Bank Exposure to Commercial Real Estate
As rising home foreclosures and delinquencies continue to undermine a financial and economic recovery, an increasing amount of attention is being paid to another corner of the property market: commercial real estate (CRE). Commercial mortgages are those that have been secured by property owned or occupied by business enterprises or more than four families. Typically, bank balance sheets break these loans into four categories: property loans secured by farms; loans secured by “multifamily” properties, such as apartment buildings or condos; construction and land development loans, which are used to acquire land and build new commercial structures; and nonfarm, nonresidential loans, which are often associated with already-constructed industrial and office buildings.
Although commercial mortgage-backed securities (securitized CRE loans), have garnered their own significant amount of attention, they account for only 20 percent of outstanding commercial mortgage debt. Loans held by banks, meanwhile, account for 60 percent of the CRE debt market—much more than any other institutional holder. Also, unlike the residential mortgage market (where a majority of lending has been done by a few large banks), the array of banks holding large concentrations of commercial mortgage debt is broad and diverse. This distribution means tremors in this market can affect banks of all sizes heavily, both nationally and in the Fourth Federal Reserve District.
The economic downturn has hit bank CRE loan portfolios particularly hard. The total volume of commercial mortgages held by banks more than tripled in the last decade both nationally and in the Fourth District. Nationally, the volume at commercial banks peaked at approximately $1.8 trillion last year. Note that the most significant growth nationally occurred in construction and development loans, suggesting that a sizable portion of CRE growth over the past few years was in speculative new properties. Without the requisite demand for these properties (and with the possibility of significant overcapacity), ongoing construction may be halted, or existing buildings may be unable to find tenants—both situations that would result in loans going delinquent or defaulting. For the first time in the last few years, most CRE loan types are seeing a stabilization or contraction in the volume held at commercial banks.
If we take a look at actual past-due loans—those 30 or more days delinquent but still accruing interest—we see that construction and land development loans do in fact account for the majority of souring loans. However, nonfarm, nonresidential loans have also experienced a significant uptick in delinquencies since the onset of the financial crisis last fall. Note that the total volume of delinquent CRE loans fell last quarter both regionally and nationally, following the dramatic climb of previous quarters. This is a positive development, signaling that CRE loans are going bad at a much slower rate, or that banks are acting more aggressively to take losses on these loans by charging them off, or both. Examining the difference between 30 to 60-day delinquencies and more than 60-day delinquencies shows that the latter have risen since last quarter but that the former have fallen, indicating a slowdown in new delinquencies but little improvement in previously delinquent loans.
[Note: This paragraph has been modified to reflect the updated chart below. The new chart has been updated through the third quarter of 2009. It now uses bank holding company data and equity capital measures to avoid data reporting discrepancies between banks with multiple entities.] Ratios of past-due loans to banks’ equity capital rose in the third quarter of 2009 as commercial mortgage delinquencies remained elevated. This metric relates problem loans to one measure of the capital buffer banks have to withstand losses. As a result, the ratio provides a sense of relative severity that the volume figures above do not. As of the third quarter, the ratio stood at 2.68 percent for all banks and 8.22 percent for Fourth District banks. Much of the steepness of the Fourth District curve relative to all banks is the result of National City Bank data. Although PNC Bank purchased the assets of National City at a shareholder discount in 2008, the latter continues to report the book value of legacy assets—which include a large amount of problem CRE loans—via the call reports.
The degree to which problems in the CRE market will further hinder financial stability and macroeconomic recovery depends on the actions of individual financial institutions and the uncertain performance of the broader economy. Because the latter is ultimately out of the hands of individual economic actors, banks that continue to recapitalize or remain well capitalized possess the best chance of enduring further economic contraction (should it occur), diversifying their loan portfolios, and extending new credit.
That said, adequate capitalization and aggressive approaches to delinquent loans may be countermanded by a flagging real economy, in particular a continued rise in the unemployment rate. The office vacancy rate is highly correlated with the unemployment rate, since shrinking or failing businesses do not need to rent or own additional commercial space. As tenants or owners disappear, the cash flow necessary to pay debt service on CRE loans disappears with them.
Finally, the very terms of many existing CRE loans impede the flexibility necessary for restructuring them. Whereas a typical residential mortgage amortizes the principal over the life of the payments, many commercial mortgages amortize only a portion of the principal and therefore require a balloon payment at maturity. This necessitates either a refinancing at maturity or delivery of the remaining principal. If neither of these options is feasible, the loan defaults.
As long as economic uncertainty, rigid loan structures, and constricted bank credit remain issues, policymakers and credit market participants can mitigate the danger of systemically significant CRE defaults. The Federal Reserve is supplying liquidity to the market through the commercial mortgage-backed securities component of its TALF program, which works to stabilize demand and financing for commercial mortgage-backed securities and (indirectly) loans at a time when many financial institutions are still reluctant to lend. At the same time, the continued raising of capital by banks and other financial institutions cushions them against losses, promotes investment in new and existing commercial real estate transactions, and contributes to the gradual deleveraging of the CRE market and financial system.