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Might banks’ growing problems with their commercial real estate loans spark a rerun of the subprime mortgage debacle? A lot of pessimists seem to think so, but I doubt it.

Yes, banks are running into severe credit problems with their CRE portfolios, and, yes, those problems are costing shareholders plenty. But there’s a difference between a normal, cyclical credit downcycle and Armageddon II. As it is, banks are enduring a lot of CRE pain, and will keep on enduring pain for several more quarters. That does not mean the whole financial system is at risk.

To begin with, the term “commercial real estate lending” covers all kinds of different kinds of activities, from financing the development of strip malls to so-called “owner occupied” loans to small businesses. Some of those categories will have issues—but by no means all. So generalizations about CRE lending should be viewed with suspicion. On one end of the credit spectrum, yes, financing strip malls can be a risky proposition. But at the other, owner-occupied credits tend to be among the most solid in the lending industry. A bank’s mix of CRE exposure is often as important as its absolute level of exposure.

In the near-term, the biggest CRE problems at many banks so far have to do with souring loans to homebuilders, many of whom have run into problems as a result of the housing bust. Those credit issues have more to do with the mortgage mess, and aren’t necessarily an omen of new problems in other parts of CRE lending. At many banks, homebuilder-related credit problems appear to be peaking, or will shortly. The problems at homebuilders will not likely start a domino effect of problems at other types of CRE lending, however.

In any event, here are six reasons to believe that the CRE downturn, while painful, doesn’t figure to turn into a system-threatening calamity:

1. Underwriting has been much better this cycle than it was in past cycles—and certainly better than the excesses that occurred during the subprime mortgage riot. There simply is no CRE equivalent of a ninja loan, or an option ARM, or a two-year teaser. (Nor, for that matter, is there any federal policy in place to promote subprime CRE ownership.)

Rather, lenders, urged on by regulators, have been careful this cycle to lend on cash flow, not asset values (as many mortgage lenders did, whether they knew it or not). LTVs tend to be lower than they are in residential lending. (At Zions Bancorp., to pick a fairly typical CRE-oriented lender, fully 55% of the bank’s portfolio has a loan-to-value of 70% or less.) So even if property prices drop by a lot (and in many markets, they have), loss severity will likely be relatively mild.

2. The bears are likely overstating the size of the potential problem. There’s just $3.5 trillion in CRE debt outstanding, against something like $10.5 trillion of residential mortgage debt. So any problems with CRE figure to be smaller than residential, from the get-go. And while critics imply that all $3.5 trillion in CRE debt is at risk to some degree, that’s not right. Remember, commercial real estate loans represent all sorts of different categories of lending, of varying inherent credit quality. The MBA reports, for instance, that among the top ten commercial real estate bank lenders, 48% of their aggregate balance of commercial (nonmultifamily) real estate loans were related to owner-occupied properties. The vast majority of those loans will stay current.

The commercial real estate market isn’t overbuilt to anywhere near the extent residential real estate was at the top of the housing bubble. In fact, certain segments aren’t overbuilt at all. Take a look at the chart below. It shows annual completions of office space, as a portion of existing stock, going back to 1956. Compare that to the residential building boom that went on in places like Las Vegas, Southern California, and South Florida as the housing bubble inflated in the 2000s. Once the bubble burst, the overhang of redundant supply has helped keep prices down. There simply isn’t a similarly sized overhang in CRE now. In most major markets, vacancy rates are still relatively low, and are nowhere near their 20-year highs.

Lenders have a lot more options in mitigating CRE losses than they do residential mortgage losses. Here’s an important difference between residential and commercial real estate lending: mortgaged commercial properties usually throw off cash flow; mortgaged residential properties don’t. That can make a big difference to lenders when the commercial mortgage goes delinquent. The commercial lender can temporarily rework the loan to accommodate the property’s reduced cash flows. Recent accounting and regulatory changes even encourage this. The residential lender, by contrast, has few alternatives to foreclosure. Skeptics dismiss CRE workouts as “extend and pretend,” but in fact workouts tend to be a low-cost alternative to foreclosure. They happen in every CRE downcycle.

5. Interest rates are low. That makes it easier for squeezed borrowers to hang on for longer than they could during the last CRE blowup in the early 1990s. Then once the recovery gathers steam, demand for space will increase and rents will rise, and much of the CRE problem will solve itself.

6. In many markets, property prices have fallen below replacement cost. In midtown Manhattan, for example, prices are off by 42% from their peak, and are now just half of replacement cost. In Dallas, prices have fallen by 29%, and are 33% below replacement cost. And in Los Angeles, prices 19% below their peak, and 20% below replacement cost. Given where prices are now, and how far they’ve fallen, further material declines in property prices seem unlikely.

Put all this together, and it’s hard to see how CRE loans are shaping up to be a rerun of the subprime mortgage disaster. Is the sector in for a further rocky period? Of course. We don’t expect to see any real signs of recovery until later this year. Meanwhile, the indications we’re seeing so far in banks’ fourth-quarter earnings reports is that lenders seem to have their arms around the problem.

That’s encouraging. As the market realizes that banks’ CRE problems are merely cyclical, and not the sign of another financial meltdown—regardless of what the doomsters have to say.

Source: A CRE Downturn Won't Crash the Markets