Thoughts & Comments
The CRE Time Bomb--Not
Doomsayers believe the coming crackup in commercial real estate credit will be a replay of the residential mortgage mess. They're wrong.

Thomas Brown  ( about me )
Posted 01/27/2010

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.

What do you think? Let me know!

  Add your comment



Pat O'Brien Posted On 1/27/2010 12:04:31 PM

I agree with your thesis but the frustrating thing about trying to gauge the banks' exposures is that they all like to tell you what LTV the loans were (as you've cited above) but that is meaningless without the corresponding cap rate. If the loan were made at an LTV of 70% it sounds pretty good but if the cap rate to calculate that LTV was 3% and the market is now at a 6% cap rate then the LTV has become 140%, it's simple linear math.

Dante Posted On 1/27/2010 12:45:31 PM

It is refreshing to read a logical article that challenges conventional wisdom.

Greg Posted On 1/27/2010 2:08:48 PM

"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." How can those figures be right? Don't they imply that even peak prices were below replacement cost in all three markets?

RFF Posted On 1/27/2010 2:09:34 PM

I had a sizeable position in (CARS) an auto reit bought out by DRA Advisors LLC in 09/2005. They suspended my payments over a year ago. Do you have info on DRA and whether they'll survive their commercial troubles? Thank you.

Jogreg Posted On 1/27/2010 2:30:49 PM

Encouraging. What about higher than normal vacancies (and risk to debt service coverage) from tenants who can't make it through the recession?

Erich Riesenberg Posted On 1/27/2010 3:47:01 PM

Would be more encouraging if you hadn't missed Armageddon I.

lolz Posted On 1/27/2010 4:03:07 PM

contrarian indicator anyone?

jrallen81 Posted On 1/27/2010 4:10:14 PM

Tom, thank you for the analysis. Zion's quarter looked excellent to me and the trends seem to be shaping up well. I wouldn't be surprised to see a nice run sooner rather than later as investors digest earnings and some of the short term political noise dies down. Happy hunting!

Jeff Posted On 1/27/2010 4:58:27 PM

Tom, I believe you are correct that CRE will be less painful than the $10.5 T resi mortgage market, but it will likely be more painful than the $1.5 T sub-prime sub-sector. One reason CRE will be better is because the Banks are being encouraged by Treasury to extend the maturity date of the loan. As long as the cash flow is adequate to meet the interest payment, the loan will stay current. Ultimately, the value of the property will have to go back above the loan, (if it doesn't, the loss will be realized eventually), but the Banks have tools to work with the CRE borrower. Given that, we had the Stuyvesant town default this week, what are the ramifications of this high profile default on Banks?

festus Posted On 1/27/2010 5:17:32 PM

If nothing else you write is correct, your observation that Owner Occupied is 48% of CRE is something that's totally not understood or addressed in expected losses. Moreover, the community banks probably have a higer % of Owner Occupied than anyone else, and the Bears have hammered them for their CRE exposure more than anyone. I would disagree about the CRE equivalent to NINJA loans. Take, for example, the loans on Stuyvesant Town or to someone like Harry Macklowe. They have interest rate reserves and cash flow projections that only work if the moon is just right. On the other hand, the place most of these exotic loans were done was the CMBS market, and with the benefit of (largely hedge fund) mezzanine money.

Kool Aid Drinker Posted On 1/28/2010 2:28:44 PM

DRA is in a world of hurt. Did you see Colonial pull out of the JV and now the portfolio is about to be foreclosed on? They are using every excuse in the book not to make payments so they can hoard cash and come out and say - "Look what we did, we saved you all this money". Their Acquisitions Department needs some readjustment. They regularly make Investment Committee decisions based on half baked notions. The head acquisitions guy needs to stop focusing on fantasy football so much. The Asset manager handling the CARS account lives to go to ICSC in Vegas, and that's about it. See if you can sell you position out. FAST.

john madden Posted On 1/29/2010 1:02:03 AM

"just" 3.5 trillion of CRE debt outstanding. I think you need both the numerator and the denominator of both ratios to make a valid comparison. good luck on that one. Res Ipsa.

Just Posted On 1/29/2010 9:58:51 AM

I hope you are correct. However, the use of "NOT" is extremely outdated. Remember, 1990 was TWENTY years ago.

Nick Posted On 2/2/2010 11:08:23 AM

Trechant and thoughtful...I wonder, however, if the impact on the system will be different because of the disproportionate concentration of CRE loans in the portfolios of banks $1billion and under in assets. The percentage of C&I loans and small business activity was all but eclipsed at many of these banks by an unhealthy reliance on CRE.

Jack Posted On 2/4/2010 10:01:51 AM

What seems to be missing is that over the past 2 years most of the real estate loans have been written down to levels required by FASB 114. New appraisals are a requirement on all loans rated Substandard or lower and the loans are usually written down to 10-15-20% below the appraisal values to account for cost of selling the property. So while there are problems at the banks for sure, the reserves now in place should handle 90% or more of the losses taken. For this reason I have a long position in KRE which I feel will reward me once the "knowledge" of what really is happening at these, particlularly small and regional banks is "discovered" Jack Moolick

tracy Posted On 2/6/2010 7:59:26 AM

What you call "owner occupied" loans to small businesses are in most cases structured using whatever collateral is available from the small business. This would include their real estate (if they own their building), accounts receivable, equipment, inventory, etc. The bank is then relying on that business to prosper or survive because that business provides the only source of payments on the loan. If the business fails or has problems, the bank has a troubled loan. This is why some banks (Wachovia was one) would not finance owner-occupied buildings. In the case of a typical office building, at least you have a several different business providing cash flow through their lease payments. With owner-occupied you are depending on just one business. As you know, office buildings have become very difficult to finance lately also. I do not have an answer, but it makes for very interesting discussions. You article was excellent.
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