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Loosening Underwriting Standards In Commercial Real Estate

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Based on the risk-adjusted returns prevailing in the current market rates, Citi analysts believe commercial real estate construction offers the best risk-adjusted return.

Keith Horowitiz and the team at Citi Research point out that in the current C&I market space, banks have moved from competing on rates to competing on terms.

Competition forces spread compression

The Citi analysts point out that competition across all loan categories remains high, with banks continuing to fight for loan growth. This has in turn resulted in spread compression over the last year.

The following table reveals pressure on spreads:

However, the analysts believe despite pressure on spreads, CRE construction offers the best risk-adjusted returns, as spreads have not compressed over the past year to the extent that loosening underwriting standards in commercial real estate spreads for permanent financing as well as other loan categories have.

Loosening underwriting standards in CRE

The Citi analysts point out that underwriting standards have loosened as competition in the CRE space has intensified in the last 12 months. Such easing has been noticed both in terms of narrowing spreads (down 35 bps on average across all categories, 12 bps in construction), and in terms of structure and covenants. However, as can be seen in the following table, the CRE yields are roughly flat as narrowing spreads have been offset by higher rates.

CRE yields

The analysts also point out C&I underwriting standards have continued to loosen, though at a slower pace.

GSE rules to force higher standards

The Citi analysts also note despite lending standards remain tight by historical levels, there appears to be room for lenders to loosen on the margin, as the refi wave subsides. However, the analysts believe, longer term, GSE putback risk and the ability-to-repay rule will cause banks to maintain higher standards of underwriting than past decades.

As can be deduced from the following graph, mortgage underwriting has loosened only slightly post-crisis.

Mortgage underwriting

Moreover, the December 2013 Ellie Mae Origination Insight affirms this view as it showed no easing in underwriting standards m/m for conventional/conforming purchasing mortgages, with average credit scores, LTVs and DTIs remain unchanged.

However, the analysts point out that auto underwriting standards continue to loosen.

Turning their focus on securities, the Citi analysts point out in order to comply with the Liquidity Coverage Ratio (LCR) requirement by the end of 2015, banks have been focusing their securities purchasing activities in Treasuries and GNMA securities. To remain asset sensitive, banks are targeting low duration assets.

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