I have seen the future and the future is C&I lending. Banks continue to stay away from Commercial Real Estate.
Commercial lenders are usually classified into two camps:
Business lenders that deal with Commercial & Industrial loans (C&I) and Commercial Real Estate lenders that deal with CRE loans (multi-family, shopping centers, office buildings, warehouses/industrial buildings, construction, and land development).
Within those two camps there are layers, for example, business lenders are usually divided by the size of their customers between corporate lenders and small business lenders. In addition, Commercial Real Estate lenders are usually categorized by specialization with some concentrating in giving loans to a particular segment of borrowers such as apartment buildings or shopping centers.
Depending on which path you take in your commercial lending career you will become one or the other. While the goal of every single bank loan is to base lending decisions primarily on cash flow, CRE lenders tend to become collateral oriented over time, and business lenders tend to concentrate in cash flow.
The bias is easy to understand. The Commercial Real Estate lender has the benefit that the collateral can not disappear from the borrower’s warehouse, and it can not be diverted to a depository account in another bank. The reliability of the loan-to-value guideline on commercial real estate was enough to provide a sense of safety and security that was eventually found to be misplaced.
I have worked in lending institutions where the Chairman’s primary banking experience was from Savings & Loans. Based on his experience, it was hard to sell him on taking large C&I exposures. He was willing to do million dollar business lines of credit, but once you went above that number it was a struggle. On the other hand, he was very comfortable doing multi-million dollar commercial real estate deals.
Then 2006 happened, and certain long-held beliefs about the underlying collateral went out the window. Commercial Real Estate got beat up hard, and commercial banks realized that long-term commitments on commercial real estate were not as safe as originally thought. It was bad enough that the vacancies and lower rental rates were killing your primary source of repayment, but it got worse when the appraisals starting coming back indicating that the bottom had fallen out of the market. The nice building that was once financed assuming a value based on a 7% cap rate was being now valued using a 9% cap rate. Buildings literally lost half of their value, and many markets have not yet started to recover.
Faced with this real estate driven recession banks have reacted in two ways. First, CRE lending has slowed to a crawl. Second, most banks that relied on CRE loans as the source to grow their portfolio are transforming themselves into business lenders. The emphasis in C&I lending has increased the demand for qualified analysts. I lost two of my Sr. analysts last year to competing banks, and found it very difficult to replace them with experienced personnel.
The new emphasis in cash flow lending has increased competition for strong borrowers, and has sometimes made some lenders bend their underwriting rules just to grow their portfolio in that direction. While this has not happened with my employer, I have heard troubling stories from risk management professionals in smaller competitors.
The latest figures released by the FDIC show that the shift to C&I as well as the continuous shrinking of CRE portfolios in FDIC insured institutions has resulted in C&I loan portfolios surpassing CRE loan portfolios for the first time in many years. We can expect this trend to continue for the next couple of years until commercial real estate rebounds.