Is Armageddon Upon Us?
Predictions of Armageddon for the commercial real estate market are being urgently issued daily by prognosticators of doom. Many analysts are breathlessly predicting that collapsed real estate prices ensure a mountain of defaulting commercial real estate loans that will lead to the failure of thousands of small and regional banks. Problem Bank List has previously discussed the potential for large commercial loan losses by the banking industry (see Banks Turn Blind Eye To Commercial Real Estate Losses).
Many of the recent forecasts of a pending massive commercial real estate “crisis” are backed by facts and figures that seem irrefutable. In addition, the forecasts of a huge commercial real estate crash and banking crisis are being made by some of the best analysts and experts in the field.
Nov. 11 (Bloomberg) — “A crisis of unprecedented proportions is approaching” in the U.S. commercial real-estate market, according to Randall Zisler, chief executive officer of Zisler Capital Partners LLC.
Property prices have fallen by 30 percent to 50 percent from their peaks, Zisler estimated yesterday in a report. The plunge has wiped out the equity in most real-estate deals that relied on debt financing since 2005, he wrote.
Zisler, whose firm focuses on real-estate investment, estimated that building owners will default on $500 billion to $750 billion of mortgage debt. This equals as much as 54 percent of the $1.4 trillion in loans that will come due in four years, by his count.
“Much of the debt is likely worth about 50 percent of par, or less,” the report said. Many banks will end up insolvent as they reduce the value of their holdings, he wrote, adding that regional and community lenders are especially vulnerable.
Oct. 30 (Bloomberg) — Billionaire investor Wilbur L. Ross Jr., said today the U.S. is in the beginning of a “huge crash in commercial real estate.”
“All of the components of real estate value are going in the wrong direction simultaneously,” said Ross, one of nine money managers participating in a government program to remove toxic assets from bank balance sheets. “Occupancy rates are going down. Rent rates are going down and the capitalization rate — the return that investors are demanding to buy a property — are going up.”
That’s right, the next train wreck will be in commercial real estate. Couldn’t be worse than last year’s residential market crash? That remains to be seen. But it’s coming soon, probably as early as the second quarter of next year, and there’s nothing that can prevent it. The government will intervene, trying desperately to delay the day of reckoning, and may even succeed. For a while. But make no mistake about it, that train is going off the tracks no matter what.
Every part of the sector – from multifamily apartment buildings to retail shopping centers, suburban office buildings, industrial facilities, and hotels – has accumulated a huge amount of defaulted or nonperforming paper. It’s an impossible, swaying structure that cannot long stand.
Banks in the U.S. “are slow” to take losses on their commercial real-estate loans being battered by slumping property values and rental payments, according to a Federal Reserve presentation to banking regulators last month.
The remarks suggest that banking regulators are girding for a rerun of the housing-related losses now slamming thousands of banks that failed to set aside enough capital during the boom to cushion themselves when the bubble burst. “Banks will be slow to recognize the severity of the loss — just as they were in residential,” according to the Fed presentation, which was reviewed by The Wall Street Journal.
Discounted News Does Not Move Markets
There is little doubt that the banking industry will be taking substantial losses on commercial real estate loans. The fact that commercial real estate has already crashed in price is widely disseminated news and probably fully discounted by the markets. The important question regarding losses on commercial loans should be structured in terms of time. The commercial loan losses already exist – the real issue is how long will it take for banks to fully restructure nonperforming loans and absorb the losses that already exist?
Based on recent regulatory actions taken to preclude a commercial real estate crisis for the banking industry, it will be many years (probably decades) before nonperforming commercial assets are off the balance sheets of US banks. The strategy for nonperforming commercial loans will follow the game plan employed for dealing with defaulted residential mortgage loans – delay, restructure, modify and pretend that the loans have value based on a possible future recovery in real estate values (see Regulators “Extend and Pretend” Guidelines).
Regulators Take Action To Delay Losses
Regulators and banks are already moving quickly to avoid taking losses on nonperforming commercial real estate loans under new loan rules.
WSJ – Banks are moving quickly to restructure commercial mortgages under new U.S. guidelines that are more forgiving of battered property values and can help banks avoid bigger losses.
Inc., regional bank Corp. and other lenders around the country are planning to review loans now considered nonperforming to determine if they can be reclassified under the guidelines announced Oct. 30 by bank, thrift and credit-union regulators, according to bank executives and people familiar with the matter. The moves could help the banks absorb fewer losses on troubled real-estate loans and preserve capital.
The guidelines are controversial, with critics accusing the U.S. government of prolonging the financial crisis by not forcing borrowers and lenders to confront inevitable problems.
Regional and small banks are the most likely financial institutions to benefit from the guidelines because of their exposure to commercial real estate. More than 2,600 banks and thrifts have commercial real-estate-loan portfolios that exceed 300% of total risk-based capital, according to an analysis of regulatory filings by The Wall Street Journal. Nearly all of those institutions have less than $5 billion in assets.
Loan Workouts Will Take Decades
Many of the banks with excessively large commercial real estate portfolios will probably fail, but banking regulators will not close 2,600 banks regardless of losses or lack of capital since there is no political will to do so. The wide spread closure of thousands of banks could precipitate a financial panic that the regulators are attempting to avoid.
The game plan is to deny and delay and work things out slowly. The good news is that there will not be a sudden implosion of the banking industry – the bad news is that, like Japan, we are probably facing decades of debt workouts and slow economic growth due to a weakened and under capitalized banking system.