, said John Migliozzi, vice president of commercial lending at East Boston Savings Bank, which has grown its commercial real estate book by more than $460 million year-over-year.
On non-recourse loans ESBS will typically require an LTV of 60 or 65 percent. But competing parties have been going as high as 70 or 75 percent, he said.
In terms of the debt service coverage ratio, whereas EBSB typically will look for 1.4 percent and higher on its commercial real estate loans, Migliozzi said he sees competitors going as low as 1.2 percent.
The 18 commercial mortgage-backed securities in Massachusetts analyzed by New York City-based research firm Trepp this year have a slightly higher LTV ratio than in 2016, although they are still at normal levels.
The debt service coverage ratio for those securities, at 1.87 percent, is the lowest since 2014. This ratio is also still at normal levels; Trepp considers a ratio of 1.2 percent the level that might draw a red flag.
All of the lending has resulted in banks building up high commercial real estate concentrations, said Kevin Malone, executive vice president of commercial banking at Blue Hills Bank, which has grown its commercial real estate book over $90 million year-over-year.
“I don’t like being so highly concentrated,” he said. “Because community banks are so local, they become geographically concentrated, and we are looking for ways to become more geographically diverse. We have done a few deals outside New England recently.”
Gilbert of KBW said she is looking hard at the duration of loan buckets through the lens of rate hikes now and in the future.
“We don’t want to see banks with a longer-duration real estate portfolio locking in rates at low levels,” she said.
Real Estate Valuations
Malone believes the market has gotten riskier “because we are pretty long in the tooth of real estate valuations.”
Rosengren of the Boston Fed told the Wall Street Journal in October that he thinks there are “overstretched valuations” in some sectors of the market, such as commercial real estate.
“We are looking hard at appraised values and tend to think they are optimistic. … We are pushing back against some of the valuations,” said Malone.
He added that the bank, cautious about valuations, has been doing its own debt-to-yield valuation, which takes the noise of interest rates out of markets and looks at whether there is a reasonable cash yield for the risk involved in a deal.
Migliozzi is another that has questioned what is going on in the luxury market, particularly for renters.
“In my mind, there are only so many people going to pay $5,000 to $7,000 per month,” he said, referencing areas in Boston like the Seaport. “Eventually they will buy [homes] … We are watching that very closely.”
Ultimately, Migliozzi still believes there are good opportunities out there, but that banks need to pick their spots carefully and make sure all of the lending criteria checks out.
“I’d like to say we are in the seventh inning of a nine-inning game,” he said.
Email: bberkowitz@thewarrengroup.com
