Why the US residential and commercial real-estate recoveries have been so different, and why they might invert, as financial conditions tighten.
Whoever said that real estate is all about “location, location, location” didn’t really have to worry about financing. Of course, location matters when investing in real estate, but the post-crisis evolution of US real-estate markets, both commercial and residential, says a lot about the role of financing, or more broadly, financial conditions in markets.
We won’t rehash what part the real-estate bubble played in the Great Financial Crisis of 2008. Yet, it’s worth highlighting that, although prices of both US residential and commercial real estate fell hard, their respective recoveries evolved differently, largely due to disparate lending landscapes.
This disparity is a major contributing factor to the very different pace of recoveries we have seen over the last several years between these two large and crucial real-estate markets. In fact, the moral of this tale of two markets has broader ramifications for the economy.
A brief recap: Commercial real estate bottomed in January, 2010, after falling 40%. In the six years since, commercial real-estate prices have increased 96% and now sit 17% above pre-crisis peaks. On the other hand, residential real estate didn't find a bottom until February, 2012, after falling a more modest 27%. Since that bottom, residential real-estate prices have only climbed 31% and are 5% below pre-crisis peaks.
The residential real-estate recovery faced three major headwinds:
- The crisis created a large supply of distressed properties from the spike in mortgage delinquencies and foreclosures. At their peak, our estimate of “shadow inventory,” or properties that faced the prospect of being sold by lenders and not at the discretion of owners, got as high as 10.8 million units.
- The regulatory environment for residential mortgage lending changed dramatically, imposing onerous new restrictions on lenders.
- Lenders faced an onslaught of fines, settlements and litigation related to different aspects of pre-crisis mortgage origination, securitization and foreclosure processing. We estimate that, for the industry as a whole, related payments to state and federal regulators, investors, the government-sponsor enterprises (for example, Fannie Mae and Freddie Mac), and others since the crisis now exceed $250 billion.
As a result, US residential mortgage lending tightened so much that only high-credit-quality borrowers could get access to financing. The private label residential-mortgage-backed securities market, which accounted for more than a third of all mortgage lending pre-crisis and specifically catered to less creditworthy borrowers, currently constitutes less than 1% of lending volumes.
The commercial real-estate market didn’t have to endure many of these headwinds—certainly not to the same extent. Chalk it up to the so-called big-boy rule, meaning commercial real-estate loans went to experienced and sophisticated borrowers who knew, or should have known, the issues in pre-crisis commercial mortgage lending. The muted focus on incremental regulation and significantly fewer litigation issues related to pre-crisis commercial real-estate financing sparked a revival of bank and insurance-company lending to commercial real estate, as the post-crisis recovery began to take hold. The private label commercial mortgage-backed-securities market staged a comeback—albeit at more modest levels, compared to pre-crisis.
Fast forward to the present, and yet another change may be in the offing. There is a growing sense of tighter financial conditions, particularly to the commercial real-estate sector. Late last year, the regulators issued a joint statement on Prudent Risk Management for Commercial Real Estate Lending, and the latest Senior Loan Officer Opinion Survey (SLOOS) shows that banks tightened their lending standards to commercial real estate meaningfully in the fourth quarter of 2015.
At the same time, they are showing signs of easing lending standards to residential real estate. To be clear, residential real-estate lending remains tight, but the change in tone and directionality from the SLOOS is noteworthy. Furthermore, those three headwinds for residential real-estate financing are fading on the margin. Distressed inventories have whittled down to around 2.7 million units; lenders have gotten used to new regulations, and residential mortgage litigation is increasingly in the rear-view mirror.
The growing sense of gathering clouds, in terms of tightening financial conditions for commercial real estate, translates into a more challenging road ahead for that US sector. The move in the opposite direction makes us more constructive on prospects for US residential real-estate markets.
If there is a moral to this tale for the broader economy, it is this: Tightening financial conditions are a key part of the transmission mechanism for “challenging technicals” to become “weak fundamentals.” The dramatic widening of corporate credit spreads and constrained capital-market access for a growing number of high-yield borrowers signal a meaningful tightening of financial conditions in the broader US economy.