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CRE Finance World Autumn 2015

8

3. Cyclical Trends Mask the Full Impact of New Regulation

CRE investment and property performance trends have improved

markedly since the economy’s financial crisis-era nadir. With

respect to asset prices, these improvements reflect the strong

relationships between capital markets and CRE investment. There

is a similar relationship between macroeconomic conditions and

property fundamentals, which have lagged capital during the

recovery. With investment and fundamentals now both improving,

CREFC members observe that strong cyclical trends are masking

the drags on commercial real estate finance resulting from current

and pending regulatory reforms. The full cost of reform, and its

impact on real estate market liquidity, may be more readily observable

during phases of the cycle characterized by economic and financial

stress and reduced liquidity.

4. New Regulation Can Reduce Higher-Regulated

Institutions’ Competitiveness

As the cost of financing increases for prudentially regulated

institutions, the relative cost of financing declines for non-bank

financial institutions (NBFIs). Reflecting this relative change,

many CREFC members expressed concern that large, low-risk

borrowers may migrate from banks to other, more competitive

sources of capital, thereby reducing the average quality of banks’

mortgage portfolios.

While lower aggregate lending by banks and SIFIs will reduce

their risk profile, this adverse selection works in the other direction,

increasing the average risk profile. The impact on the total risk

in the market is ambiguous, contrary to the original policy goal.

5. New Regulation Imposes Greater Costs on Small and

Medium-Size Borrowers

The incidence of higher regulatory cost — who ultimately bears

the cost of regulation — will fall to both lenders and borrowers.

In secondary and tertiary markets, small regional and community

banks are often the only consistent sources of construction and

shorter-term financing. Even as smaller banks bear a relatively

higher regulatory burden than larger banks and NBFIs, several

CREFC members observe that smaller borrowers will internalize

a larger share of those increased borrowing costs.

The large drop in secondary market liquidity that coincides with

and follows a downturn places stress on asset values and slows

price discovery. Contrary to policy goals, constraints on smaller

lenders that reduce market liquidity may exacerbate loss rates

and severities for investors and lenders alike.

6. Ambiguous Link to Loan Quality

CREFC members and researchers are divided on the question of

whether current regulatory initiatives will induce higher average

loan quality. Several CREFC members expressed that with greater

demands on finite balance sheets, banks and other regulated

entities will make better lending decisions.

Others market participants observed that when lenders internalize

the costs of regulation, they will need to meet higher return

requirements, which in turn will drive riskier behavior. Alternatively,

if lenders push costs to the borrower, i.e. the incidence of the

lending costs falls to the borrower, better borrowers can substitute

into another financing source. Either way, the regulated loan pool

can deteriorate given higher costs.

7. Impacting the Economy through CRE

The overall impact of new regulation on the CRE industry and

its adjacencies — including construction activity, construction

employment and the broader economy — is significant. In the

median scenario tested by CREFC, the model estimates show a

cumulative subtraction from economic output of $209 billion over

10 years. Across scenarios, the estimated ten-year cost ranges

from $168 billion in the low impact scenario to $936 billion in

the extreme downside case where construction activity declines

by more than 5 percent from baseline projections. The primary

channels of spillovers from regulatory reform are distortions to

asset prices in the presence of costlier leverage and, over the

medium- and long-term, a reduced supply of real property. Apart

from reduced construction activity, a lower inventory of real property

implies that firms will face higher costs in the space market.

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CREFC Regulatory Impact Study: Besides the Financial Costs, Regulation Impacts Business Strategy and Underwriting Criteria

“Fragmentation of regulatory authority

has allowed for parallel — and sometimes

overlapping — regulatory initiatives.”