The CRE disaster

July 23, 2009

Earlier this week, I was surprised when I read that Moody’s put the decline in commercial real estate at 16% over the last TWO MONTHS.  That’s a stunning rate of decline that has very negative consequences for banks who are still carrying commercial whole loans on their balance sheet at close to 100¢ on the dollar.cre-vs-residential-prices

For comparison, consider the chart to the right, which compares the Case-Shiller Composite 20 Index for residential real estate prices with the Moody’s/REAL National All Property CRE Index.*

(Click chart to enlarge in new window)

Peak to trough the declines are similar:  Residential is down 33% from its July ’06 peak while commercial is down 35% from its October ’07 peak.

But note the stunning rate of decline of late for commercial.  28% since September.  Residential is off half as much over that time.

To be sure, comparing these two indices isn’t totally fair.  As Dan Alpert of Westwood Capital pointed out to me, there are millions of transactions that go into Robert Shiller’s residential index.  It’s very granular.  On the CRE side there have been very few actual sales that indicate recent pricing.  So you have to read Moody’s/REAL with a grain of salt.

Directionally, however, the index is correct.  Commercial is collapsing very quickly, even as residential looks to be forming a (temporary?) bottom.

What are the implications?  Consider the $1-$1.5 trillion in commercial mortgages being held as whole loans at commercial and savings banks in the U.S.**  Because whole loans are “held to maturity,” they are typically carried at full value until the borrower actually defaults.  Never mind that the underlying collateral is now worth far less than the mortgage.

But banks aren’t forced to take writedowns until an event of default.  To avoid that they can play all sorts of games to make things easier for the borrower.  According to Alpert:

Banks and other lenders with loans collateralized by income-producing properties have been offering borrowers nearly any forbearance imaginable: loan extensions, interest rate reductions, delayed principal payments, wavers of covenants and guarantees, and in some instances additonal funding—anything and everything to avoid taking a current loss, as long as there is some cash flow or reserve balance to draw on so as to maintain that the loan is performing against its (often heavily modified) terms.

The bottom line is that banks still have hundreds of billions of losses buried on their balance sheets.  Commercial real estate prices aren’t coming back, which means these loans will have to be marked down eventually.  The longer banks wait, the more painful the writedowns will be.

Bank shareholders should take note.  Assuming the government isn’t going to absorb all these losses, their equity may eventually be wiped out.


*As I was drafting this post I noticed that CR has been working on the exact same data!  He has more to add on the subject, be sure to check it out.

**Excludes “multifamily” borrowing.  Source: Fed Statistical Supplement December ’08.


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CRE loans are typically held in regional banks right?
So we could easily see a rising number of FDIC takeovers of the small banks.

Posted by Dave | Report as abusive

Reminds me of an old addage (updated here):

If I owe the bank $50,000 and can’t pay, it’s my problem.

If I owe the bank $50 million and can’t pay, it’s the bank’s problem

Posted by Steve in Ks | Report as abusive

If commercial real estate foreclosures really get going, the unemployment number will grow rapidly. This economy will take many years to heal itself.

Posted by Mark | Report as abusive

the bank’s strategy is now definitely hiding the CRE and credit card problem, letting the residential mortgage get back to normal in a few years time, and then trigger the CRE / credit card bomb and then again ask the stupid taxpayers to save them plus fetching bonus, and then trigger the next next bomb…
I doubt whether US will heal in the coming decade as we will repay the whole mess created in this decade.. we are now repaying the interests only. so sad

Posted by Rose Eli | Report as abusive

I think there’s a couple points of banking that undermine your CRE article somewhat. First, loans are “provisioned” but never “marked” down, unless there’s a chargeoff. Until the bank finds that there is some amount of principle that will not be recovered, they will only provision against loss. A weak commercial mortgage may actually have a loss provision of 20% or higher, but this is not netted against individual loans or even loan categories (Residential, commercial, etc), although that presentation is technically up to the bank. As a result the ability of the public to judge if a bank is properly addressing weakness in the CRE is very limited.

Second, loans aren’t provisioned to the value of their collateral, at least not directly. The provision is foremost a reflection of the strength of the borrower, and only secondly the value of the collateral. This decision is mostly automated by quantitative criteria that grades each particular credit and assigns a pre-set provision rate depending on the grade. Certain criteria (credits of X rating or wrose of Y size or larger, for instance) will flag credits for further review, and periodic collateral reviews will further adjust the amount of provision held. The process is slightly different at every bank, of course.

Third, it doesn’t necessarily matter whether the individual collateral is still an income producing property as long as the borrower is still in a net cash flow position. If the loan is to a single property venture with no recourse to a parent, then sure it matters, but again because the borrower’s cash flow is negative or non extistant not the property’s (although its a petty academic point since the example is a single property venture).

Finally, it makes lots of sense for the borrowers to work with the property “owners” to amend the deal terms. As long as the borrower is paying something, its better than nothing. There’s no need to take a writedown because the deal was altered to extend principle payments, reduce interest, or waive convenants. After all, the balance sheet loan only represents unpaid principle, not present value cash flows. If the loan was amended to forgive principle, that would be twinned by a partial chargeoff for sure. If the bank extends a reduced interest rate, then they are taking a writedown of a sort… it’s just amortized over the life of the loan in the form of lower interest income. I would be surprised if there weren’t clawbacks to restore the higher interest rate given certain criteria in such an interest reducing arrangement.

Lost in all this is that this sort of action (amending deals for weak credits) happens all the time in all industries that have bank credit facilties. It’s hardly unique to CRE right now, and frankly banks love it because its a good fee revenue generator in good economic times and bad.

Also, to the extent that loan loss provisions cushion future losses, the bank will not see any tier 1 capital losses as loan loss provision is excluded from tier 1. Provision is a tier 2 capital factor, so it would hit Total Risk based capital.

In the end, losses on CRE loans industry wide will probably be at a fraction of the rate of residential mortgages. The underwriting was almost certainly better across the board, the visibility of the creditor during the life of the loan is better, and the processes for loan modification are much more time tested. Plus CRE operators usually have more than one source of cash flow (multiple properties v. a job) and are more willing to ride out a negative equity situation.

I’m imagining Crescent Real Estate sending BAC jingle mail. It’s good for a smirk.

Posted by Andrew | Report as abusive

Are we sure that housing isn’t “starting to form a bottom” in the same way it was in Feb 2008? There are still a lot of defaulted mortgages that aren’t yet even being foreclosed upon, much less put back onto the market.

Posted by Olav | Report as abusive

No doubt Olav. I think both curves will keep heading down for a while. I guess I was just noting how CRE’s rate of decline is accelerating even as the rate of decline for residential is decreasing.

It’s all about second derivatives!

Posted by Rolfe Winkler | Report as abusive

[…] how much more quickly the commercial market has been crashing. As Rolfe points out, since October 2007, commercial is down 35%. Residential is down 33% since its peak, but the […]

Posted by The Next Big Wave « BuelahMan’s Redstate Revolt | Report as abusive

Why are the feds chasing their tail?
They could have done a MAJOR turn around by encouraging business to risk their shrinking budget by actually stimulating those who are the heart of the economy.

You can’t raise the boot straps without getting the middle up and off the ground. If you try – everything goes upside down!

Look at Federal minimum wage – some states do not follow it (just like San Fransisco does not follow the law saying illegal entry into the USA is wrong)

To fix R.E. problems you need cash flow!
Middle Class spends more across all markets per dollar of income than any other group. (homes – auto – vacations – fresh vegetables – steak …)

So why doesn’t the Fed offer help to INCREASE middle Class wages?

give all business a $300.00 tax rebate for EVERY full time wage they increase by a minimum of $1.00 per hour for a full fiscal quarter. If an employer can afford to do so – second fiscal quarter give the same employee ANOTHER DOLLAR $1.00 per hour … do this for 12 fiscal quarters.

What will it do?
let middle class people NOT go bankrupt
get more mortgages paid for
get more loans paid on
get more auto’s purchased
get more homes purchased by those who can ACTUALLY afford them.
Get more sales of all types going so business can afford to pay mortgages.

Make Sense?

Posted by Twitters LoudAmerican | Report as abusive

You’re assuming that people would take the money and spend it instead of save it or reduce their debt.

Also, you’re giving a business $300 to pay the employee $520 more… so you’re asking a business to give away $220 for essentially nothing (not considering the potential increased 401K expenses) since the worker is going to be as productive as before.

Posted by Andrew | Report as abusive

Andrew’s excellent discussion is spot on, until the last two paragraphs.

CRE underwriting, compared with residential underwriting, certainly was not better across the board. Late-cycle CRE loans were liar loans too, same as residential. CRE just had different lies. “Pro forma” is the effective equivalent of “no income verification” in residential.

With regard to visibility, I suspect that Andrew meant to say that the visibility of the CRE debtor (not creditor) is better during the life of the loan – meaning that most CRE loans have requirements for annual P&L reporting by the borrower. Good theory, but not much help in reality. Most borrowers don’t produce their annual reports until you chase ’em hard (who’s got time for that today?), and the annual P&Ls are about as reliable as the pro forma P&L that the underwriter used.

The processes for CRE loan modification may be much more time-tested, but that doesn’t mean that they’re any more effective, or even do-able in current market conditions. Twenty-five percent of CRE loans are securitized. Attorneys are billing millions (billions?) trying to figure out how to modify/unwind CMBS structures, while more and more debtors default.

As for the 75% of CRE loans that are in the portfolios of financial institutions, large and small, and on government agency books (multi-family and SBA), it looks more than likely that the fundamental change in the rules of the game of late will result in long-term paralysis.

While it’s true that rolling loans gather no loss, they gather no profit either. The big players don’t send jingle mail to BAC, they send bankruptcy filings, same as the small players. In fact, CRE operators have even less incentive than homeowners to fund the negative, out of other cash flows or out of their personal pockets, since it’s just business, and personal guarantees are meaningless. (Lenders do the math – legal costs and staff time vs negligible collections over years. Besides, personal guarantees are dischargeable in bankruptcy, even on SBA loans.)

When Wall Street realized that you can decouple risk and reward – talk about a Minsky Moment – keeping all the reward for yourself and shifting all the risk to somebody else, the global economy started dancing to a wholly (holy?) different tune. For good or for ill – it’ll probably be years before we know which – policymakers have decided to keep the orchestra playing in our now-worldwide game of musical chairs.

So, as long as residential lenders don’t foreclose or don’t take their REOs to market, and as long as CMBS holders don’t back down and hold out for their promised piece of the pie instead of a fraction of it, and as long as CRE lenders modify bad loans on dying or dead properties and businesses, in other words, as long as the music keeps playing, then nobody gets caught without a chair. But everybody’s just circling around and around the same chairs, and nobody’s outside the circle making new chairs. Except the folks in China and India, of course.

Posted by Henry | Report as abusive

[…] The CRE disaster Rolfe Winkler Reuters, July 23rd, 2009 […]

Posted by Commercial vs Residential Real Estate | The Big Picture | Report as abusive

[…] The CRE disaster Rolfe Winkler Reuters, July 23rd, 2009 […]

Posted by Commercial vs Residential Real Estate | | Report as abusive

Thanks to everyone for their great feedback. Here’s what I have been trying to figure out lately: How do we make money from the inevitable CRE loan issues? I can’t figure out which banks are holding loans vs. which repackaged them. I am pretty sure that Wachovia underwrote the largest amount (in dollars) of CRE in 2007, which was the peak and worst timing for banks, but did they hold the loans or sell them as CMBS or other derivatives (in which case they wouldn’t have much exposure on the downside)?

Does anyone have any suggestions on who to short? There are probably some small public regional banks but I can’t figure out who. I was recently told to take a look at Fifth Third Bank but I haven’t done so yet. I missed my bid on Countrywide puts by pennies when the stock was at $44 and it has haunted me since. I don’t want to miss this opportunity…

Thanks in advance for everyone’s thoughts,

Posted by Jeremy R | Report as abusive

Time to emigrate. The USA is done. Canada and Europe will suffer as well, but they and the better parts of Asia have systems that are better equipped to community decisions. The legacy clown special interest parts of AMerica, basically broken down into the races, with the rural yokel idiots fightring with the urban whites, with anger going in every direction, will probably prevent a solution. America has come together in the past, but maybe not this time. Besides, is there any possible way to pay off this debt at all levels other than utter destruction of most elite wealth or the dollar? There is no other way. THe elites are trying to put off the day of reckoning and maybe start a war, but that isn’t going to work this time either. Maybe a mass flu, mixed with a complete financial imposion, and introduction of a new currency. Hard to say.
Maybe all this debt doesnt matter as much as we doomers think.

Posted by Jackson Wallace | Report as abusive

[…] The CRE disaster […]

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