While the residential real estate bubble collapse has used up all the oxygen in the economic room, economists and real estate analysts have been telling us for more than a year that the impending commercial real estate foreclosure wave will add to the damage. They’re still telling us that, and their voices are getting louder.
Elizabeth Warren, chair of the Congressional Oversight Panel in charge of watching the Troubled Asset Relief Program, said last week after her panel issued its February report, “There’s been an enormous bubble in commercial real estate, and it has to come down. There will be significant bankruptcies among developers and significant failures among community banks.”
More than the big banks, community banks sold more commercial loans than residential. Also, they did not securitize and sell them off. They held on to them. Some 40% of the US banking system, about 3,000 community banks, hold a high proportion of commercial real estate loans as a percentage of their capital. Those are the same banks that the government hopes to see start lending to consumers and small businesses again one of these months.
Unfortunately, money they lose when the commercial real estate foreclosure wave begins is money they won’t be able to lend, even if they survive the shakeout. Warren said that such a large-scale failure of banks and seizing up even further of capital for lending would dampen the economic recovery.
There’s roughly $3.7 trillion in outstanding commercial real estate-backed loans. More than $1.4 trillion in commercial real estate debt is slated to roll over in the next three years, just when willing lenders and adequate liquidity don’t exist. Warren expects half of it to be underwater by the beginning of 2011. By comparison, “only” one-fifth of residential mortgages are currently underwater. What makes commercial more dangerous now is that most commercial lease agreements come with three- or five-year terms. That means those negotiated at the very height of the real estate bubble are about to roll over.
The reason that’s a problem isn’t hard to follow. The evaporation of consumer spending crimps a store owner’s revenue until the store goes bankrupt. They can’t pay their lease. That happens to the store beside them, and the one beside them, and so on. Enough of them breaking their lease agreements, and a dearth of new tenants, leaves the property owner unable to pay its mortgage. Because such mortgages are local in nature, the impact will be local, too. This is not the blowing up of a derivative now residing in Norway. It’s the local bank not getting paid as the local property owner doesn’t get paid as the local shop owners don’t get customers.
The Feb. 10 report from Warren’s panel states: “A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American. Empty office complexes, hotels and retail stores could lead directly to lost jobs.”
Just what we need.
I can tell you from my own research of local banks along Colorado’s front range that commercial lending is all but frozen right now. The FDIC mandated in 2008 that almost all community banks lower their loan exposure to commercial real estate to a level below 100% of their Tier 1 capital balance. If that Tier 1 was $1 billion, for instance, which is about right for a $13 billion community bank, then the commercial real estate book would not be allowed to exceed $1 billion.
Trouble is, most community banks went into 2008 with a commercial real estate book worth more than twice their Tier 1 capital balance. Some that focused on the sector are up around four or five times their Tier 1. When the rule came down from the FDIC, community banks all but unplugged their phones. Even screamingly low-risk deals with loan-to-value (LTV) propositions at or below 50% are turned down constantly.
What’s about to come due? Deals from the peak with 90% LTVs and interest-only terms. Where will that crowd go for refinancing? Nowhere. The only organization that stands to benefit is the US Postal Service, by delivering all the keys to the banks.
It’s unclear how much of this is already priced into the market, or perhaps ignored by the market. JPMorgan CEO Jamie Dimon, for instance, said last month, “Commercial real estate is a train wreck, but it’s already happened.” He thinks investors specializing in distressed debt are all over the situation, and that their buying will keep refinancing moving along. He pointed out that a change in ownership won’t necessarily mean a loss of jobs. A new buyer of a mall, for example, will still need people to run it if it’s going to succeed.
Elizabeth Warren disagrees. From her panel’s report:
There is a commercial real estate crisis on the horizon, and there are no easy solutions to the risks commercial real estate may pose to the financial system and the public. The Panel is concerned that until Treasury and bank supervisors take coordinated action to address forthrightly and transparently the state of the commercial real estate markets — and the potential impact that a breakdown in those markets could have on local communities, small businesses, and individuals — the financial crisis will not end.
Warren said, “When commercial properties fail, the result is a downward spiral of economic contraction; job losses; deteriorating store fronts, office buildings and apartments; and the failure of the banks serving those communities. These are the same small banks that provide loans to the small businesses that create jobs and boost productivity. If hundreds more community banks go under the effect could be to dump sand in the gears of our economic recovery.”
According to Real Capital Analytics, there are more than 10,000 troubled commercial properties worth more than $205 billion in the US. The damage to banks could end up being more than that, with estimates hovering around $300 billion.
It’s hard to know the impact that the commercial property crunch will have on the economy and the stock market by extension, but it’s yet another risk to weigh. Here’s Elizabeth Warren:
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