Commercial Property Woes Reveal Bank Insolvency

Includes: IYR, XLF
by: Anthony Alfidi

Reading between the lines in this Bloomberg article tells us everything we need to know about why the economy is in a phantom recovery and why this bear market rally is built on nothing. Let's take a look at commercial real estate:

Commercial-property sales in the U.S. this year are forecast to fall to the lowest in almost two decades as the industry endures its worst slump since the savings and loan crisis of the early 1990s.

Okay, this isn't much of a surprise, although CRE industry veterans quoted in the article are aghast that they've never seen a buyer's drought of this magnitude in their careers. The lesson for investors is farther down:

The default rate on commercial mortgages held by U.S. banks more than doubled in the second quarter to 2.88 percent, according to New York-based Real Estate Econometrics. It may reach 4.1 percent by year end, the highest since 1993.

That may mean more pain for banks that hold the mortgages and signal that this year’s gain in real estate investment shares may be overdone.

Banks are nowhere near healthy, depsite all of the happy talk you hear on CNBC. Bankers are happily paying themselves huge bonuses again, and I suspect they're doing so out of fear that they may never see such income levels again if the banking system heads over a cliff soon. Three more snips from the article will show us where we're headed:

“We’re not forcing the banks to disgorge” distressed properties, said Susan Wachter, professor of real estate at the University of Pennsylvania’s Wharton School in Philadelphia. “It’s a different crisis, a far worse crisis.”

FDIC regulators who should know better are not forcing banks to write off bad loans and seize properties, so technically insolvent banks continue to function.

Maturing commercial property loans are high on the “worry list” of San Francisco Federal Reserve President Janet Yellen, she said in a July 28 speech to the Oregon Bankers Association.

Leaders at the Fed know banks' true conditions and are maintaining a ZIRP funds target to forestall the second phase of our systemic crisis.

The entire real estate dynamic has shifted, said Frank Liantonio, executive vice president of Cushman’s capital markets group. Liantonio, 60, with a career that goes back to the early 1970s, said he’s been through six down cycles from the mid-1970s to the dot-com bust of the early 2000s. This is the worst, he said.

“Property is no longer controlled by the owner,” he said. “It’s controlled by the lender, and the lender in most instances doesn’t have the ability to take the charge to earnings and sell the property. That’s one reason why you’re not seeing any transactions.”

I bolded part of that final quote to show how the continuing insolvency of our banking system keeps the real estate market frozen. This is why REITs and ETFS like IYR have rebounded recently. Investors are attracted to the false hope that commercial real estate will remain attractive because of the inability of insolvent banks to foreclose on defaulted loans.

Note that IYR is up almost 100% and XLF is up almost 140% from its March lows. These price levels are unsustainable given the slow-motion crash in CRE disguised with the full complicity of bank regulators.

Disclosure: Anthony J. Alfidi has no position in XLF or IYR at this time.