An article on the front page of the Wall Street Journal “Money and Finance” section this morning brings up some disturbing analysis of the commercial real estate market. The story discusses the danger that many banks face as they continue to hold commercial mortgages which are growing weaker by the day.
In particular, the article notes that banks with the most exposure to commercial real estate have dwindling loss reserves to the point where only 38 cents are set aside for every dollar in bad loans. In 2007 this level was at $1.58 so there has been a significant deterioration over the past two to three years. Much of this debt will need to be financed in the next few years which creates a problem for both borrowers and banks. As property values drop and vacancies mount, many borrowers will simply not have the resources to refinance these loans.
More pain likely lies ahead for this sector and for those banks with heavy commercial real estate exposures. ~Bill Dudley, New York Fed President
Most commercial property loans are set up as interest-only loans which means that the principal balance remains stable even as the property values continue to drop. This means that when the loans are due to be refinanced, there will likely be few options for borrowers who will not qualify for new financing. Banks holding existing mortgages are often willing to simply extend the current terms for another several years rather than face the tedious process of foreclosure and repossessing the properties.
In today’s low interest rate environment, many commercial properties can service the mortgages even with significant vacancies. However, when rates begin to rise, the margin of safety will be dramatically reduced and the potential for delinquencies, charge offs, and foreclosures will likely rise sharply. One analyst cited believes that commercial real estate losses could reach an astonishing 45% next year. Bank regulators are closely watching for this scenario which is likely a significant factor in the rising number of banks on the FDIC “black list.”
The interest rate environment has been very favorable to banks over the past several quarters. At this point, the Fed has made it possible for banks to borrow at a near zero interest rate, which leads to profit in almost any investment. Many institutions have even plowed the money back into treasuries which yields a virtual risk-free return (albeit very small). But with Australia unexpectedly raising rates yesterday and many strategists claiming that the recession is over, the potential for a series of rate increases is becoming more pronounced. This could be bad news for banks and commercial real estate borrowers once the market begins to discount these higher rates.
Of course there are two sides to every story, and many banks are claiming that they have already written down the majority of their problem loans. This would certainly cause the reserves to be depleted as loan loss reserves are used for the express purpose of buffering these types of losses. It is normal for reserves to dwindle during times of economic weakness, and then to be built back up when banks are showing healthy profits. But the general consensus is that many banks have not been as conservative in building up their reserves over the past 5 years and will not have the financial means to survive an upcoming crisis unscathed.
From an investing standpoint, it is important to understand the balance sheet and the makeup of assets when considering a bank as an investment. Many regional banks have extreme exposure to loans backed up by apartments, office buildings, and warehouses. While the balance sheet data may show a healthy level of assets, investors should be skeptical and assume that many of these assets could experience significant write downs in future months.
The residential mortgage market has likely hit bottom and there are certainly some interesting opportunities to buy REITs and banks who will benefit from new liquidity hitting this market. But for the commercial side of this business, the worst is likely still to come.
FD: Author does not have a position
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