Story Highlights:
• Continued weakness in commercial real estate will have serious repercussions on the financial sector and economy in general
• Current estimates of bank failures are grossly underestimated
• Survey of CRE professionals finds values will fall an additional 10% and that bank and REIT equities are overvalued
The current events unfolding in the commercial real estate market are akin to watching a train wreck in slow motion. Despite credit loosening for many other sectors of the economy, financing for commercial real estate (“CRE”) remains very difficult to obtain for everything but premier properties. Government programs have not given nearly as much attention to opening up financing in CRE as they have in ABS, commercial paper, or MBS. While TALF and PPIP programs are starting to gain momentum in the CMBS market, sorely needed new issuance is nowhere in sight. The political difficulties of helping large developers and real estate companies obtain financing are no doubt a leading reason for the government’s lack of attention.
As Bernanke acknowledges, CRE is the biggest remaining obstacle to the resuscitation of American banks. As we saw last fall, a failing financial sector has serious repercussions on the entire economy. Nearly half of the $3.4 trillion in outstanding CRE debt is held by the nation’s banks, and Deutsche Bank estimates that banks will sustain losses of $300 billion on these investments. However, losses could potentially be much higher given that consensus CMBS losses are 8%-11% and banks hold much more toxic varieties of construction and land loans. The outlook for these institutions is bleak. Many are small regional banks which have already suffered immensely from consumer weakness, and they do not have the profitable trading operations of larger banks to absorb the coming losses.
One can only hope that Sheila Bair is correct in her estimate that 2010 bank failures will track those of 2009. A survey I conducted of CRE professionals found the strong majority believing that regional banks were most vulnerable from weakness in CRE. Since banks could not compete with the conduit lenders that contributed loans into CMBS trusts during the CRE bull market of the past few years, they were left to finance construction loans and land loans (which were largely excluded from CMBS), which both are now among the most toxic asset classes. The value of land for development has naturally plummeted and the primary credit protection on construction debt is only a guarantee that the borrower will complete the structure. Therefore, bank losses in the current CRE cycle will be at least as bad as those in the early 1990s when over 2,000 banks failed. Since the more pessimistic banking analysts are calling for only 1,000 bank failures in total, the troubles in banking today are grossly underestimated by markets.
Other pressures in banking may complicate the issue. Since CRE, like unemployment, lags the economy, a recovery could be underway just as CRE credit losses are peaking. The Fed’s inevitable raising of short-term interest rates will flatten the yield curve, impeding the profitability of all banks. Higher rates would also likely put a large contingent of floating-rate loans into default, as many distressed properties are currently covering debt service due to a one-month Libor rate that is now 25bps.
Recent earnings reports confirm the train wreck is progressing. Banks aren’t taking charges on bad loans, as the gap between troubled loans and bank charge-offs has doubled in the past year. In addition, many loans are staying current simply because banks are extending debt, known as “kicking the can down the road,” or paying themselves interest from reserves established when the loans were originated. BB&T’s third quarter numbers showed credit loss provisions nearly doubling, while the value of its foreclosed properties, mostly undeveloped land, reached a record $1.4 billion.
Equity investors have largely shrugged off CRE issues this year and all survey respondents believe that bank and REIT shares have rallied too far and too fast. For example, M&T Bank holds a $20 billion CRE portfolio and has not taken large credit provisions to date, yet the company trades at 2.5x book value. The REIT sector has outperformed the market and rallied considerably year-to-date, and many firms are now trading at levels in excess of their NAV. According to the Moody’s CPPI index, values are down 40% from the peak and survey consensus is that values have 10% more to decline.
In addition, the troubled $700 billion CMBS market is seeing delinquency rates rise each quarter. The current consensus is for loss rates of 8-11% on recent vintage CMBS. With spreads on super-senior AAA CMBS bonds in excess of 500bps, new issuance remains impractical and a serious impediment to a CRE recovery. Survey respondents believe the TALF and PPIP programs for CMBS will only be a short-term fix, with a meaningful recovery requiring rating agency reform, greater transparency in the CMBS trusts, and CMBS book runners retaining portions of subordinate classes. Greater simplicity in transactions was also a common theme advocated by CRE professionals, who believe borrowers will need to contribute more equity and reduce the use of mezzanine and B-notes.
