Commercial Real Estate: A Red Flag?

by: John M. Mason

Summary

Delinquencies and default rate are rising in the commercial real estate sector as more and more commercial-mortgage-backed securities are slated to mature in 2017.

The commercial real estate area has cast a shadow over the financial markets for the past ten years, connected with loose lending practices, financial crisis and the Great Recession.

Some of the continuing concern for the commercial real estate sector may be turning into a reality in the near future and needs to be closely watched.

Over the past ten years or so, commercial real estate has kind of been the giant in the shadow, the sector that was not quite right…but, was not totally wrong.

Before the financial crisis connected with the Great Recession hit, many analysts complained that too many projects were being accepted in the debt market with too low of a credit rating.

Then the Great Recession hit and many commercial properties were faced with defaults when the loans on the projects, bullet payoffs, came due.

Fortunately, the Great Recession ended before the payoffs hit and the projects were able to be refinanced without much disruption to the industry.

In fact, commercial real estate debt led all other sectors in volume of activity coming out of the recession as the maturing projects were refinanced and as new projects were booked. Saving the commercial real estate market and turning it into one of the boom sectors of the new economic recovery was one of the real success stories of the period of economic expansion.

However, concern about the commercial real estate industry never really left the sector. Clouds always seemed on the horizon as analysts kept observing cracks in all the good news that seemed to be coming from the industry.

Now, those shadows seem to be darkening.

Peter Grant writes in the Wall Street Journal that weaknesses are starting to show in the industry.

"Landlords are battling a slowdown in sales and rising vacancy rates of multifamily housing units across the U. S. and of office space in Houston, Washington and other big markets. Commercial-property sales volume was down 8.6 percent in the first nine months of 2016…."

"Defaults are rising as well. More than 5.6 percent of some $390 billion worth of commercial-property mortgages that have been packaged into securities was more than 60 days late in payments in September."

This was up from a 4.6 percent delinquency rate earlier in the year.

Where are the problems centered?

Loose credit standards from before the financial crisis. "Ten-year loans issued in 2006 and 2007 are doming due now, and many borrowers aren't able to pay them off despite rising property values."

Morningstar Credit Ratings LLC predicts "borrowers won't be able to pay off roughly 40 percent of the commercial-backed- securities loans coming due next year."

Going further: "Suburban office properties and shopping centers are being hit particularly hard."

This is where many of the problems were located before, during and after the Great Recession, the area where many refinancings took place.

The problems in commercial real estate lending in the commercial banks has been given as one of the reasons that the Federal Reserve continued to pump money into the banking system during its three rounds of quantitative easing.

Almost two-thirds of commercial bank lending on commercial real estate is located in banks that are smaller than the largest twenty-five domestically chartered banks in the United States. There was great concern within the Federal Reserve System that these "smaller" banks needed to be protected from the problems surrounding the commercial real estate sector and thus the Fed pumped money into the banking system to take as much pressure off the banks as possible.

The state of the commercial real estate loan portfolios of the commercial banks continued to be a concern of the Federal Reserve throughout the subsequent period of economic recovery.

Furthermore, while the problems that seem to be building are located in the mortgages that have been packaged and resold and in commercial banks, there is also news that many smaller investment firms that build up inventories of commercial real estate properties that will eventually be packaged into mortgage-backed securities are now getting out of the business.

The business, called "Conduit Business," is now being turned over to the remaining larger firms. But, this business is now changing due to the increases in risk and volatility connected with the sector.

In addition, there is a provision of the Dodd-Frank law that is going to be hitting this sector at the "worst time." This is the provision that issuers of commercial-mortgage-backed securities must keep 5 percent of the securities they create.

This "will make borrowing more costly and complicated, raising the chances that some property owners won't be able to refinance loans from the boom years."

Finally, there is the specter of rising interest rates. Longer-term bond yields have risen dramatically since the Presidential election last week and this movement has spilled over into the mortgage area. Rising interest rates will just put more pressure on the refinancings and make it even more difficult for borrowers to turn-over the debts that they have coming due.

The chances that this rise in longer-term rates will also be followed by the Federal Reserve raising its short-term policy interest rate has also risen dramatically over the past week.

The year 2017 could be a very interesting year for the commercial real estate market.

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.