Charles Davidson: Welcome to another Economy Matters podcast. I'm Charles Davidson, staff writer with Economy Matters, the Atlanta Fed's digital magazine, and I'm visiting today with Brian Bailey. Brian is a subject matter expert, as we say here at the Atlanta Fed, on commercial real estate [CRE], and Brian works in what's called the "risk and resiliency unit" of our Supervision, Regulation, and Credit Division. Brian, thanks for your time today. I appreciate you being here.
Brian Bailey: Charles, I appreciate the invitation—thank you for having me.
Photo: David Fine
Davidson: : All right. Well, Brian, commercial real estate—always a fascinating and important topic—but to start with I wanted to just ask a couple of baseline-type questions. First off, can you define what we mean here at the Atlanta Fed by "commercial real estate" and "commercial real estate loans," because sometimes that can get a little fuzzy.
Bailey: Absolutely. There are a lot of different types of loans in the field today, but really I'm going to define those via the regulation, and regulation driven primarily from SR 07-1
. Basically it's a commercial real estate loan, and I'll paraphrase: it includes land development, it includes multifamily, and it includes the highly technical term "nonfarm, nonresidential"—which basically means a structure for lease, whether it's a strip center, an industrial building, or an office building—so nothing that's owner occupied.
Davidson: Okay, let's say a developer wants to develop a subdivision—put in the streets, put the pipes in the ground, and so on. A bank lends the money for that. Even though that's going to be residential real estate constructed there, that's considered a commercial real estate loan, correct?
Bailey: It falls under "land development and construction." Absolutely, that is correct.
Davidson: Okay, all right. Well, one more baseline-setting, historical question here I wanted to ask you with: what role did CRE lending play in the financial crisis? Obviously, a housing crisis was at the center of that, but where did CRE fit into that episode?
Bailey: Well, you think about real estate, and there are a number of linkages between residential and commercial, so there are synergies between them, and so usually as one goes, so does the other. There may be some time that lapses between those movements, but generally speaking, they kind of run together. And really, those synergies look like infrastructure development. We have to have pipes in the ground and streets, whether it's a residential subdivision or whether it's an office park. We have a lot of the same traits. When you think about the electrical that's done in your house—same thing that's done in an office building, plumbing, so the list goes on and on. Financing, certainly—the rates, or there's interconnection between the two. So certainly there are a lot of dynamics.
Another synergy—a fun one—is that the office park that we talked about. They may very well have tenants that are home builders and residential mortgage folks, and so if residential falls on hard times, obviously those tenants fall on hard times, and then commercial real estate struggles. So really, in my view, when the economy softened we kind of exposed this speculation that was going on in residential. We also exposed overleverage that was taking place—and had taken place—in commercial real estate.
And so when that overleverage came out, certainly that created problems along with—using the example I talked about where we had a significant number of home builders and a significant number of firms that catered to home development—home financing. They've got commercial space, all of a sudden residential gets very soft and they're giving back space. So commercial real estate is quick to follow, and that further exposed this overleverage and the potential use of not fully transparent assumptions to value some of these buildings, etc. So that's kind of—in a nutshell, very simplistically—how commercial real estate factored into some of this dynamic.
Davidson: Here at the Atlanta Fed, in Supervision, we're all about safety and soundness, right? The ultimate mission there is to try to ensure that banks remain safe and sound. So where does CRE fit into that? In other words, why is this industry, this realm, so important to the Atlanta Fed—and really, the Federal Reserve System more broadly?
Bailey: That's a great question, Charles, thank you. And really, I would take it a step back. So, yes—there is a huge, important emphasis right now on being a model bank supervisor and making sure that as we're going through the banks that they're adhering to the policies that they've represented to their board and to their shareholders, that we're doing these operations, these procedures, as far as commercial real estate lending.
Why is it so important? Well, right now there's $2 trillion—trillion with a "t"—of commercial real estate loans on bank balance sheets. So a huge, huge number. Bank supervision is critical because banks are one of the primary and largest providers of capital in the industry. The industry is capital-intensive—think about how much it costs to build a building. Additionally, over time it's become more complex because we've seen groups of small banks that have decided that "we're going to do a loan that we couldn't normally do ourselves," a participation loan. And that creates a number of issues.
We've also seen a transformation, and some movement right now, to where banks are lending money to originators—to folks who then originate CRE loans. And so that creates a different complexity to the dynamic, but certainly without bank supervision there is the potential for there to be inconsistency in operations. And that, in my mind, may impact the availability of capital, and with that impact of capital you start seeing price fluctuations, which could impact the safety and soundness of the financial system.
Taking additionally on that step back, I would say, too, is that—from the Bank's perspective—one of our mandates is full employment, and I won't speak for my esteemed colleagues in Research, but construction, which is hugely important to commercial real estate, is very significant, in my view, to the overall economy. My estimate is that the workforce in construction makes up 5 to 6 percent of the current workforce. Those jobs pay on average $30 an hour, which—doing the simplistic math—is over $60,000 a year—that's a big number. We need those jobs, and fortunately in the last few years we've seen some of the resurgence. Commercial real estate is capital intensive, as I talked about. When we create those jobs, we see ancillary jobs and support jobs that spin off of those, that are created by that—so certainly that is fulfilling our mandate of full employment.
Other things I talk about—you think about if you take a piece of land and you build a building on it, all of a sudden you've created value, and that municipality now has a stream of higher real estate taxes. You've also created income taxes from the positions that are created. In the case of a retail strip center, you've created sales tax dollars, and so in a lot of ways we're creating tax dollars that are then spent by the community on vital services like fire and life safety—things like that.
So that is a big focus, and then you look at the amount of wealth in commercial real estate, and you think about how that influences folks' retirements, their investments. And you think about the pension funds, the life insurance companies, the publicly traded and the private REITs are all in the space, so certainly it is a big industry, and certainly has ramifications from a monetary policy/full employment standpoint, and it also certainly has big implications from a safety and soundness standpoint.
Davidson: Right. You mentioned REIT. That's "real estate investment trust," right?
Bailey: That's correct, yes.
Davidson: Right, okay. So, Brian, what sort of approach do financial regulators take here in trying to ensure that the lenders don't get carried away—irresponsible—with their CRE? I mean, we don't send examiners in and say, "Don't make this specific loan"—right? It's not that intrusive, right?
Bailey: Well, we need those loans, as I just talked about, to continue to spur economic growth. There are a number of risks associated with a commercial real estate loan. If you think about it, if you're a banker you really have to get your crystal ball out and you say, "I'm going to make a decision to lend money that I don't get my money back for three, five, seven, ten years down the road." So you really have to understand not only the property, but the borrower, and so there are a number of risks that we try to look at as we're in these banks.
Those risks look at credit and interest rates and strategic risk, to name just a few, because you think about the dynamics. I'll name a few. The credit piece takes into account the market effects, takes into account, potentially, interest rates rising, which then—if the borrower goes to refinance—may impact the value of the property. It also impacts their debt service if that's a growing interest rate environment, so "will the borrower be able to refinance and repay that loan from the banks?"— certainly near and dear to our heart.
If you look at interest rates—another dynamic, but not really one that you think about because from a bank's perspective. I'm taking depositors' money, which I'm paying—let's just pick a number, 1 percent—and I'm lending it at 6 or 7 [percent]. Well, if I've lent that money long term—again, and I'm in a rising rate environment—that 1percent may all of a sudden be 4 or 5 [percent], and if that's the case, all of a sudden my margins compress significantly. So there is another side of interest rate risk to the bank that people may not really be quite aware of.
One of the other areas that we push pretty heavily is the strategic piece. We want to make sure that the bank has the necessary knowledge and experience to identify, measure, and monitor—and control—the risks that are unique to CRE. And you think about those risks—has the borrower, if it's on a retail property, thought about the Amazons of the world, which are gobbling up significant amounts of market share, and what does that do to their tenants? It's a valid question, so I think there are a number of focuses that we're trying to talk to the bank about, gauge their competency. And certainly out of the regulation that has come into being in the last several years, we've seen those competencies grow significantly, which has been great. And I think that that will benefit the banking industry for years and years to come.
Davidson: Right. Well, Brian, talking about the strategic issues that the lenders need to keep track of, wouldn't even something like rideshares—Uber, Lyft, and so forth—that's going to change maybe how many parking spaces you need, that's going to change what their borrowers who are commercial developers. That's going to change their business, right?
Bailey: Absolutely. Technology is disrupting a number of industries. Real estate has been later to feel it because real estate is a lagging adopter of technology. But as you said, parking could significantly be impacted by ridesharing. It could also be impacted by autonomous cars—and I think there was a podcast done a couple weeks ago on that.
Davidson: That's right, nice plug [laughs].
Bailey: Yes, right on, absolutely. So I think that dynamic, but let's look on the other side. You think about retail right now. Right now, the e-commerce crowd—so that includes Amazon and a number of others—right now e-commerce accounts for about 9.5 percent of total retail sales, which is a fraction of the overall pie.
Davidson: It doesn't sound that big.
Bailey: But I'll tell you—you look at the dynamic, and it is decimating a number of suburban malls, and so if you are a lender in that dynamic you've got to be concerned. You've got to be concerned if you have lent on the strip center, or the standalone retail property on the periphery that depends on that mall traffic, because less traffic going to the mall means less traffic and less opportunities for the tenants, which then puts pressure on the borrowers' ability to cover debt service.
Davidson: Well, also sort of in the same vein, I think—CRE, commercial real estate, tends to be really, really local, right? So a certain downtown could be really hot—a lot of condos going up, let's say, a lot of office buildings, while in a suburban area just down the road, there may not be a lot going on. Why does it tend to be like that?
Bailey: Part of it, I think, is maybe the local government's view of growth—maybe they're pro- or anti-growth. But I think a lot of it has to do with preference. You're talking about the multifamily phenomenon that has gone up in most of the downtowns across the United States, and really there has been this move more toward urbanization with the millennials. They've, in some respects, been in this environment and want to stay in this environment. They were in this environment during a number of their college years, in some respects. Their friends are here and they want to stay here. And we've also provided and geared a bunch of services through mass transit to making more of these apartments walkable.
And so I think that there has been a focus on that dynamic. At the same point, I think that if you look at the 'burbs, I think that maybe some of the growth and some of the movement that we've consistently seen downtown in the urban areas that naturally occurred from the urban areas to the suburban areas has been delayed. Whether it was too much student debt or whether it's because we're building these apartments that are like the Taj Mahal and you never want to leave—I don't know, exactly. There are a number of issues, I think, but I think eventually we'll see a return back to this natural flow to the suburbs.
Davidson: Right. Well, Brian, we talked a little bit about Amazon and e-commerce more generally and how that's affecting traditional retailers. It's also affecting the industrial real estate sector, if I'm not mistaken. So the e-commerce players tend to need these really spacious, really tall distribution warehouses because they have to get product out very quickly, to people all over the place. How long do we see that dynamic continuing?
Bailey: And I know a lot of developers—industrial developers, particularly—who are very happy right now because of that.
Davidson: I'm sure.
Bailey: But I left my crystal ball at home, so I'm not sure I have an exact answer on how long it will last. But certainly you have to look at the stage right now, and you say that really, e-commerce has picked up momentum. But really, you've seen that momentum in the last five, maybe seven years, and we've really seen the push to fulfill the sellers' capabilities over the last mile to deliver it to the consumer within the last three years or so. So really, in my view, we're kind of still in the infancy. We're at least in the expansionary phase, and why I would say that: one was aware in a number of major markets in 2012 and 2013, where there was a very significant shortage of those million-square-foot, high-cube distribution centers. And that doesn't change overnight. It takes a number of months to build—assuming you've got the permits in place—to build these facilities, and we see more and more firms continuing to try to jump in and establish and grow their delivery capabilities over the last mile.
So my view is, it's in the expansion phase. At some point, you're absolutely right—it will mature, and we will go through a consolidation. At that point, there probably will be a number of million-square-foot boxes that are in excess, and we'll have to figure out something to do—not unlike, we have a number of malls right now that we're working through to figure out what we're going to do with them. So it's part of real estate. Real estate is a capital-intensive, long-life asset, and you go through these disruptions in the marketplace. You look at malls. The first indoor mall was built in 1956 in Minnesota, and malls in general have lived a very long life. But we are now, with technology, changing. At some point it will be the same dynamic with these large industrial boxes, probably when these millions of drones can just come and drop the box off right at our door. At that point, when there are millions of drones flying over our heads, I'd recommend investing in healthcare, because of the potential drops of these boxes [laughs].
Davidson: Yes, I think our friends at the FAA will have to get involved there, on some level. [laughs] Brian, it's kind of fascinating the way, just from our conversation today, it's pretty clear that in commercial real estate you're affected by all sorts of macroeconomic trends, even sociological trends—where people want to live, the kind of places they want to live in—technological trends, how people want to buy things. It's interesting how all of that ultimately has some effect on commercial real estate, right?
Bailey: Oh, yes, you bet. And yet, as you mentioned, there's also this very local component. So you've got this very local component, but you also have the national component from a financing perspective. You may have someone from overseas come in and they like your property, and because of various conditions in their home country they may be the top bidder. And so, yes—I think that it's fascinating to see those dynamics, and the social influences are significant as well, and so it's fascinating. At the same point, we know that the biggest driver of commercial real estate is job growth, and so certainly the macroeconomic picture is very important to commercial real estate.
Davidson: Right, all right. Well, Brian, thanks so much for your time. I think that was a pretty interesting discussion—I enjoyed it.
Bailey: Thank you, Charles. I appreciate it.
Davidson: All right. And thanks for listening. We have a lot more information about commercial real estate, and the microeconomy more generally, on our website at frbatlanta.org. And please come back next month for our next Economy Matters podcast. Thanks so much.