Will Commercial Real Estate Crisis Demolish Community Banks?

Sometimes it pays to be late to a story. In this case, the decline in commercial property values probably has a lot to do with the problems community banks appear to be facing which I discussed in the post below.

First, the facts. According to the WSJ, Moody’s Investors Services reported today that its index of commercial real estate property prices fell 8.6% in April (see graph for the trend, click for larger view). With the April fall-off, prices are now down about 25% from last year at this time. The Moody’s survey covers multi-family, office, retail and industrial properties so it’s pretty comprehensive. For the wonkish among you, here is a link that describes Moody's methodology.

That’s bad enough, but now let me share a few comments from Deutsche Bank today on the subject of the commercial real estate market. It comes from Reuters:

The U.S. urban commercial real estate markets probably will not recover until 2017, the head analyst of commercial mortgages for Deutsche Bank Securities (

“The froth is still working itself out,” Richard Parkus, Deutsche Bank head of Commercial Mortgage-backed Securities and Asset-Backed Securities Synthetics Research said at the Reuters Global Real Estate Summit in New York. “We are currently in something which is comparable to what we saw in the 1990s and potentially worse.”

U.S. commercial real estate values could fall by more than 50 percent from the peak in 2007, he said.

Although asking rents are down about 28 percent in New York, factoring in free rent and other perks by landlords, rents are down about 50 percent, Parkus said.

“Rents will be back to where they were in 2017,” Parkus said. Building prices also will take six to eight years to recover, he said.

The U.S. commercial markets are deteriorating at an increasing pace as rent dries up and demand plummets. That is leaving borrowers struggling to make their monthly mortgage payments.

“The number of new loans that are becoming delinquent each month are defaulting at rates between 5 percent and 8 percent per year, with the most loosely underwritten loans of 2007 defaults at 8 percent per year, Parkus said. That puts accumulated losses at about 4 percent this year, and 12 percent over the next four years.

Loans loses ranged between 7 and 11 percent a year during the commercial real estate crash of the early 1990s.

“We are not only not approaching stability, we are at a period of maximum deterioration,” Parkus said.

I usually don’t excerpt an entire column but this one was so short and, at least to me so startling, that I didn’t want to grab pieces or put my own spin on the facts.

This wasn’t supposed to happen. Time and again we’ve heard from government officials, banks and so-called experts that the one fairly bright spot was commercial real estate. It wasn’t supposed to be over built as it was in the 90’s and, yes it would take its lumps, it wouldn’t be one of the real problems in recovery. I guess you throw that one out the window!

For my money, Deutsche Bank has some of the best research and on the ground intelligence to be found in the CRE sector, so I take them pretty much at their word. A lot can happen but they don’t even have to be half right for this to turn into one spectacular crash. In that case, recovery is going to be even slower and more difficult than many have forecast. If residential and commercial construction do not rebound in any significant manner in the next year or two, this country is in for a prolonged period of anemic growth.

I started by referring to the community banks that are having problems paying their TARP funds. Those banks are stuffed to the gills with commercial property loans. I don’t think it’s overstatement to say that if the losses approximate Deutsche Bank’s projections that thousands of banks are going to be compromised to the point of failure.

If memory serves me correctly, I think the S&L bailout cost a bit over $100 billion. I may be low on that number. This one might well be many multiples of that number and could dwarf what we’ve paid out for the big banks. Maybe we need to take a look at what we’re facing before we go all in on health care, more fiscal stimulus, “green” investments and whatever else strikes the fancy of the Washington establishment. I get the feeling we might have to dig deep for some more fundamental problems.

Comments

[Dave Wrixon]

Destroy is probably not fair, just a nail in the coffin in most cases.

2009 Jun 23 06:11 AM

[conceptwizard]

The losses approachable in Cmmercial Real Estate is staggering. It could be the backhoe that fills in the the grave.

Commercial real-estate loans could generate losses of $100 billion by the end of next year at more than 900 small and midsize U.S. banks if the economy's woes deepen, according to an analysis by The Wall Street Journal.

Such loans, which fund the construction of shopping malls, office buildings, apartment complexes and hotels, could account for nearly half the losses at the banks analyzed by the Journal, consuming capital that is an essential cushion against bad loans.

The potential losses on commercial real estate are by far the largest problem facing the midsize and small banks, easily exceeding losses on home loans, which could total about $49 billion, according to the Journal's analysis. Nearly one-third of the banks could see their capital slip to risky levels because of commercial real-estate losses, the Journal found.

The Journal, using data contained in banks' filings with the Federal Reserve, examined the financial health of 940 small and midsize banks. It applied the loan-loss criteria that the Fed used in its stress tests of the largest banks.

The Fed this month estimated that the 19 stress-tested banks could face losses of $599 billion if the agency's gloomiest economic scenario comes true.

2009 Jun 23 07:28 AM

[Mad Hedge Fund Trader]

It won't help. The Dana Point, California St. Regis Monarch Beach Hotel has defaulted on a $70 million loan, while lenders have repossessed the “W” Hotel in San Diego. Thus, the spotlight is again refocused on the next phase of the financial crisis, where an army of shoes are falling. A torrent of tenant bankruptcies is creating “see through” buildings in cities throughout the country, which are becoming as abundant as Priuses at an Obama rally. Some players see a further three year bleed that could take property prices down another 40% from here. Large, publically traded REITS have used the three month stock market rally to raise $11.5 billion in new equity that will enable to reduce debt and leverage, as well as buy up of weak competitors and distressed property. Look at Simon Properties Group (SPG), up 128% from the March lows. The saving grace here is that the recent bubble was nowhere as inflated as the S&L crisis in the early nineties. But cap rates may have to climb to the double digit levels we saw then before this period of punishment ends. Cash rich hedge funds are circling.

2009 Jun 23 10:04 AM

[Alphameister]

I agree that this is the scariest problem on the intermediate-term to long-term horizon.

2009 Jun 23 10:14 AM

[Donald Ingram]

Small to medium sized community banks are very vulnerable to commercial loan failure simply because of the amount of this commercial paper on their books.
Of particular concern is the hold-to-maturity loans. These contracts contain a line of credit that the borrower may use to pay the interest on the loan. What happens when the loan defaults, its made all the worse because the line of credit is drawn down also, on top of the now defaulted loan! Along with the commercial (small to medium) mortgages rising in default status, these grass roots financial institutions will find the going very tough. As to how many will fail? That is something the FDIC is watching closely and worrying about.

2009 Jun 23 11:37 AM

[billddrummer]

To MHFT,

We've already seen double-digit cap rate transactions, fostered by REITs needing to raise quick cash. Fully leased industrial property with 1.3X coverage sold at a 13% cap rate earlier this year.

It's grim, and getting grimmer.

2009 Jun 23 11:38 AM

[Larrysyr]

"This wasn’t supposed to happen. Time and again we’ve heard from government officials, banks and so-called experts that the one fairly bright spot was commercial real estate."

I don't understand this statement. Brick and mortar retailers are going down, malls are dying, and consumers are overspent. We have known this for a long time. Commercial real estate has always been one of the pieces destined to fall. The losses will be staggering. But they should not be surprising.

2009 Jun 23 04:17 PM

[Tom Lindmark]

If you go back to the beginning of this debacle you will find a lot of opinions that commercial real estate would weather the downturn fairly well. Obviously, they were wrong. I am still somewhat surprised that the commercial real estate market is crashing so violently. With the exception of retail, it wasn't that overbuilt. I guess it just points out the severity of the recession.


On Jun 23 04:17 PM Larrysyr wrote:

> "This wasn’t supposed to happen. Time and again we’ve heard from
> government officials, banks and so-called experts that the one fairly
> bright spot was commercial real estate."
>
> I don't understand this statement. Brick and mortar retailers are
> going down, malls are dying, and consumers are overspent. We have
> known this for a long time. Commercial real estate has always been
> one of the pieces destined to fall. The losses will be staggering.
> But they should not be surprising.

2009 Jun 23 04:30 PM

[Donald Ingram]

Tom - You say not over built? Retail square footage per customer or per person tells a different tale. North America far outstrips anyone else when it comes to not only retail commercial space but other types of space as well eg. warehouse, light industrial, office, hotel/condo combo and entertainment. Sales have been brisk with mark offs up to 50% and above. Foreign liquidity moving in.

2009 Jun 23 07:21 PM

[User 386855]

“Rents will be back to where they were in 2017,”

Is that a typo?

2009 Jun 24 07:28 AM

[billddrummer]

To Tom,

I believe the reason commercial real estate is suffering now is because of the number of FIRE (finance, insurance & RE) jobs that disappeared during the housing crash. Mortgage companies, real estate brokers, title companies and other businesses tied to the residential market vanished overnight, leaving massive vacancies in the office market. To add insult to injury, those lost businesses cratered demand for office supplies and equipment, pulverizing the transportation and warehousing industries.

As you mentioned, retail has its own problems, principally overbuilding with too much leverage.

As a result, seemingly all the major sectors of commercial real estate were hammered at once.

Appreciate your thoughts!

2009 Jun 26 02:55 PM