Commercial Real Estate Loans May Be Next Shoe to Drop

Residential mortgages have gotten most of the attention during the current credit crisis, but a heavy concentration of commercial real estate [CRE] loans may be a better metric for gauging which banks are most at risk for failure in the coming months, according to Standard & Poor’s.

Eleven banks failed in the first half of 2008 and not surprisingly, S & P’s RatingsXpress Credit Research is predicting more this year and in 2009, due to continued deterioration in capital ratios, liquidity and in CRE, land development and construction loans.

Since construction loans are bullet loans with interest reserves accruing until a project is completed, we expect that problem construction loans will continue to rise in coming quarters. We also expect that loss severities among defaulted construction loans will be materially higher during this economic downturn compared with earlier downturns given sharp price declines among homes and condominium projects.

The rating agency also said most of the failures would be concentrated in small banks, especially those with a high degree of exposure to commercial real estate.

Among banks that have already failed this year, CRE loans accounted for an average 60 percent of loan portfolios.  In contrast, in the three bank failures of 2007 more than 70 percent of the loan portfolios were concentrated in residential loans.

Banks with significant exposure to real estate in California, Nevada, Florida, Arizona, Michigan and Georgia are suffering the biggest downturns in credit quality, and S & P said it expects further home price declines and economic weakness to continue pressuring banks active in those markets.

S&P said while it’s hard to predict the number of bank failures, it does not believe failures will reach the levels seen during the savings and loan crisis of the late 1980s and early 1990s.

For details, see “U.S. Bank Failures Expected to Rise.”

Comments

[DaveW:]

Proshares Ultrashort Real-Estate ETF (SRS) in the mid $70's is a nice entry point right now, price target $110 or better. Other thoughts, bloggers?

2008 Sep 23 12:46 PM

[johnthebear:]

Agree with you totally DaveW.

I just pray that it continues to work in the future as in the past. I am looking for SRS going to $200 in the next 6 months.

As the article reports, many smaller banks will fail with the large volume of commercial loans. There is simply not enough money available to allow buyers to get financing when buildings come on the market, which will happen all over as vacancy increases and foreclosures also increase. Those buildings will be sold at firesale prices!

Looks like we are heading to caves, automatic weapons and canned food for survival! God help us!

Thanks for the article.

2008 Sep 23 02:06 PM

[AlanB:]

This will be interesting to see how it unfolds. In the San Francisco Bay Area the competition for quality commercial real estate assets was intense over the last few years. The speculation was based on improving market conditions (i.e. better future rental rates). So now you have a weakening economy, less job growth and therefore less tenants expanding. Many of these deals were financed with short term money. Refinancing in today's market, I'm guessing, will be more expensive and/or the debt will be less available. And we'll continue to see more foreign sources stepping in. My company, rofo.com is a resource for businesses to find commercial space (office, retail, industrial). We have not seen a fall off on the tenant demand side for space (as of yet) but we are seeing more sublease spaces coming on the market. It will become more of a buyer's market over the next couple of years.

2008 Sep 23 02:38 PM

[Cesar Valencia:]

A better instrument for shorting commercial real estate is to buy puts on the IYR. Ultra Shorts are not the best instruments to maximize returns. Don't take my word for it, just take a look at the charts comparing the URE, SRS and the IYR.

2008 Sep 23 04:00 PM

[DaveW:]

Okay, revealing my rookie status here.... Any recommendations on the best way to learn how to use puts/calls and option trading? Options for Dummies, or the like?

2008 Sep 23 04:07 PM

[Cesar Valencia:]

Let me take this one step further. If you short both the SRS and the URE you could make some "risk less" money. I mean risk less in the sense that you CRE is supposed deteriorate. Compare the charts of both one year out and you'll see what I'm talking about.

2008 Sep 23 04:09 PM

[Cesar Valencia:]

If you don't know how to use options you could just sell them short. Options have many intricacies that might overwhelm the rookie investor. For example, implied volatility will be very high in this uncertain environment so options will be costlier. Put options are contracts that give the buyer the right to sell stocks at a specified price by a specified date. The buyer of the option would then gain on the price of the stock going down. The good thing about options is that you can sell them, so you don't have to keep them until maturity. Call options are just the opposite. The buyer pays for the right to buy the underlying stock at a set price. If stock prices go up, the owner of the option gains the difference between the higher price of the stock and the lower price of the strike price.
Hope this helps a little.

2008 Sep 23 04:14 PM

[DaveW:]

It does Cesar, thank you. I do understand the basic mechanisms as you outlined above but am eager to learn and understand all the tools available to the trader/investor. I agree, before I would use them I would have to understand all of the underlying intricacies and nuances. Thanks again.

2008 Sep 23 04:33 PM

[1worldcurrency:]

What if they ban shorting reit's?

2008 Sep 24 01:08 AM

[johnthebear:]

It could happen

2008 Sep 24 11:05 PM

[Cochise:]

I watch out for Wells Fargo, they have thousands of commercial loans with valuses based on inflated valuations prepared by MAI, Appraisal Institute Members. Not to mention the ones they acquire from Wacovia which were similarly appraiserd.

Jan 18 02:40 PM