An Update on Banks’ Commercial Real Estate Exposure
Since our summary of banks’ commercial real estate (CRE) exposure last August, mortgages backed by commercial property have continued to experience weakness in the form of delinquencies and defaults. A handful of factors are perpetuating the stress on nonfarm-nonresidential mortgages and construction loans, in particular. First, the fragility of the economy itself has led to high rates of unemployment, which necessarily decreases the demand for commercial space.
At the same time, loans made near the peak of the credit boom (especially those related to construction) are deteriorating in quality rapidly, largely because of economic weakness as well as loan terms with low levels of borrower equity. The latter has become a problem as CRE property values have fallen roughly 35 percent overall from their peak in mid-2007. Finally, as noted in the August article, many CRE loans do not pay down principal (amortize) fully over the course of the loan term. As a result, loans that come up for renewal or restructuring often do not have sufficient borrower equity to be refinanced prudently. As a result, borrowers and/or banks must put up additional capital to ward off default.
As the charts below indicate, banks at the national level are seeing their overall CRE portfolio decline due to a contraction in construction and land-development loans. These loans are typically short in nature and are likely defaulting or not being refinanced because of poor market conditions. Construction loans for new projects would have declined for the same reason.
Commercial real estate loans that are thirty or more days past due (and still accruing interest) ticked up in the third quarter of last year. A clear majority of problem CRE loans are concentrated in commercial mortgages and construction loans, and about $16 billion and $22 billion, respectively, fall into this thirty-days-and-accruing category. Past-due CRE loans swelled in the last quarter of 2008, and because the volume of problem loans has continued to remain elevated, these loans must be staying delinquent in the months up to default—as opposed to being restructured or becoming current again â€“ and/or additional loans must be entering the pool of problem loans. Either way, this figure suggests that CRE delinquencies are worsening or, at best, stabilizing.
Delinquent loan volumes still do not give us a sense of the scale of the problem for bank viability. For that, we can look at the ratio of problem loans to banks’ equity capital buffer at the bank-holding-company level. The figure below shows that CRE delinquencies are nearly twice as severe as they were in the 10 years leading up to the financial crisis. To stabilize the situation, banks will have to count on a reduction in past-due loans, raise additional capital, or both.
Delinquencies can be prevented or mitigated by restructuring loans already in the portfolio, but this usually requires new capital to be put up by banks or borrowers, and thus reduces their equity available for other loans and losses. However, such an equity injection may help avoid a default, which would be more destructive for both borrower and lender. In the worst case, a bank simply refinances an irredeemable loan, which forestalls an inevitable default and locks up capital that could otherwise be used to make better loans in the near term.
Historically, employment has been closely linked to the demand for commercial real estate. When people are out of work, employers no longer need as much space for employees and equipment. Consequently, commercial vacancies rise, property values fall, and property owners have a more difficult time meeting their mortgage payments. Stabilization of the unemployment rate would help provide a demand floor for commercial properties and the bank loans that rely on them.
Banks across the nation continue to grapple with past-due CRE loans at levels far higher than at any time in the past decade, both in terms of volume and relative to equity capital. As a result, the total amount of bank CRE credit in the economy has shrunk by about $45 billion from its peak. A majority of problem loans are related to commercial properties in use or still under construction. Because these types of loans usually do not amortize fully, a number of them may require additional equity from borrowers (putting up bigger down-payments for a roll-over), lenders (via principal reductions or defaults), or new investors with their own capital. Finally, this deleveraging process must be accompanied by stabilization, and eventually growth, of the labor force in order for property demand to return and banks’ CRE portfolios to be sound again.