Commercial Banks And Commercial Real Estate: How Healthy?

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Includes: IYF, VNQ
by: John M. Mason

Summary

There is more and more information that maybe commercial real estate may be facing some headwinds and might suffer as the economy suffers.

Concern continues to grow about the commercial banking sector as the yield curve flattens out and as price disinflation seems to be spreading.

Furthermore, more and more attention is being given to the exposure of commercial banks to derivatives with total outstanding derivative contracts exceeding a little more than twice world assets.

Two weeks ago, I wrote a post about "What is The Real Condition Of Banking." Some commenters expressed some doubts about my concerns, especially about the health of commercial real estate. This week, there seems to be growing evidence that there may be some problems in the commercial real estate sector, and this is only adding to the difficulties now being faced by the banking industry as a whole.

Two pieces in the Wall Street Journal capture the concerns about commercial real estate: Serena Ng writes that "Warning Light Flashes for the Commercial Property Boom"; and Craig Karmin writes that "Hotel Investors Check Out Early."

Ms. Ng writes that, "Bonds backed by commercial real estate loans have weakened significantly since the start of the year amid concerns of an economic slowdown. Risk premiums on some slices of commercial mortgage backed securities have jumped 2.75 percentage points since January 1, a move that translates into a roughly 18 percent drop in prices for triple-B rated bonds..."

"Investors in some cases are demanding to be paid as much to take on CMBS risk as they are to take on corporate junk bonds."

"Property owners and developers now are facing the prospect of higher rates on loans, tougher refinancings and diminished property values as debt issuance slows and financing becomes more expensive."

"Close to $200 billion in real estate loans that have been bundled into securities are scheduled to mature this year and next, and most need to be refinanced..."

Ms. Ng adds that "the $600 billion CMBS market accounts for around a quarter of all U. S. commercial real estate loans."

Mr. Karmin writes that "Investors are shrugging off the lodging industry's best fundamentals in years to dump hotel stocks, a move that could signal a broader downturn for the commercial real estate sector."

He adds "Lodging, among the most economically sensitive businesses, is typically the earliest to feel the pinch from concerns over economic growth."

"Shares of U.S. hotel operators, owners and timeshare companies tumbled more than 22 percent in 2015 compared with flat returns for the broader U.S. stock market, and are down another 13 percent to date...nearly twice the broad market's drop."

Looks like investors are starting to dump investment in this sector soon after the Federal Reserve ended its third round of quantitative easing, an indication that maybe commercial real estate lending profited from the bubble created by the Federal Reserve over the previous five years or so.

The reason that the hotel industry is hit earlier than office buildings and shopping malls at the turn of monetary ease is that the hotel industry is very fluid as room rates and bookings can be sensitive to the economy. Office buildings and shopping malls "lock in revenue with multi-year tenant contracts" and so lag what is happening in the economy.

Most commercial real estate loans run from five to seven years in length and only pay off at maturity. During the Great Recession, there were great concerns that many commercial real estate loans would be coming due in 2010 and 2011 and the commercial banks would be faced with problems about refinancing the loans.

During the Great Recession, many commercial real estate projects were postponed because of the state of the economy. These loans, however, were not determined to be delinquent because they did not come due until they matured.

The economy started to recover in July 2009, and as things progressed into 2010 and 2011, the economy began to pick up speed and builders and contractors took the dormant real estate projects back to the banks to refinance them. Now that things were better, the banks not only refinanced the loans, but also added further amounts to them as the builders and contractors needed more funds to fully fund the renewed projects.

Commercial real estate lending boomed at commercial banks, and the Federal Reserve, through three rounds of quantitative easing, helped the banks underwrite the refinancings by providing the liquidity needed to keep the banks solvent.

Now, we are out five and six years from this turnaround and the economy is not performing so well. Commercial real estate loans are starting to come due again...and in quite large numbers. This is just one reason some concerns are being raised in the banking sector at this time.

Martin Wolf, in his latest opinion piece at the Financial Times, is calling banks "weak links in the economic chain." He argues that "the world economy is not necessarily heading for a crisis, it is probably just heading for a slowdown - but risks abound."

To Mr. Wolf, the banks are still highly leveraged, and with poor financial markets conditions, fees from trading and wealth management are challenged. Furthermore, the flatter yield curve is harming the performance, and the deflationary tendency now alive in the world is threatening.

"People worry about the health of these huge, highly leveraged, extremely complex and opaque behemoths," concludes Mr. Wolf.

And, what is getting so much attention in today's press? Break up the "big guys," the "too big to fail" banks. This is the cry of Neel Kashkari, the President of the Minneapolis Federal Reserve Bank.

This brings us to one final article published today by the Financial Times and written by John Kay. The subject of the article is derivative contracts.

To get a gist of the article, let's look at Mr. Kay's concluding paragraph:

"Accounting practices provide an appearance of precision that may be a poor guide to a world characterized by multiple risks and radical uncertainty. The superficial information we have from balance sheets and capital adequacy calculations understates the scale of complexity and interdependence in the global financial system. Market participants are right to be skeptical, and nervous, about banks."

He is talking about interest rate swaps, foreign exchange derivatives and credit default swaps. The Bank of International Settlements states that there are $550 trillion outstanding derivative contracts, a number that is a little over two times the value of all the assets in the world.

"Credit default swaps, the instrument at the heart of the 2008 global financial crisis, are now relatively small..." only about $15 trillion, which is "only slightly less than the U.S. gross domestic product." JPMorgan (NYSE:JPM) and Deutsche Bank (NYSE:DB) "account for about 20 percent of total global derivatives exposure." Read Kay's article; it can give you another insight into the commercial bank risk exposure.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.