These complex commercial property changes are having significant impacts on various stakeholders, especially those involved with finance. It is important to seek clarity and perspective on these emerging trends, their implications for all involved and ways for finance professionals to effectively navigate this evolving terrain.

“Recent trends in the commercial real estate market, particularly in renowned technology hubs like San Francisco, have included sharp downward movements in property valuations.”

At the forefront of the massive change are mortgage brokers who in the past had standardized models to assess the risks associated with properties. With fluctuating values, especially in major markets such as San Francisco, Chicago and New York City, these models now need a fresh lens.

Properties that were traditionally perceived as lucrative and virtually recession-proof are now enveloped in layers of uncertainty. This newfound unpredictability calls for a more meticulous and nuanced approach to risk assessment, ensuring that every potential pitfall is accounted for.

Recent trends in the commercial real estate market, particularly in renowned technology hubs like San Francisco, have included sharp downward movements in property valuations. As the backbone of the U.S. tech industry, cities like San Francisco have traditionally commanded premium prices. But current data paints a different picture and indicates a directional shift in macroeconomics.

Office-space dilemma

The commercial real estate market in San Francisco includes a few recent sales of office buildings at shocking discounts. Some properties are being discounted by 60% to 70% or more compared to what they were valued at just a few years ago.

Historically, office spaces in business hubs have been in high demand, driven by a thriving tech community, startups and ancillary businesses. But a combination of factors, including the broader acceptance of remote work following the COVID-19 pandemic and the high operational costs associated with maintaining offices in prime locations, has led to reduced demand and has subsequently pushed down valuations.

“As always, relationships are the bedrock of the mortgage industry. In these times, a network that includes both quality lenders and borrowers is an invaluable asset.”

JLL reported that San Francisco’s office vacancy rate increased to more than 30% in third-quarter 2023. It was the 15th consecutive quarter in which the vacancy rate increased. The dip in the city’s office valuations has had a cascading effect, leading to a deluge of tax appeals. Among the major players, Brookfield Properties requested a 75% reduction in the value of an office tower on Market Street, while Columbia Property Trust sought a 50% cut on three of its office holdings.

Blackstone wasn’t far behind, appealing for reductions of 20% to 25% for three of its waterfront properties. In the fiscal year ending this past June, tax filers in the city appealed for an average reduction of 48% on property assessed at more than $60 billion.

For cities, this wave of appeals spells fiscal strain. San Francisco, which was already grappling with a projected budget deficit of $780 million through 2025, anticipates refunding $167 million due to these property tax appeals.

Cook County troubles

While San Francisco’s declining values and increasing tax appeals create a challenging landscape, property owners thousands of miles away in Cook County, Illinois, are grappling with an entirely different kind of shock: skyrocketing property tax bills. About 40,000 residents in Cook County are filing appeals.

Amid a backdrop of rising inflation that negatively affects consumers, some commercial real estate owners have seen their tax bills double or triple in a single year. Data obtained from the Cook County Treasurer’s Office indicated that tax bills for some 20,000 properties increased by 100% or more between 2021 and 2022. A majority of these properties are residential but some are commercial.

One particularly jarring case came from the Roseland neighborhood on Chicago’s South Side, where a homeowner was served with a property tax bill that jumped 1,000% year over year. Meanwhile, in the Chicago Lawn neighborhood, a senior citizen received an 884% hike in her tax bill.

Cook County Assessor Fritz Kaegi’s office attributed these sharp increases to neighborhoods that have “undergone significant change” and that many properties were “most likely previously undervalued.” But these explanations tend to provide little consolation. Some business owners told local news services that they might not be able to keep their doors open.

Future implications

The underlying sentiment in Cook County reflects a growing sense of alarm and uncertainty that is being felt in many major cities. While property owners understand the need for periodic tax hikes to finance county services and pensions, they feel cornered by the extremity of these increases, especially given the limited time they have to arrange for payments after receiving their bills.

This may be part of the new normal as real estate markets change and fluctuate, sometimes in extreme ways. This evolving landscape is going to be difficult to navigate, especially for those in the realm of mortgage finance.

Mortgage brokers will need to develop a nuanced approach to risk assessment to find their way through this new environment. And many lending standards will need a fresh look. This includes the loan-to-value (LTV) ratio. A cornerstone in the mortgage domain, LTV ratios are greatly influenced by property valuations.

With declining prices, these ratios are bound to witness significant shifts, which could impact the capacities for potential borrowers. A property that might have fetched a substantially high loan amount a year ago might now merit considerably less, reshaping the lending landscape.

Interest rate impacts

The changes in property valuations don’t stop at risk assessments and LTV ratios. They extend their reach into the very core of property financing — interest rates and loan terms.

Many lenders, in their bid to shield themselves from potential defaults, have adopted a more conservative stance. This could manifest in the form of adjustable interest rates or more stringent loan terms, particularly for commercial mortgages in areas that are experiencing sharp valuation declines.

The age-old adage of not putting all your eggs in one basket seems more relevant than ever. The unpredictability of certain markets underscores the importance of diversification. Instead of heavy investments in a single market or property type, spreading one’s portfolio across different regions and diverse property segments might emerge as the wise strategy. This approach hedges against potential losses in one sector and also offers avenues for gains in others.

The path ahead

In the intricate landscape of today’s real estate market, commercial mortgage brokers are presented with a unique blend of challenges and opportunities. To navigate these waters, a holistic approach that combines traditional expertise with adaptive strategies is essential.

Central to this is an emphasis on a data-driven strategy. As professionals deeply entrenched in the commercial mortgage ecosystem, the ability to harness and interpret current market data is indispensable. Beyond the standard metrics, diving into granular data points can offer pivotal insights, allowing for timely and strategic decisionmaking. In a volatile market, data-informed strategies will set brokers apart.

Data cannot exist in isolation, no matter how comprehensive it is. A deep understanding of local market dynamics is more crucial than ever. Each commercial district holds unique challenges and potential. Leaning into expertise to better discern microtrends can provide a leg up, ensuring that every deal is optimized for success.

As always, relationships are the bedrock of the mortgage industry. In these times, a network that includes both quality lenders and borrowers is an invaluable asset. It ensures seamless transactions, fosters trust and positions you as the go-to expert amid market uncertainties.

It’s crucial to stay attuned to the broader policy landscape as well. Decisionmakers, including city officials, are actively working on frameworks to steady the commercial real estate market. One example is San Francisco Mayor London Breed’s proposal to offer tax incentives that would encourage companies to set up offices in the city. Keeping a finger on the pulse of such policy shifts can offer you and your clients a strategic advantage, ensuring that you’re capitalizing on every available opportunity.

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The path forward for commercial mortgage brokers, while laden with complexities, is also ripe with potential. A combination of data-centric strategies, deep local-market insights, solid relationships and a grasp of evolving policy directions serve as a compass to guide brokers through these times. Their expertise, paired with these tools, will ensure not only survival but success in the evolving commercial real estate landscape.

The intersection of declining valuations and soaring tax appeals has caused uncertainty for commercial real estate owners. By understanding these shifts and their implications, mortgage brokers can chart a course that not only navigates through such challenges but also identifies potential opportunities for future growth and innovation. ●

The post Feeling the Squeeze appeared first on Scotsman Guide.

In Episode 022 of the Scotsman Guide Author Showcase, Carl White interviews Chris de la Motte of Sonar about his article, “AI Is Already Shaping the Industry’s Future,” in the November 2023 issue of Scotsman Guide Residential Edition.

Chris de la Motte is CEO and co-founder of Sonar, the groundbreaking mortgage experience platform celebrated for revolutionizing the digital mortgage landscape. Backed by FirstMark and Liberty Mutual, Sonar is an integrated loan origination, point of sale software, product pricing engine and customer relationship management platform, powering the entire mortgage journey from application to closing. Prior to Sonar, de la Motte was president of Simplist, one of the fastest- growing digital mortgage companies. Visit Sonar at yoursonar.com.

The post Author Showcase: Chris de la Motte, Sonar appeared first on Scotsman Guide.

The potential of AI knows no bounds — it spans from enriching the customer experience to amplifying operational effectiveness and output. AI’s capacity to expedite task management benefits both mortgage processors and originators by boosting daily accomplishments. The realm of AI already encompasses underwriting, automated document scrutiny, fraud detection and more. And the evolution toward digitization continuously molds the trajectory of the mortgage industry’s future.

To stay competitive, you must begin to harness AI within your mortgage enterprise. These resources are not intended to supplant a human role but rather to simplify it. Through the adoption of AI-driven technology, you can manage increased workloads without compromising on excellence or customer service. For mortgage originators, the incorporation of AI has brought about significant changes by promising improved accuracy, efficiency and client experience.

Mortgage originators play a critical role in facilitating the lending process, acting as intermediaries between borrowers and lenders. Their responsibilities range from evaluating loan applications to assessing creditworthiness and determining appropriate lending terms. The introduction of AI-powered tools into this domain has significantly impacted the way these professionals operate, enabling them to make more informed decisions and deliver higher levels of borrower satisfaction.

Risk assessment

One of the primary areas where AI has made a substantial impact in lending is risk assessment. Mortgage originators rely on assessing the creditworthiness of borrowers to determine the terms and conditions of a loan.

AI-driven algorithms have proven invaluable in analyzing vast amounts of data to predict credit risk more accurately than traditional methods. These algorithms consider a wide range of factors, including credit history, income, employment stability and even behavioral patterns, enabling originators to make more informed lending decisions.

By leveraging AI-driven risk assessment tools, originators can identify potential risks and opportunities that might have been overlooked through conventional, manual methods. Assessment tools not only enhance accuracy but also speed up the decisionmaking process, allowing for quicker responses to loan applications and reducing the time that clients spend waiting for a decision.

The integration of AI into mortgage lending has also opened up avenues for creating personalized borrower experiences. Originators can now utilize AI-powered chatbots and virtual assistants to interact with borrowers in real time, addressing queries and concerns promptly. These AI-driven communication channels are available 24/7, ensuring that borrowers receive the assistance they need whenever they require it.

AI can analyze client data to understand individual preferences and behaviors, enabling mortgage originators to tailor their services accordingly. This personalized approach not only improves homebuyer satisfaction but also fosters stronger relationships between borrowers and originators.

Data analysis

Mortgage origination involves extensive documentation and paperwork, which can be time-consuming and prone to human errors. AI-powered optical character recognition (OCR) technology has revolutionized this aspect of lending by automating the extraction and digitization of information from physical documents. This technology not only reduces the risk of manual errors but also significantly speeds up application processing times.

By automating document-related tasks, mortgage originators can redirect their focus toward value-added activities, such as building relationships with borrowers and providing strategic financial advice. The optimization of tasks through AI-driven solutions enhances overall operational efficiency and improves the originator’s ability to handle a higher volume of loan applications.

The capability of AI to manage and analyze data has demonstrated great value in predicting market trends and facilitating well-informed decisionmaking. For mortgage originators, this translates to enhanced strategic planning and the ability to align lending practices with market dynamics. AI algorithms can analyze vast datasets of historic and current market information to forecast potential economic shifts, interest rate changes and other indicators that could impact lending decisions.

With predictive analytics, originators can proactively adjust their strategies, ensuring that their lending practices remain competitive and flexible to changing market conditions. This approach positions them as trusted advisers to borrowers, offering insights that can influence the timing and terms of loan applications.

Ethical concerns

While the integration of AI offers undeniable benefits to mortgage originators, it also raises ethical concerns. The use of AI-based algorithms in lending decisions must be closely monitored to prevent bias and discrimination. It’s essential to ensure that the datasets used for training these algorithms are diverse and representative, thereby preventing the perpetuation of existing biases.

Transparency also becomes crucial for maintaining trust between originators and clients. Borrowers need — and have the right — to understand the factors that influenced the lending decision. AI systems should be designed to provide transparent explanations for the outcomes they produce, letting borrowers understand why a particular lending offer was made.

As AI technology continues to evolve, its role in mortgage lending will expand. The combination of AI with other emerging technologies, such as blockchain, could revolutionize the way mortgage contracts are created, managed and executed. Blockchain’s transparent and secure nature could enhance the integrity of mortgage transactions, reducing fraud risks and streamlining the process.

In the realm of mortgage lending, AI has proven to be a game-changing innovation for originators. From improved risk assessment and streamlined document processing to personalized customer experiences and predictive analytics, the impact of AI is undeniable. Mortgage originators are well positioned to harness the power of AI to elevate their services, optimize operations and adapt to ever-changing industry dynamics.

With the adoption of AI comes the responsibility to ensure fairness, transparency and ethical use. Originators must maintain a balance between leveraging the benefits of AI and upholding ethical standards while navigating these new tools. As technology continues to advance, mortgage originators who embrace AI with a focus on its responsible implementation will undoubtedly thrive in this new era of lending. ●

The post AI is Already Shaping the Industry’s Future appeared first on Scotsman Guide.

But without accurate data and credible information to determine the catalysts of rising expenses and diminishing revenues, it can be increasingly difficult for a borrower to discover the value of a property. It is equally likely that the cause of decreasing cash flow is either internal or external — or a perfect storm of both.

Commercial mortgage originators can help borrowers find their way to better data analysis by introducing them to and helping them understand the value of commercial property performance benchmarks. In any trade, a gauge is vital to consistently produce the highest-quality observations and results. In the commercial real estate space, benchmarks are among the most useful tools to measure the performance of real assets.

Originators can work with their clients to pull data and interpret results. With the answers in hand, operators can develop an optimization strategy and all parties can confidently move forward with financing efforts.

Benchmarking properties

Real estate benchmarks consist of external property data associated with various measurements, including market rents, occupancy rates, operating expenses and net operating income. This data is collected from management teams for assets across a range of sizes, features, locations and classes.

The data is then organized and analyzed to identify trends and typical benchmark ranges. Owners can compare the benchmarks against their internal property data, with the results helping them to identify areas of operational improvements or strategic changes to maximize market trends. The subsequent decisionmaking tree will differ depending on the answers and the principals’ objectives.

Benchmarks, however, are beneficial for more than asset optimization. They are indispensable in assessing the value of a single property or portfolio in the acquisition, refinance or disposition processes. They can also help to narrow the bid-ask spread and identify value-add opportunities. During times when valuations are in flux, benchmarks can help borrowers get a better idea of a property’s true value.

Property performance benchmarks have been around for years, but the size and quality of these datasets have grown substantially due to recent technological innovations. Organizations such as the Institute of Real Estate Management, the National Apartment Association, and the Building Owners and Managers Association, regularly collect and report data tied to commercial real estate, including multifamily, office, industrial and other types of assets.

Collection and analysis

Benchmarks do not offer much utility unless operators possess quantitative data to understand the performance of any properties to be acquired and can then compare this information to marketwide data points. Gathering this external data, however, can take significant time and labor. It requires coordination between management teams, especially when the owners are benchmarking a portfolio of assets.

Once the information is assembled, it can be analyzed to prepare the necessary data points for comparison. For assets or portfolios on a midsize or large scale, this analytical work requires specialized expertise. Therefore, whether hiring internally or contracting with third parties, the retention of data analysts (or data scientists for more complex portfolios) is a prudent move to draw the needed points and conclusions from the raw datasets.

This is an area where innovation can create greater efficiency, clarity and results. Industry-specific data and asset management platforms connect all systems or silos where data is housed. They automatically aggregate, organize and analyze the data, then report the key performance indicators (KPIs) and insights. While it’s not a substitute for seasoned analysts and decisionmakers, technology can significantly streamline the benchmarking and optimization process.

Competitive sets

With internal data for their own properties in hand, the next step for operators is to identify the groups of external assets for comparison, aka “competitive sets.” Comparing owned asset data to that of a properly assembled competitive set allows a borrower to objectively view the value of their properties and how they’re performing relative to the rest of the market.

For instance, if internal revenues are down year over year but are on par with the rest of the market, this provides a clue that the property is being well run and any change in value may be tied to external factors. Conversely, when these metrics fall short of market averages, it can signify that attention is needed internally.

Determining which properties comprise the competitive set is an important component of the benchmarking process. While the perceived sets are typically those with similar superficial characteristics (i.e., asset type, location or size), the actual set may include properties with similar operational parameters that can be statistically identified. Mortgage originators should seek out team members or advisors with experience in collecting and analyzing benchmark data and grouping it for effective comparisons.

Once the competitive set is defined and the data is prepared, the owner or asset manager can then determine how the property compares with similar assets from a revenue or expense standpoint. If the property is in the top quartile across the board, it is doing pretty well. But if it is in the bottom quartile, it is clear that work needs to be done.

Key indicators

Owners and operators should concentrate their attention and efforts in areas where they can influence results. Some data points or KPIs to look at on the income side include net effective rents, gross rents, rent adjustments, and losses or gains to lease rates. In regard to outflows, it pays to compare management costs along with the expenses of leasing, utilities, insurance, taxes and maintenance.

Revenue as a percentage of operations is a crucial measurement and a high-level point of comparison. It is valuable to know by what percentage revenues exceed or fall short of expenses. Expense ratios are another critical group of metrics to evaluate in the controllable expense line.

Another important benchmark is to look at the level of cumulative or specific expenses that are being consumed as a percentage of the gross operating income. The analysis will let a borrower know whether the property is being managed efficiently, and if the geographic market is favorable in terms of typical operating costs that are influenced by location-specific variables such as taxes, materials and labor.

In addition to providing the basis for assessing the performance of a particular asset, market lease rates and occupancy metrics help owners understand the strength of the subject market and other geographic areas. The data points uncover how much upward potential there may be for rent increases, and they are instrumental in the due-diligence process for acquisitions.

Strategy and decisionmaking

Commercial mortgage originators need to keep in mind that the purpose of this entire process is strategic planning and decisionmaking. Whether for optimization, acquisition, disposition, refinance or other initiatives, benchmarking equips the broker and borrower with knowledge of where an asset or portfolio stands in respect to the broader market.

For each of these objectives, a strategy powered by technological innovation and management is best served by the insights gained through benchmarking. Knowing the KPIs through internal benchmarking and comparing them to the market as a whole creates a starting point for finding both problems and solutions. But from there, a framework is required to efficiently plan optimization efforts and align team members across an organization with a clear vision and unified approach.

An ideal framework for using this new information is objectives and key results (OKRs). These are tools used by companies to set goals and create the steps to reach them. OKRs encompass key performance indicators, which can be used to measure the results of how the company did in achieving its set goals. This process is complex, but there are many resources available to plan and implement an OKR-driven strategy.

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The U.S. economy is testing the resolve of all stakeholders in the commercial real estate industry, with property owners and potential buyers positioning themselves to take advantage of this time of fluctuating values. Benchmarks are both a ruler and a compass that equip commercial mortgage originators and their clients with tools to navigate murky market conditions. They’ll be more likely to gain a true sense of direction in their pursuit of stability and growth, despite the upswells in mortgage rates and expenses. ●

The post All About the Benchmarks appeared first on Scotsman Guide.

While inflation may be abating, the capital markets are in a period of discovery. Many commercial mortgage lenders have significantly pulled back in the wake of the Silicon Valley Bank, First Republic Bank and Signature Bank failures earlier this year. What made these collapses unique was the speed at which their deposit runs occurred. Now, unsurprisingly, there are growing concerns from regulators that are exploring new and better ways of monitoring lender balance sheets and liquidity.

As an example, the Fed is now considering the implementation of “reverse stress testing.” This approach would evaluate the conditions needed to break a financial institution, rather than creating an artificial stress scenario and its projected impact. Institutions with assets of $100 billion or more already receive more scrutiny and are under more regulatory obligations at the federal level. While these banks tend to make the most loans tied to commercial real estate, they also have fewer effective options for loan risk management or balance-sheet optimization. Recently, many of these lenders have looked to the insurance industry for a possible solution.

Similar in concept to private mortgage insurance on residential loans to consumers, commercial property loan insurance (CPLI) is an investment grade-rated loan guarantee product designed to serve as an effective risk transfer and mitigation strategy. By leveraging this option to insure the most risky portion of a commercial mortgage, lenders can gain significantly better access to liquidity, balance-sheet optimization and risk management when financing a real estate project. It’s something that mortgage brokers and borrowers should understand as they work with lenders to structure safe and cost-effective financing.

Prudent approach

The Federal Reserve requires banks with more than $250 billion in assets to be stress tested each year. (Institutions with at least $100 billion in assets are evaluated in even-numbered years.) Importantly, these rules now cover a large portion of prime commercial real estate lenders.

The enhanced scrutiny impacts these institutions’ balance sheets and liquidity. Although a lender could possibly raise more debt or equity to address this, doing so is expensive and dilutive. Another option is to curtail commercial real estate lending activities, and many institutions have already met (or are exceeding) their concentration limits, meaning that they’ll receive additional regulatory scrutiny. Many lenders are even selling their commercial mortgage notes, especially for certain office and retail properties, at significant discounts.

Regardless of size, focus or geography, all commercial real estate lenders need to ensure they are employing best practices when it comes to risk management. The recent and relatively quick collapses of the three previously respected banks are harsh reminders of what can happen if these measures fall short.

Constant due diligence is a requirement for all types of risk — and not only for an institution’s loan exposure. The banks that failed this year had some things in common: Their loan portfolios were reasonably solid and up to date, but they improperly managed interest rate and deposit risks. These events also serve as reminders that the industry-ingrained stance of “waiting until others go first” has proven to be a faulty if not fatal approach.

Insurance basics

The unexpected deposit runs and rapid interest rate increases that felled these banks can have significant impacts on any lender’s balance sheet. In addition to liquidity issues, these can also affect capital requirements, concentration levels and loan-to-value regulatory parameters, which can put an institution at risk by severely hindering its operations and profitability.

Just as regulators are exploring new methods of stress testing, many commercial real estate lenders are seeking new approaches to optimize their balance sheets. Commercial property loan insurance has emerged an alternative. Other available options (including credit-linked notes, credit-risk transfers and credit derivatives) tend to offer mixed success at best, since they can be costly or unreliable.

There are two main strategies for lenders to employ in regard to CPLI. It can be used alone or in conjunction with a fixed-income collateral agreement. Either of these strategies can be highly scalable. Commercial mortgage lenders can quickly compare these paths by identifying the risk weighting for a specific loan amount, then reviewing the costs of each option using market percentages of first-loss protection.

For example, on a loan pool of $1.13 billion with a conservative overnight rate and spread of 12.5%, the cost to leverage loan insurance (with or without a collateral agreement) can be roughly 40% to 60% lower than using credit-linked notes or credit-risk transfers. This also provides more capital, operational efficiency and scalability for the lender.

Using CPLI on its own is an effective option, but commercial real estate lenders can also leverage it in conjunction with additional cash, or cash-equivalent collateral, for added risk-weighted benefits. Regulators are likely to view this collateral as having a zero risk weighting, which means a much lower impact on a lender’s overall capital requirements — and likely its concentration requirements.

Creating an agreement for pledged collateral that serves as a credit enhancement for a commercial mortgage is a fairly straightforward process, with the collateral remaining liquid and held in an escrow or equivalent custodial account. An investment grade-rated CPLI policy would then be purchased, either by the lender or the borrower, to remove the need for a personal guarantee. This places the insurer in the first-loss position ahead of other parties while protecting the collateral at hand.

Urgent action

This year’s bank collapses gave all lenders a sobering reminder of the consequences of a risk management failure. These events not only highlighted how difficult it can be to predict and plan for unexpected events — the purpose of any insurance product — but more importantly, why adhering to the status quo related to due-diligence strategies could be a costly or fatal move.

Banks are likely to be further scrutinized in the months ahead. As regulators broaden their methods of assessment, the commercial mortgage lenders that have traditionally taken a wait-and-see approach may quickly find themselves in a difficult position.

Additionally, as underwriting continues to be impacted by current pre-recessionary market conditions, and as nonbank lenders rush to fill the gaps left by many banks moving away from commercial real estate, the cost of borrowing is likely to continue to rise. Lenders that start to explore their options now rather than waiting until they are forced to react are likely to increase their risk mitigation capabilities. They could capture a significant competitive advantage in the marketplace or possibly even regain lost market share.

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With commercial mortgages representing the largest portion of assets in the portfolios of many community and regional lenders, the impact of failing to act could be devastating. As other areas of the capital markets explore alternatives to optimize balance sheets and lessen risk, the implementation of commercial property loan insurance can offer lenders an immediate and cost-effective solution. This can provide the regulatory relief and better risk management they need to thrive, regardless of anticipated market cycles or unexpected events. ●

The post Lessons Must Be Learned appeared first on Scotsman Guide.

When comparing the cost of a substantial rate increase with all the expenses associated with postponing a construction project in the hope that rates will fall, starting the project is usually the right answer. The current lending environment may be the perfect time for mortgage brokers to educate their clients on the benefits of a spread-based loan with payments that fluctuate as base interest rates move up or down.

“It is better to realize a profit today than to face the uncertain costs of a delayed development in the future.”

Borrowers can often buy a collar, an option used to hedge exposure to interest rate movements, to help protect against large rate increases. But the reality is that short-term construction or bridge loans that experience rate changes aren’t likely to be very significant to the overall cost of a project. For instance, any construction loan amount with a 3% higher rate makes a relatively small difference on a monthly basis as funds are disbursed and the project nears completion.

Not worth waiting

A $50 million multifamily housing project, for example, would experience a relatively small increase in its overall cost if rates rise when compared to the potential internal rate of return realized by most real estate projects of the same size. After all, how long can apartment developers wait without putting their money to work while rates remain in fluctuation? Not moving forward means losing money. The developer needs an income-producing asset.

Using this multifamily development as an example, let’s say the cost of capital has increased by 400 basis points from the previous year when the financing has been approved. Due to the higher rate, the actual cost of the project would increase by about $2 million. Dividing this figure by the 150 units in the building comes to $13,333 per unit.

If the average unit was originally priced at $350,000, then the additional cost of $13,333 results in an increase of less than 4% per unit. This will almost certainly be much less than the average market increase in price during the next 18 months.

At the same time, the cost of carrying the undeveloped land and not building the project will also be much more than 4%. This argument gives the mortgage broker a logical reason to have an educated conversation with the client about focusing on the income opportunity and moving forward to build the multifamily asset.

Taking action

A broker needs facts in this period of fluctuating rates to be able to close more loans. While the cost of a few points of additional interest may well be significant, the reality is that the carrying costs — the total expenses associated with owning a property — may be considerably more than the increased cost of financing.

This is especially true when comparing the profits gained once a project is completed versus doing nothing. Delaying a project always results in nothing gained, either in cash flow from tenants or in a sales transaction. An argument can be made in waiting for the market to recover, but the facts rarely support this theory.

According to 2021 data from the National Council of Real Estate Investment Fiduciaries, the average annual return on investment (ROI) for U.S. commercial real estate over the prior 25 years was 10.3%. This compares favorably to the S&P 500, which had an average annual ROI of 9.6% during the same period. Given the current market parameters, it seems to make obvious sense to borrow capital and maximize returns rather than sitting on nonproductive assets.

Sitting still will always result in nothing. Conversely, moving forward despite a real or perceived interest rate risk is likely to produce a viable return if all other costs are equally well managed.

Market factors

The potential profit for a particular real estate investment can be affected by various external factors. Clearly, the key elements include the market conditions at any given time. When there’s limited inventory available, it typically drives up the price of properties that are being listed for sale. This type of seller’s market will impact ROI in a positive direction.

The upfront cost to acquire real estate also factors into the profit that investors stand to earn when they’re ready to sell, and the cost of debt is part of this calculation. The more you pay for a property, the less money you stand to pocket in the end, unless the value has appreciated significantly (which has happened in many markets in recent years).

The prevailing cost of debt, which can also impact profits when developing or marketing real estate, is of interest to people in the capital markets. When interest rates are relatively high or on an upward trend, as they are today, prices often decline to attract wary buyers. A lower sales price means a lower profit for the current owner. But as previously mentioned, it is far better to develop now and borrow at a higher rate than to do nothing, which also has a cost.

Location is another key factor that will always increase or decrease the ROI. A residential property located alongside a highway, for instance, is likely to command a lower sales price than one near a park or a beach. Amenities included in the development project aid in marketing and absorption efforts, and they are factors of relevance for lenders when projecting support for the loan in question.

The cost of materials required for construction or renovation is an additional factor that impacts ROI. When goods such as lumber or steel are more expensive, it drives up the amount spent on a project, which eventually cuts into profits earned when the property is sold.

This is a perfect corollary to the increased cost of debt. Yet many borrowers are more concerned about interest rate increases, which even in times of fluctuation are often substantially lower than any changes in raw material costs. This is a good discussion point for a commercial mortgage broker when talking with a potential client. It is better to realize a profit today than to face the uncertain costs of a delayed development in the future.

Historical basis

For comparison’s sake, it may be helpful to look back to when average interest rates for residential mortgages dropped to a record low of 2.65% in January 2021. To put it into perspective, the monthly payment for a $100,000 loan at the historical peak rate of 18.63% in October 1981 was about $1,559, compared to about $403 at the rate of 2.65% nearly 40 years later.

The markets then experienced the recent roller coaster, with rates going from the lowest point on record to the highest level since March 2002 in a period of about 21 months. After the COVID-19 pandemic hit the U.S. in 2020, the Federal Reserve cut its overnight rate to nearly zero to stabilize the economy, as businesses closed to stop the spread of the virus and public health officials ordered Americans to shelter in place.

Rates spent much of 2021 between 2.7% and 3.1%, giving many borrowers an opportunity to refinance or buy real estate at some of the lowest rates ever recorded. Then, in June 2022, the increase in the Consumer Price Index (an important gauge of inflation for consumer goods and services) peaked at 9.1% — the largest 12-month spike in decades.

Even before the inflation report, interest rates were already headed higher, starting the year off at 3.55%. They steadily rose each month in 2022, with the weekly average 30-year fixed rate rising to 7.08% as of this past October. By June 8, 2023, the average 30-year mortgage rate stood at 6.71%, according to Freddie Mac.

Yes, this can be scary when you look at the rapid changes and volatility. For prospective borrowers, however, these types of rate increases may well result in a relatively small increase in their overall project budget, one that’s not dissimilar to an increase in the cost of construction materials.

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One truth about commercial real estate is that good deals with solid foundations will still get done in times of financial instability and rate fluctuations. One of the main tasks for mortgage brokers is to help their clients look past difficulties and find a path to funding their project. The other option is to do nothing, which is sure to result in nothing gained. ●

The post Finely Balanced appeared first on Scotsman Guide.

Not only are regulations evolving at the federal and state levels, but many financial institutions are now doing business all across the country. If a company has a footprint in all 50 states and, in some cases, even if they have clients residing in states where they are not located, they may be subject to any number of state-level compliance obligations.

Mortgage companies and financial institutions are also well aware that laws and regulations at the state level can vary widely in the ease of their public availability, the requirements they impose, and the forms and manner of publication. Keeping on top of all these regulations adds up to a potential nightmare for compliance teams.

But there are ways to keep your company’s head above water when it comes to compliance. One critical component to ensure that your company has a connected end-to-end compliance program is an authoritative source library (ASL).

Structured foundation

Simply stated, an ASL is a comprehensive inventory of a company’s compliance obligations. These may include federal and state laws and regulations. This library can also include rules and guidance that might be published by industry associations, interagency bodies or self-regulatory organizations.

A key piece to any ASL is robust regulatory change. Ingesting regulatory changes that are connected to your library drives the compliance program for your organization, allowing you to map obligations to specific business units within your company, and to manage and control regulatory compliance risk.

The benefits of keeping your library complete and up to date include providing a structured foundation for your compliance program. Compliance teams without a content repository worry about saving emails from subscription lists, bookmarking webpages for regulators or associations to track the latest releases, and even maintaining paper registers. This only leads to lost data and uncertainty.

An appropriately curated ASL means that a compliance professional can rely on the essential information they need being in one place and, just as importantly, that the information is being consistently structured. This allows for informed analysis because they will be able to compare like items across content types, jurisdictions and lines of business.

The connections you make, in turn, allow you to pull back and form a comprehensive view of your overall compliance program. You can determine the overall program impact of a regulatory change because you can clearly see the relationships among your library items.

Competing priorities

It is important to remember that one size does not fit all when it comes to setting up an ASL. Each company has to determine its compliance obligations based on where they do business, what types of business they engage in, their corporate structure, and attendant responsibilities for subsidiaries, affiliates and vendors.

No two institutions have identical ASLs as a result of these differences. In fact, curating the right content set is an essential element of creating a connected ASL. Doing so requires an upfront commitment to make sure that you have identified the resources you will need, and it’s a vital component for the long-term success of the project.

Every company faces competing priorities, so why should this type of compliance program management get a place at the head of the line? Well, there are a variety of negative outcomes for failing to maintain this library. Banks, credit unions and mortgage companies can face fines, corrective action plans and consent orders, all of which can be costly and publicly embarrassing, eroding the confidence of your clients, business partners and even other regulators.

There have also been recent examples in which a record of poor compliance has caused regulators to place limitations on expansion into new geographic locations or lines of business, and to carefully scrutinize proposed mergers and acquisitions. In other words, if the organization cannot prove compliance with its current obligations, it may not be entrusted with new ones.

Delivering proof

Let’s assume that your company has created an ASL of the applicable laws, rules, regulations and guidance, and it is being maintained through a robust regulatory change process. You still need to be able to answer whether you are compliant and offer proof. Being able to demonstrate, document and report compliance — whether to a regulator, an internal audit team or other stakeholders — is achieved through the following tasks:

Identify the requisite laws, rules, regulations and guidance within your ASL, and establish a sustainable regulatory change management system.

Validate the continued, connected completeness of your compliance program.

Develop a comprehensive approach that allows you to report on the integrity of these systems.

A well-documented risk register and controls serve as sources of proof for your compliance program. Failure to perform risk and control assessments may result in these being done for you in a public manner by a regulatory agency.

You may be unsure who is responsible for a particular piece of the compliance program, or you may not have a reliable method to hand off work items within a specific team and across other business units. A spreadsheet that is edited by multiple people may have version-control issues.

Generally speaking, manual processes result in a high volume of busywork for skilled personnel and may not enable them to be able to see through the weeds. If manual processes are problematic, it’s time to think about automation.

Business sense

Effective management of your organization’s key risks, as well as its assessments and controls, is a must-have. It is supported by and through a dynamic ASL. This also makes good business sense and provides the owners of compliance risk management with daily risk intelligence.

A connected ASL provides your institution with documented decisionmaking, task assignments and implementation steps, and it is centrally available to be monitored and reported on year after year. This can occur regardless of changes in leadership or other impacts to the organization.

In other words, you’ll know the laws, rules, regulations and guidance your institution needs to comply with because these are located in your ASL. You’ll know that your institution is in compliance because you’ve made the connections between your regulatory obligations and the elements of your compliance program that manage the risk, and you can prove you are in compliance through the recordkeeping and reporting capabilities of automation. ●

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Originators also face significant risk in terms of compliance. Even the smallest mistake can lead to severe consequences, including fines, legal action and loss of license. To excel in this business, originators must understand common compliance mistakes and how to avoid them.

“One of the primary compliance risks faced by mortgage originators is the failure to adequately verify a borrower’s income and assets.”

Compliance risks are a serious threat to your business. Beyond the financial losses and legal complications, there’s the potential for harm to your reputation, which can either sink your career and business or cause lingering damage for years.

Borrower confusion

One of the primary compliance risks faced by mortgage originators is the failure to adequately verify a borrower’s income and assets. This can lead to fraudulent applications or subsequent loan default. To avoid this risk, it is crucial to verify all income and asset information provided by a borrower and to ensure that all documentation is accurate and complete.

Originators are responsible for conducting proper due diligence on prospective borrowers, including verification of income, employment and credit history. Failure to conduct proper due diligence can lead to compliance risks and potential legal issues, such as violation of the Equal Credit Opportunity Act.

Another compliance risk that originators face is failing to disclose all relevant information to borrowers. This could include neglecting to provide information about the loan product and interest rate, or not explaining the terms of the loan clearly and concisely.

Undisclosed fees

Another common mistake is the failure to disclose all fees and charges. Mortgage originators are required to provide borrowers with a good-faith estimate of all costs associated with a loan. This includes not only interest rates but other expenses, such as closing costs, origination fees and application fees. Failing to disclose these fees can result in legal action and damage to your reputation.

A failure to divulge all relevant information could lead to misunderstandings between the borrower and the lender, which could ultimately lead to legal action. To avoid this mistake, originators should explain the terms of the loan in simple language, outline all fees and charges, and answer any questions that the borrower may have.

The Truth in Lending Act (TILA) is a federal law that requires lenders to disclose the terms and costs of a loan to borrowers. Originators must comply with TILA requirements, such as providing borrowers with a loan estimate and a closing disclosure within specific time frames.

A lack of compliance with TILA requirements could lead to legal action and fines. Originators must stay up to date with TILA requirements and ensure they provide borrowers with the required documents within the specified windows of time.

Proper licensing

The Secure and Fair Enforcement for Mortgage Licensing (SAFE) Act is a federal law that requires originators to register with the Nationwide Mortgage Licensing System and Registry (NMLS). Originators must also complete prelicensing education, pass a written test and undergo a background check. Not complying with the SAFE Act could lead to fines or the loss of the originator’s license. Originators who work at federally regulated institutions (including most banks) are exempt.

As a mortgage originator, you have a responsibility to ensure that your business is compliant with various laws and regulations. Originators must keep detailed and accurate records of all loan transactions. They should also store these records securely and be prepared to provide them if necessary.

Originators must also comply with state and federal regulations, including the Fair Housing Act, Equal Credit Opportunity Act and Real Estate Settlement Procedures Act (RESPA). They must remain current with state and federal regulations to ensure they comply with all applicable laws.

Lastly, failing to adequately train staff is a common mistake within compliance risk. Mortgage companies should take steps to train all staff members on regulatory and policy compliance. This can ensure that your business is operating within the law. It is important to provide ongoing training so that staff members are up to date on all relevant regulations and policies.

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It is important to maintain accurate records, comply with all state and federal regulations, and disclose all fees and charges to borrowers. Adequately train your staff members and avoid predatory lending practices. By following these tips, you can ensure that your business is compliant and operating within the law. ●

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The Dodd-Frank Act of 2010 included Section 1071, which mandated the collection and dissemination of data on loan applications to small businesses, including those owned by women and minorities. The data is aimed at enforcement of fair lending laws and to assess whether the needs of businesses targeted by the law are being addressed.

“This is a very far-reaching regulation with significant implementation challenges, and it also involves the collection of very sensitive data about the status of the businesses.”

The Consumer Financial Protection Bureau (CFPB) didn’t issue rules regarding this process until March 2023. As the bureau gears up to begin enforcement, business-purpose lenders need to prepare for the extensive task of collecting data on their end. Timothy R. Burniston of Wolters Kluwer recently spoke with Scotsman Guide about the new rules and some of their possible implications for commercial real estate.

What is Section 1071 of the Dodd-Frank Act about?

When Congress passed the Dodd-Frank Act in 2010, it amended the Equal Credit Opportunity Act to require financial institutions to compile, maintain and submit to the CFPB certain data regarding applications for credit for small businesses, including those that are owned by women and minorities. The data would be published annually by the CFPB. The statutory purpose of the CFPB’s new rule implementing Section 1071 of the Dodd-Frank Act is to facilitate fair lending enforcement and to enable the identification of business and community development needs, and opportunities for women-owned, minority-owned and other small businesses.

Why is this receiving so much scrutiny right now?

The key thing to remember here is that this is a fair lending regulation, not just an exercise in data collection. The data is going to be used by regulators, examiners, advocacy groups, the media and plaintiff’s attorneys to look at patterns associated with access to credit and matters that may be indicative of potential redlining, underwriting issues and pricing issues. The bank regulators will also likely use that data in connection with reviews of applications for certain expansion requests such as mergers and acquisitions. And the same data will also be used by the bank regulators in connection with Community Reinvestment Act exams.

How will this rule impact commercial real estate?

It would impact the industry in a lot of significant ways. First off, this would require an institution that’s covered by the regulations to have procedures in place that are reasonably designed for the application process. These procedures would ensure consistency in the collection and reporting of a number of data elements, and the institutions will need to have controls and train the staff monitoring the programs.

This is a very far-reaching regulation with significant implementation challenges, and it also involves the collection of very sensitive data about the status of the businesses, whether they are owned by women, minorities and people who identify as LGBTQ+. This will involve identifying the race, sex and ethnicity of the principal owners of a business, along with a number of other data elements. So, there will be many internal challenges in collecting the information and challenges after the collection process to analyze the information.

What is the timeline for implementation?

The CFPB put in place a tiered implementation schedule based on the number of small-business loan originations. If a company does more than 2,500 originations in 2022 and in 2023, it will have to start collecting the information by Oct. 1, 2024, and will have to provide it to the CFPB by June 1, 2025.

If a company does between 500 and 2,500 originations in both 2022 and 2023, then collection will begin in April 2025 and be reported by June 1, 2026. For companies doing fewer than 500 originations annually but more than 100 in 2024 and 2025, collection will begin in January 2026, with the first submission due in June 2027. For those organizations with the largest number of originations, they have roughly 17 months before they have to start collecting. ●

The post Q&A: Timothy R. Burniston, Wolters Kluwer appeared first on Scotsman Guide.

No matter the type or asset size of the financial institution in question, effective navigation of regulatory changes continues to lead the list of challenges facing compliance professionals at banks, credit unions and other lending organizations. Originators will want to understand how these concerns can impact the bottom line for their own companies and for their lending partners.

The Regulatory & Risk Management Indicator survey was first developed in 2013 to methodically collect key trend information on the breadth and depth of regulatory and risk concerns among lenders. The survey also identifies the areas needing attention in the coming year.

“Even though the main score is lower, this does not mean that regulators have been looking the other way or becoming less vigilant.”

As in past years, people responded from institutions of all sizes, although a majority (81%) in the most recent survey represent smaller banks and savings and loan institutions, followed by credit unions (18%). The nearly 330 people surveyed are primarily from bank management and executive levels, followed by those in compliance roles as well as those in lending functions.

The survey aims to take the pulse of compliance and risk officers for banks and other lenders. Over the years, it has also revealed where respondents believe their organizations currently stand, where they need to be and how they will go about addressing challenges.

Rigorous examinations

The survey measures lender concerns about current regulatory and risk trends, along with anticipated impacts to an institution’s relative abilities to manage risk. It includes a “main score” that offers a snapshot of the risk and regulatory compliance landscape that lenders must navigate.

While the main score decreased from 128 points in 2021 to a score of 94 last year, which suggests an overall easing of concerns, these results are somewhat misleading. This is because two of the major drivers for the lower score included a reduction in the number of formal enforcement actions (down 18%) and the overall dollar volume of penalties and fines (down a whopping 94%) that were imposed as part of these enforcement actions. But there were several other factors that also reflect ongoing concerns, most notably involving an increase in the number of new major regulations.

Some of the reduction in the number of enforcement actions and the dollar amount of fines is simply attributable to timing. Developing an enforcement case is complicated and often plays out over a lengthy period. The survey period covered regulatory activities for the period from July 2021 to June 2022. Consider the $3.7 billion fine levied by the Consumer Financial Protection Bureau against Wells Fargo at the end of 2022. This large penalty did not take place during the most recent survey, but it will be reflected in next year’s overall survey score.

Also, even though the main score is lower, this does not mean that regulators have been looking the other way or becoming less vigilant. On the contrary, regulator examinations are just as rigorous as ever. No one should take the lower score to mean that risk and compliance management is getting any easier. 

Formidable challenges

Change management was identified as the most pressing regulatory compliance challenge in the next 12 months by a majority of respondents. This shows that the ability to absorb the breadth and volume of regulatory change is an overwhelming and formidable challenge, regardless of a financial institution’s resources.

Complicating the implementation of these changes is the general business environment and its own set of challenges, especially in the present economic environment. It also suggests that institutions are feeling pressure from regulators, with several significant regulatory initiatives underway. Most notably, these include Community Reinvestment Act (CRA) modernization, small-business lending data-collection efforts via Section 1071 of the Dodd-Frank Act, and changes to the Bank Secrecy Act.

Survey respondents are anticipating challenges arising from the implementation of regulatory changes across their enterprises. The CRA rule changes and the 1071 regulations could hit at roughly the same time. Each are complicated and will require a consolidated effort across institutions to implement.

“Today’s environment is too complex to manage compliance without the help of technology and automated processes.”

These regulations have been on the horizon and in play for the past several years. For many banks, CRA changes will require new evaluation methods, new data to collect and a new examination process to adjust to, along with new approaches for working with their communities and business partners.

In some ways, CRA rules and Section 1071 are intertwined and have to sync up. Furthermore, the 1071 data will also be used for fair lending analyses. Lenders will have to implement a system for obtaining and reporting the data. They will also need to analyze and determine what the data shows about their lending patterns, especially in regard to the gender, race and ethnicity of small-business loan applicants. Sixty-eight percent of survey respondents are either “very concerned” or “somewhat concerned” about their ability to manage implementation of the forthcoming 1071 regulation.

Surprising findings

Wolters Kluwer expected that more survey participants would report experiencing increased regulatory scrutiny on fair lending examinations. Sixteen percent of respondents indicated more scrutiny, only slightly higher than in 2021 and likely attributable to a higher regulatory focus on fair lending. It will be worth watching these results in the 2023 survey.

Climate-related financial-risk management is also an area to monitor. Only 27% indicated they were giving significant attention to climate-related risk management, with 23% giving it some consideration. These numbers are likely to rise as the approach by regulators on climate-related risk management becomes clearer and more developed.

The survey revealed a significant increase in concerns for managing risk across business lines. In fact, the 59% share was the highest for risk management in the past four years. There was also a significant increase for third-party risk management. This share went from 15% in the 2021 survey to 26% in 2022, reflecting the growth of third-party partnerships and increased regulator attention.

There were across-the-board increases in compliance management system investments. These included investments to strengthen risk management, update policies and procedures, manage regulatory content, improve quality assurance capabilities and bolster consumer complaint management.

Respondents are also giving considerable attention to interest rate increases, inflation, recession potential and ransomware attacks in their enterprise risk-planning efforts. Finally, and maybe not surprisingly, 83% indicated their belief that a reduction in overall regulatory burdens was either “somewhat unlikely” or “very unlikely” during the next two years.

Top obstacles

The top three obstacles cited for implementing an effective compliance program included manual processes (54%), inadequate staffing (44%) and too many competing business priorities (38%). Let’s break these down a bit.

With manual processes, today’s environment is too complex to manage compliance without the help of technology and automated processes. Spreadsheets just don’t work. The share of those who expressed concern in this area jumped from 45% in 2021 to 54% in 2022. Manual processes lead to errors, inconsistencies and disconnects across the so-called three lines of defense. The three lines of defense start with operational management controls executed on a daily basis. That’s backed up by risk and compliance controls to ensure the first line of defense is properly designed and operating as intended. The last line of defense is an internal audit.

Inadequate staffing concerns saw an increase over the 2021 score of 41%. This modest jump could reflect a couple of things, ranging from the effects of the “Great Resignation” to the long-standing challenges of attracting and retaining talent. Another factor might be work-from-home practices. Anticipation about the future could play a role here as compliance officers look down the road and see a lot to do; their responses may suggest that future staffing is inadequate to handle the load.

Finally, having too many competing business priorities is a challenge that speaks for itself. There has been an emergence of anecdotal evidence of people having to take on more than one role, and the survey results reinforce this trend.

How might financial institutions overcome these obstacles? It appears that the potential answer lies in the appropriate deployment of technology. Regulators are expecting this, especially in an environment where many banks are under remote supervision. This means incorporation of technology into enterprise risk-management programs.

It also involves having a fully functioning compliance management system integrated with your institution’s three lines of defense. With these tools and the analytics they provide, one can build solid business cases for identifying and securing needed resources — including more team members — earlier on your lending institution’s journey to a more sound and effective compliance foundation. ●

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